Which is more tax-effective: putting R1.5m in a unit trust or my access bond?

A reader asked:

“I currently have a R1.8 million bond on a property that is being let. The monthly rental covers the bond, rates, levy and insurance. I recently got an insurance payout of R1.5 million. The rental is declared to Sars on an annual basis.

“Which would be more tax-effective: investing the R1.5 million in a unit trust or placing the amount into my access bond? If I do the latter, would I be able to claim it back as capital investment on my property from Sars?”

Thank you so much for the question, which is in fact a commonly asked questions by clients. There are many factors to consider when determining the best option. To provide you with a more precise answer, it would be useful to know how much time you have left on your home loan and what interest rate you are being charged, but we will do our best to answer your questions as thoroughly as possible.

Firstly, with regard to the question about being able to claim your lump sum payment into your bond as a capital investment on your property, this would not be possible. If you were running your investment properties through a business entity and you used your own capital to finance repairs and/or make structural changes to the property, you could potentially write off those costs as an expense inside the business. But making an over-contribution towards your home loan is not seen as a tax-deductible contribution.

With regard to whether to invest the R1.5 million in a unit trust portfolio or inject it into your bond, there are a number of factors to consider, the first being what is referred to as ‘opportunity cost’. For the purposes of this response, we have assumed that you have a new 20-year bond at an interest rate of 7% per year. According to our calculations, the total interest you would pay on a R1.8 million bond over a 20-year period at a rate of 7% per year would be R1 550 000. Should you inject your capital of R1 .5 million into your home loan, you would be able to reduce the interest payable over 20 years by R1 290 000, which translates into a return on your investment of 3.15% per year over the next 20 years.

When considering the unit trust option, it is impossible to say with certainty whether you could generate a better return if you invested these funds into a unit trust portfolio. However, given the time horizon of 20 years, common advice would be to invest aggressively in equities to increase your chances of higher returns over the long term. While investment markets have underperformed in recent years, over the long term we expect equities to yield annual returns of around inflation plus 6% (9-11% depending on inflation).

Another consideration to factor into your decision-making process is that the low interest rate on your bond is unlikely to continue for an extended period of time. As the global crisis dissipates, we can expect the SA Reserve Bank to increase the repo rate which, in turn, would increase your bond rate – ultimately resulting in a bigger saving on interest should you inject the capital into your bond. On the other hand, the interest portion of your bond repayment on an investment property is a tax deduction in your hands. This means that, should you inject capital into your bond, you would need to consider that the forecasted interest payable over 20 years on an investment property is a tax deduction in your personal capacity.

A third option that you may want to consider is to use your capital of R1.5 million together with your access bond to reduce tax and boost your retirement funding. By putting the capital amount into your home loan, your monthly bond repayments would effectively pay off more capital rather than interest. At the end of each tax year, assuming you have the capacity, you can withdraw the maximum tax-deductible amount from your access bond and invest it as a lump sum in your retirement annuity.

This lump sum contribution into your RA would result in a reduction of your tax bill as you would qualify for a tax return on this contribution. Once you receive your tax return, you can put it back into your access bond. In doing so, you are retaining liquidity in your access bond, maximising tax-efficiency, and creating extra savings every year simply by moving your money between your home loan and your RA.

This article first appeared on Moneyweb and was republished with permission.