Tax Aware Borrowing

Geoffrey R. Berlin CFP® of J.P. Morgan says that two kinds of debt may qualify you for a substantial tax benefit on interest paid

Many high earners are reeling from the news that the new U.S. tax law that went into effect on January 1, 2018, capped aggregate deductions for state and local property and income taxes at $10K for joint filers.

But if you itemize, there are other personal deductions to be had. If your debt falls into one of two categories—mortgages or loans used to purchase taxable investments—you may qualify for substantial deductions on the interest you pay. That can be a very welcome benefit in high-tax states like California and New York.

In many cases, applying the rules of deductibility for mortgages and investment interest expense can allow borrowing to play an integral role in your overall wealth strategy. Many taxpayers find they are able to:

  • Lower their federal and state tax obligations
  • Improve their cash flow
  • Reduce their effective borrowing costs

For example, individuals in the top federal income tax bracket of 37% paying $100,000 of loan interest this year could, in theory, turn that into a $40,800 tax savings.1 They also may enjoy a tax break at the state level. 

Not all types of personal loans qualify for an interest deduction. There is no deduction for interest paid on car loans or credit card debt, for example. Similarly, you must be primarily liable for the debt to take a deduction for the interest paid. Acting as a guarantor on a loan, even if you make some of the loan payments, generally does not entitle you to an interest deduction.

Generally speaking, though, you will be able to deduct the interest you pay on mortgage interest and money borrowed for taxable investments. Of course, to get these deductions, you will have to itemize. Beyond that, here’s how it works:

Deducting Mortgage Interest

You may be able to deduct mortgage interest on up to $750,000 of principal indebtedness secured by one primary and one secondary residence.2

Before the 2017 tax overhaul went into effect, that number was $1M. Rest assured, there’s a grandfathering of mortgage indebtedness incurred before December 15, 2017; it’s still deductible up to $1M, which likely includes refinancing of that debt (subject to certain limits).3

Be careful, though. The IRS is tracking how you use the loan proceeds and will enforce this important rule: Mortgage interest on a qualified residence is deductible only if the loan proceeds are used to build, acquire, or make capital improvements on the property in question.

[To read more of Geoffrey R. Berlin, CFP®’s thought leadership click here]

Loans for Taxable Investments

Interest paid on the money you borrow for taxable investing is generally deductible up to the amount of the net investment income you recognize in any given year.

The investment income that qualifies for the interest deduction generally includes:

  • Interest
  • Dividends that do not qualify for the preferential 20% top tax rate
  • Annuity income
  • Certain royalties

It does not include qualified dividends or net capital gain—unless you make that choice. (See “Weigh your choices,” below.)

Any rent you receive is generally not considered to be investment income.4

Special rules apply to passive activities. This type of investment, generally made through a limited partnership or limited liability company, is an equity interest in an operating business in which the investor does not materially participate. The current deduction of interest and other related passive activity expenses is limited to passive activities income.

Minimize Your Tax Bill

The deduction for investment interest may do more than the mortgage interest deduction to minimize your tax bill. 

That’s because, unlike the mortgage interest deduction, there is no cap on what you may deduct for investment interest—so long as your investment income equals or exceeds your borrowing costs.5

If the interest paid is more than you earn in one year, you can carry the excess deduction forward indefinitely to future years. One key ­caveat: You must use the loan proceeds to invest in something taxable. However—saving grace—­investment earnings do not have to be taxable in the year in which you take the deduction.

For example, an investor may borrow to buy small-cap stock that doesn’t generate a dividend. In such cases, the interest could not be deducted against income from this particular small-cap stock, because none was realized. However, it may be deducted against other sources of investment income in the investor’s portfolio.

What’s not allowable is for you to borrow to buy tax-exempt investments and then claim the interest as a deduction. Here, too, the IRS will be watching carefully. 

So consider some good financial hygiene: Think about depositing any borrowed funds in a segregated account. That way, if you use the funds for a tax-deductible purpose, such as purchasing taxable securities, there will be no commingling of the acquired assets with other assets.

The deduction for investment interest may do more than the mortgage interest deduction to minimize your tax bill.

Weigh Your Choices

The law excludes qualifying dividend income and capital gains from the definition of investment income that qualifies for an interest deduction; this therefore reduces the investment interest that can be deducted in any year. However, taxpayers can elect to include qualifying dividend income and capital gains in investment income if they forgo the lower tax rate on those dividends and/or capital gains.

Therefore, below certain levels of investment income, you as a borrower will have a choice:

  • Deduct more investment interest
  • Or be subject to a lower tax rate on dividends or capital gains, and carry excess investment interest forward for use in a subsequent year.

The American Taxpayer Relief Act of 2012 fixed the tax on qualifying dividends and long-term capital gains at a maximum rate of 20%, rather than at the maximum ordinary income tax rate (now 37%).

Borrowers also should consider the Medicare surtax on unearned income in their decisions. This surtax, which imposes an additional 3.8% tax on modified AGI6 over $250,000 for married couples filing jointly, also can be reduced by deducting investment interest.7

It’s a lot to consider, but well worth the ­effort—and the conversations with your advisors—to make sure you take proper advantage of this potential tax benefit. end

The article is intended for informational purposes only; it is not intended as an offer for any specific product or service.  C-Suite Quarterly (CSQ) is not affiliated with JPMorgan Chase & Co. The article contains the views of a J.P. Morgan employee, which may differ from the views of J.P. Morgan Chase & Co., its affiliates and employees.  The views and strategies described may not be appropriate for everyone.  Certain information was obtained from sources we believe are reliable, but we cannot verify the accuracy of the content and we accept no responsibility for any direct or consequential losses arising from its use. For specific guidance on how this information should be applied to your situation, you should consult a qualified professional.

[For more on J.P. Morgan’s approach to Private Banking click here]

1. Includes $37,000 from income tax savings and $3,800 from Medicare surtax savings. Deductions discussed in this article consider the regular tax calculations for individuals; however, the remarks are generally applicable to alternative minimum tax (AMT) calculations as well, albeit at a reduced marginal tax rate of 28%.
2. The 2017 tax act repealed the ability to deduct interest on $100,000 of home equity indebtedness. This change is scheduled to sunset after 2025, as will the reduction in the mortgage deduction limit from $1M to $750,000.
3. Taxpayers who entered into binding contracts before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and who purchased the residence before April 1, 2018, are also grandfathered up to the $1M limit.
4. Income from private equity investments and hedge funds may also qualify.
5. Similarly, as a general matter, interest expense on debt incurred in connection with the trade or business of a material participant may be fully deductible.
6. Modified AGI is AGI plus the amount excluded from income as foreign earned income, net of certain disallowed deductions and exclusions.
7. Deductibility for Medicare surtax is based on the Treasury Regulation ­under Section 1411.
The article is intended for informational purposes only; it is not intended as an offer for any specific product or service.  C-Suite Quarterly (CSQ) is not affiliated with JPMorgan Chase & Co. The article contains the views of a J.P. Morgan employee, which may differ from the views of J.P. Morgan Chase & Co., its affiliates and employees.  The views and strategies described may not be appropriate for everyone.  Certain information was obtained from sources we believe are reliable, but we cannot verify the accuracy of the content and we accept no responsibility for any direct or consequential losses arising from its use. For specific guidance on how this information should be applied to your situation, you should consult a qualified professional.

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