Many investors focus on managing their assets, carefully choosing and monitoring the allocations within their portfolios. 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 portfolios.

Investors with mortgage or investment loan interest may qualify for significant tax deductions, reducing the net cost of borrowing and potentially extending 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 only deductible 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 recent changes to tax laws in early 2018, interest paid on home equity loans may still be tax deductible. U.S. taxpayers may not claim a deduction for interest on home equity indebtedness, which is when the debt is secured by a residence and the proceeds used for purposes other than substantially improving the residence. However, if the home equity loan proceeds are used to buy, build, or improve the U.S. taxpayer’s primary or secondary residence, the interest may be deductible, as long as the combined mortgage and home equity debt does not exceed the new $750,000 aggregate limit[2].

Investment Loans

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

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 if so elected in Form 4952, the effect of this election is forgoing a lower tax rate in order to increase investment income
  • Entity Treatment:
    Special rules apply for entities including LLCs, LPs and operating businesses

Each of the above tax deductions relies upon the ability to trace the proceeds of the loan to the qualifying activity in order to determine deductibility. 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 the deductions, therefore foregoing the standard deductions.

Considering a Tax Efficient Strategy

There are many considerations to weigh when structuring debt as part of a tax efficient strategy. It is important to consult with your tax advisor in order to optimize potential tax benefits and with your banking advisor who can assist in structuring your liabilities as part of a broader wealth management plan.

Borrowing for tax efficiency

Example 1:

A client is interested in acquiring a $3MM home and is considering financing the purchase of the residence. The considerations for the financing options and the associated tax implications are below:

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

The client obtains mortgage financing for the $3MM home but can only deduct interest on up to $750,000 of mortgage debt, due to limitations on qualified interest deductions.

Option #2: Investment Interest Deduction (uncapped)

Alternatively, the client could use excess liquidity to purchase the home. At a subsequent date after the purchase of the home, the client could borrow $1.5MM via cash-out mortgage to invest in taxable securities. The client could deduct interest paid on the loan as an investment interest expense, as long as the investment income is at least as much as the borrowing cost. With this scenario, there is no limit to investment interest deduction and excess interest expense can be carried over to future tax years if the investment income is lower 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 $3MM and obtains a cash-out refinance for $1.5MM. The client uses the $1.5MM in proceeds from the cash-out refinance to invest in taxable investments. With this strategy, the client could deduct interest paid on the $1.5MM loan as investment interest expense. The client 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, but the investment interest expense would be uncapped and have the potential to carry over to future tax years.