Tax aware borrowing

Affluent home buyers can often make a choice in how they finance the purchase of a primary or secondary residence. The use of existing liquidity in coordination with a traditional mortgage may maximize tax benefits and create opportunities for positive arbitrage.

Two common structures for borrowing to minimize taxes

1.  Traditional mortgage with limited deductibility

This option involves directly taking out a $10 million mortgage for a home purchase. However, under this strategy, only the interest on the first $750,000 of the mortgage is tax-deductible or for mortgages secured before December 16, 2017, the deductible interest extends to the first $1 million. While the mortgage fulfills the immediate  need for liquidity, the tax benefits are constrained by the capped deductible amount.

2. Leveraging post-purchase liquidity forfull deductibility

This option operates on a different timeline. Initially, $10 million ofliquidity is used or created to facilitate the purchase of the property without a mortgage. After the property acquisition, you can obtain a subsequent $10 million loan, potentially using the property as collateral. The crucial distinction here is that these loan proceedsare then channeled directly into taxable securities or investments.This includes passive activities like limited partnerships (LPs) orlimited liability companies (LLCs) where the investor isn’t materiallyinvolved. Income from private equity, including carried interest, falls under this category, making this strategy particularly appealing to private equity professionals.

The deductible is typically allowable up to the net investment income recognized within a given tax year. Income from long-term capital gains interest, dividends and rent doesn’t usually qualify, except in specific instances.

To leverage investment interest deductions effectively, certain guardrails must be observed to optimize benefits. These include:

No cap on investment interest deductions. The investment interest deduction comes with no upper limit other than it is limited to the extent there is deductible investment income for a given tax year. Any unused interest expenses can be carried forward indefinitely. The only caveat is the loan proceeds must be invested in something taxable in the year in which the deduction is taken.

Strategic investment choices. Choosing investments in non-dividend paying stocks such as small-cap or tech stocks that don’t generate immediate income can allow you to use the interest expense deduction against other sources of investment income in your portfolio, such as returns from private equity. This applies even to investors not directly employed at private equity firms but earning income through LPs.

Avoidance of non-taxable investments. Loan proceeds should be strictly invested in taxable avenues. Investing in non-taxable investments, like municipal bonds, negates the interest deduction.

Segregated account tracking. Maintaining a separate account solely for borrowed funds simplifies tracking and provides clear evidence not only of their allocation toward taxable investments but also the clear direct distribution of loan proceeds to an investment, reducing the chance of disputes or misinterpretation.

Careful timing. To avoid IRS scrutiny, demonstrate clear intent by avoiding activities that might cast doubt on the investment purpose. Purchasing non-taxable investments soon after borrowing or using tax-exempt investments as collateral may raise red flags.

While this strategy offers substantial benefits, tax-aware borrowing has several complications to be weighed:

Tax rate considerations. Long-term capital gains (LTCG), which are traditionally excluded from investment income, are typically taxed at a lower rate (20%) compared to the maximum ordinary federal income tax rate (37%).¹The law excludes qualified dividends and long-term capital gains from description of investment income. By converting capital gains to ordinary income to offset interest expenses, careful calculation is crucial to ensure overall tax benefits. As long as your interest expense is high enough to offset your regular tax rate, it’s sufficient. It must be emphasized that carried interest and other types of income that receive LTCG treatment from LPs do not suffer this issue. 

Medicare surtax. Electing to forgo the lower tax rate on capital gains might trigger the Medicare surtax of 3.8% on net investment income for taxpayers with adjusted gross income exceeding $200,000 for single filers.²

Optimizing tax efficiencies

Tax-aware borrowing redefines real estate investment deductions by converting mortgage interest deduction limitations into investment expense deductions that don’t have the same hard cap as the mortgage deduction. Redirecting borrowed funds directly into IRS- acceptable investments offers significant tax advantages, reducing federal income tax and cutting borrowing costs. Understanding your options optimizes tax efficiency and maximizes real estate impact amid tax complexities.

Feel confident about your future

BMO Wealth Management—its professionals, its disciplined approach, its comprehensive and innovative advisory platform—can help provide financial strategic planning. For greater confidence in your future, call your BMO Wealth Management Advisor today.