Tax Efficient Borrowing Strategies

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

The Tax Cuts and Jobs Act lowered the home mortgage interest deduction from $1 million to $750,000 for homes purchased on or 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, meaning 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 an improvement that adds value to the home, prolongs the home’s useful life, or adapts 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.^[3] 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.^[4] U.S. taxpayers may be able to deduct such interest costs up to the amount of net investment income in that tax year.^[5] 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. Table 1 on page 2 provides some examples.^[6]

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 against which the deduction may be taken includes interest, dividends, annuity income and royalties; qualified dividends and net capital gains may be included by election on IRS 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.

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 against which the deduction may be taken includes interest, dividends, annuity income and royalties; qualified dividends and net capital gains may be included by election on IRS 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 liquidity7 to purchase the home, there is an alternative strategy. At a subsequent date after a cash purchase of the home,8 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 the individual’s net investment income. Excess interest expense can be carried over to future tax years if net 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 net investment income.

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.

For more information, please contact your PNC Private Bank advisor.

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Important Legal Disclosures and Information

1. Mortgage interest deduction (IRC Sec. 163 (h), as limited for tax years 2018 through 2025 by IRC Sec. 163(h)(3)(F). For specifics see IRS Publication 936, Home Mortgage Interest Deduction, and speak to your tax advisor. Id.

2. “Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity).” IRS Publication 550, Investment Income and Expenses.

3. For specifics see IRS Publication 550 and speak to your tax advisor. Qualified dividends are not included in investment income unless an election is made to include them, in which case the amount included is not eligible for the lower tax rates applied to qualified dividends. Net capital gain is not included in investment income unless an election is made to include it, in which case the amount included is not eligible for the lower tax rates applied to net capital gains.

4. IRS Publication 550, Investment Income and Expenses.

5. Liquidating securities to generate cash sufficient to pay the purchase price could result in a capital gain and a resulting income tax. Consult your financial and tax advisors to determine the consequences of selling portfolio assets.

6. Failure to allow sufficient time to elapse between the purchase of the home and borrowing could cause the IRS to invoke the step transaction doctrine, thereby treating the borrowing used to invest in securities as a home equity loan limited by the mortgage interest deduction rules.

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