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Advantages of Tax-Aware Borrowing

5 Minute Read

Anyone who has purchased a home is well aware of the tax benefits of deducting the mortgage interest to offset part of their income tax liabilities.  However, with the passage of the Tax Cuts and Jobs Act in 2017, those benefits were reduced when the allowed interest deduction was decreased from $1,000,000 to $750,000 of acquisition indebtedness. This change, in addition to rising real estate values, severely curtailed the income tax benefits for  high-net-worth families.

But taxpayers who have a good understanding of investment loan interest rules might be able to lower their federal and state tax liabilities while improving their cash flow.

Understanding interest tracing 

Deductibility of a loan is often traced to how the loan proceeds are utilized. Loan interest on the purchase of a qualified residence is deductible if the loan proceeds are used to build, acquire or make capital improvements on the residence. If the loan proceeds are not used for these purposes, then loan interest will not be deductible.

Taxpayers who have a good understanding of investment loan interest rules might be able to lower their federal and state tax liabilities while improving their cash flow.

Similarly, loan interest paid on money borrowed to make taxable investments may be generally deductible against the net investment income earned by the taxpayer. As an example, a taxpayer wants to buy a new home for $5 million. The taxpayer currently has an investment account valued at $10 million. If the taxpayer received a loan of $4 million for the home purchase, interest associated with $750,000 will be deductible. But the larger portion of the interest associated with $3.25 million ($4 million less $750,000) will not be deductible.

A second option would be for the taxpayer to obtain a loan for $750,000 and personally pay the remainder of the purchase price by selling a portion of their investment account. The taxpayer would then be able to get the full deduction of the interest on the loan, but have less money in their investment account. This could potentially result in a negative impact on their long-term net worth.

A third, although somewhat more complex, option would be for the taxpayer to do the second option, but take out a loan against the investment account and then use the loan proceeds to invest in marketable securities. Assuming that an investment loan of $3.25 million can be obtained, they would then be able to maintain a similar investment account balance, yet fully deduct the interest on both the mortgage loan and the investment loan.

Key points to consider:

  • In order to benefit from these deductions, the taxpayer must itemize their deductions.
  • Investment interest is deductible against net investment income, which includes income from taxable stocks and bonds, taxable interest, non-qualified dividends, annuity income, royalties and short-term capital gains.
  • For purposes of deductible investment interest, net investment income does not include qualified dividends and long-term capital gains.
  • Unlike the mortgage interest deduction, there is no cap or limit to the deduction as long as the investment income equals or exceeds your borrowing costs.
  • For tax years 2018 through 2025, no investment expense other than the investment interest deduction is allowed.
  • Investment expense in excess of investment income is carried forward and can be treated as interest expense in the next tax year.

Tax-aware borrowing has significant advantages, but also requires careful consideration before moving forward with the strategy. The choice of any tax approach should always begin by consulting with your tax, legal and investment advisors. 

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This is a publication of The Private Bank at MUFG Union Bank, N.A. (the Bank). This publication is for general information only and is not intended to provide specific advice to any individual. Some information provided herein was obtained from third-party sources deemed to be reliable. The Bank makes no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bears no liability for any loss arising from its use. Wealth planning strategies have legal, tax, accounting and other implications. Prior to implementing any wealth planning strategy, clients should consult their legal, tax, accounting and other advisers.