Many investors focus on growing their net worth by managing the asset side of their personal balance sheets. However, optimizing the liabilities side of their balance sheets can be just as important when trying to achieve financial goals. 

Using debt as part of an overall wealth strategy can help investors maintain and grow their net worth.

Investors with mortgage or investment loan interest may qualify for significant tax deductions which may reduce the net cost of borrowing and potentially extend investment portfolio growth. 

Mortgage Loans

When the Tax Cuts and Jobs Act was passed in December 2017, the home mortgage interest deduction limit was lowered from $1,000,000 to $750,000 for homes purchased after December 16, 2017. U.S. taxpayers may now deduct residential mortgage interest on up to $750,000 of principal balances secured by one primary and one secondary residence ($375,000 in the case of married taxpayers filing separately)[1]. Mortgage interest is deductible only if it is acquisition indebtedness; that is, if the loan proceeds are used to acquire, construct, or substantially improve the qualified residence which secures the loan. A substantial improvement is defined by the Internal Revenue Service (IRS) as adding value to the home, such as a kitchen remodel; prolonging the home’s useful life, such as replacing the roof; or adapting the home to new uses[2].

Home Equity Loans

Despite the 2018 changes to the rules regarding deductibility of home mortgage interest, in some circumstances, interest paid on home equity loans may still be tax deductible. The interest may be deductible if the home equity loan proceeds are used to buy, build, or improve the U.S. taxpayer’s primary or secondary residence as long as the combined mortgage and home equity debt does not exceed the $750,000 aggregate limit.[2] However, beginning in 2018, U.S. taxpayers may not claim a deduction for interest paid on home equity indebtedness when the proceeds from the loan are used for purposes other than substantially improving the residence.

Investment Loans

Investors may be able to deduct the interest paid on loans where the proceeds are used to acquire taxable investments.[3] U.S. taxpayers may be able to deduct such interest costs up to the amount of net investment income recognized from those taxable investments in that tax year.[4]

Deductibility as an investment expense requires the ability to trace the proceeds of the loan to the qualifying activity. 

For example, the proceeds from an investment loan must be traceable to a taxable investment portfolio in order for the resulting income to be deductible. In addition, the taxpayer must itemize in order to claim this type of deduction, foregoing application of the standard deduction. The table below (Table 1) provides some examples.[5]

Table 1: Benefits and Considerations of Investment Loans

Benefits Considerations
  • Interest deductibility is uncapped: 
    Unlike the mortgage interest deduction, there is no limit to the amount of interest you can deduct as long as the investment income is at least as much as the borrowing costs.

  • Deductions can be carried forward: 
    If the interest cost exceeds the investment income during the year, the deduction can be carried forward indefinitely.
  • Investment Types:
    Investments must be taxable in order to claim the deduction. For example, a tax-exempt municipal bond portfolio would not qualify.

  • Income Types:
    Income qualifying for the deduction includes interest, dividends, annuity income, and royalties; qualified dividends and net capital gains may be included by election on Form 4952. By making the election you forego the lower tax rate that normally applies to such income in order to increase investment income.

  • Entity Treatment:
    Special rules apply for entities including limited liability companies, limited partnerships and operating businesses.

Considering a Tax Efficient Strategy

There are many considerations to weigh when structuring debt as part of a tax efficient investment strategy. It is important to not only consult with your tax advisor in order to optimize potential tax benefits but also with your banking advisor who can assist in structuring your liabilities as part of a broader wealth management plan.

Borrowing for Tax Efficiency Examples

Example 1:

An individual is interested in acquiring a $3 million home and is considering financing the purchase of the residence. The individual, in consultation with financial and tax advisors, should consider the following:

Option #1: Mortgage Interest Deduction ($750,000)

If the individual obtains mortgage financing for the entire $3 million purchase price, the individual can only deduct interest attributable to $750,000 of the mortgage debt, due to limitations on qualified interest deductions.

Option #2: Investment Interest Deduction (uncapped)

If the individual has sufficient available excess liquidity[6] to purchase the home, there is an alternative strategy. At a subsequent date after a cash purchase of the home,[7] the individual could borrow $1.5 million via cash-out mortgage and invest the loan proceeds in taxable securities. The individual could deduct interest paid on the loan as an investment interest expense, up to the amount of income from the investment. Excess interest expense can be carried over to future tax years if the investment income is less than the interest expense.

Example 2:

The client implements a tax efficient levered investing strategy using an unencumbered property:

The client has an unencumbered property valued at $3 million and obtains a cash-out refinance for $1.5 million. The individual then uses the $1.5 million in proceeds from the cash-out refinance to invest in taxable investments. The individual could deduct interest paid on the loan as an investment interest expense, up to the amount of income from the investment. Excess interest expense can be carried over to future tax years if the investment income is less than the interest expense. The individual would not be able to claim the interest paid as a mortgage interest deduction, since the proceeds of the loan were not used to buy, build, or improve the home.