The Basics of Leverage
April 13, 2005 by SMD
Leverage:
The financial advantage of an investment that controls property of greater value than the cash invested. Leverage is usually achieved through the use of borrowed money. [quote from here]
I want to run through an example of leverage. This example is driven by the fact that the leveraging is happening from inside a company [either a corporation or proprietorship]. So, in reality this example has two methods of accelerating your money combined.
Let’s say you use $25,000 of your company’s funds to purchase a property worth $250,000. This is the first and most obvious use of leverage, since you have only used a 10% payment to control 100% of an asset. Most people are familiar with this technique since it is used to purchase most residential homes.
But it gets better: depreciation. Since you purchased the asset within a business and depending on the type of asset, a certain percentage will be depreciable. That’s a percentage of the full amount! Here’s an example. Let’s say you are entitled to a 3% depreciation on the $250,000 property per year. That amounts to a $7500 tax write-off in year one. If you are being taxed at a 30% rate (30% of 7500/25000) it will yield a direct saving of $2250. That represents a 9% return on your original investment of $25,000 just in the depreciation on the property. This is thanks to the fact that the tax break occurs against the leveraged amount of the entire investment.
Leverage advantage #3. You get the appreciation on the full amount of $250,000. So if the property goes up 10% you have made $25,000 (minus taxes if applicable) which represents a 100% return on the original investment. In addition, if the property goes down in value, then, because the investment is a business asset, the loss becomes tax deductible as well.
So clearly, in the case of real estate leveraging is a great tool. When combined with holding assets in a business structure and proper tax planning it becomes a very powerful financial accelerator.
Final thought:
“If you’re working hard physically and not getting ahead financially, then you’re probably someone else’s leverage!” -RichDad
Leveraging can also be used in other ways such as options trading in stocks and currency.
Comments
Feel free to leave a comment...
and oh, if you want a pic to show with your comment, go get a gravatar!