When will the Fed take their foot off the gas? Have we hit a global recession? Can I even afford to take out a loan?
As a comprehensive wealth advisor, clients bring me questions like these every day. The answers are rarely simple, but the crux is this: don’t be scared, be prepared. And in uncertain times, solid preparation often involves creativity.
Loan rates are through the roof, so researching alternatives is a wise move. And in the eyes of the IRS, not all debt interest is created equal; some loans are eligible for tax deductions.
One interesting alternative to traditional loans is to leverage the securities in your stock portfolio into borrowing power – and possible tax benefits. If you own a diversified investment account and have borrowing needs (emphasis on diversified), you could consult with your financial advisor about the pros and cons of adding a borrowing feature (like a margin loan) to your investment account.
Let’s be clear – I want you to be scared of this option. Using your securities as collateral is a sophisticated strategy that requires careful planning and consideration. That said, a number of my own clients have used smart borrowing strategies to accomplish goals like financing a home, paying off a car – and even investing in more securities.
People often think of relying on the equity in their homes as a savvy move to fund various purchases, which may not be deductible. Moreover, for homes purchased after 2017, only the interest on loans up to $750,000 is tax-deductible – and only if you itemize.
While margin interest rates fluctuate and are generally a bit higher than mortgage interest rates, some advisory firms are able to negotiate competitive rates for their clients. And in certain circumstances, margin interest may provide a healthier tax deduction than other borrowing options.
Below are 3 interesting scenarios:
Let’s assume “Julie” lives in California and is in the highest tax bracket – paying a total of about 50% between state and federal taxes. (A bracket in which her advisor should leave no stone unturned). She also owns a $2MM investment account.
Scenario 1: Julie buys a house
Julie wants to buy a $1.5MM home. After putting $300k in cash down, she needs to finance $1.2MM.
Julie could take a traditional mortgage of $1.2MM at 7% – but only the interest on the first $750k is tax-deductible. This means Julie would pay $84k in interest, but could deduct only $45,000.
So, I might advise her to move money into various buckets to take advantage of the interest deductions. This is where it gets interesting:
Here, Julie takes a traditional mortgage for only $750,000 at 7%.
Her firm offers a preferred margin rate of 5%*. So, instead of using her home to secure the remaining amount, she borrows $500,000 through a margin loan and buys additional securities using her investment account as collateral – a step that keeps the margin loan in compliance with IRS borrowing rules. Later on, she sells securities for no gain and funds the remaining $500,000 purchase.
In this scenario, Julie would be able to deduct all of her interest, leaving her with an effective borrowing rate of about 2.9% after the tax deduction. It is important to note that the margin rate is variable and the mortgage rate is fixed.
Scenario 2: Julie buys additional stocks
Julie wants to take advantage of an opportunity to buy an investment at $75,000 that yields 8% – but she doesn’t want to use up her cash, which she keeps for emergencies. Instead, she borrows the money on margin at 5%* and receives a tax deduction so her net borrowing cost is 2.5%.
Scenario 3: Julie buys a commercial property
Julie has a great opportunity to buy a commercial property for her business for $300,000. The rates and terms she’s quoted for commercial loans aren’t great, there are big prepayment penalties, and she fears that by the time she gets pre-approved for the loan, the property will be gone.
Julie can use margin (including the margin loan she used for her home, she’d owe $800,000 altogether – still well under the $1MM limit of her advisory firm). And because Julie used the funds to purchase a business property, the interest here is also completely deductible. Once the property is purchased, she could also look into obtaining a second mortgage on her home to replace the margin loan if she wanted a fixed rate. In this instance, the fixed rate mortgage would also be completely tax deductible and avoid the prepayment penalties of a commercial loan.
Be sure to consider the risks and the fine print
As we mentioned, leveraging your portfolio assets is a sophisticated borrowing strategy with inherent risks, and requires significant planning and oversight. No one wants a margin call – this is when your portfolio falls below the required threshold (again, usually 50%), and you’re required to pay to bring it back up. To reduce this risk, it’s important to ensure your portfolio is well-diversified; if you’re overly concentrated in one area and we have another 2008 – you’ll want to do a stress test. Being well-balanced between sectors and asset classes can reduce your chances of a margin call.
*It’s also very important to know that interest rates on margin loans and pledged asset lines of credit are variable and will fluctuate.
Remember, margin loans are expert territory, so consult with your financial advisor and your tax advisor to be sure you understand how the rules and regulations apply to you.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.