Knowing the tax rules regarding interest expense can help investors avoid costly mistakes.
In late 2008, the Federal Reserve Board announced it was lowering interest rates to near 0% as a way to combat the high unemployment rate of that time. That change created an opportunity for those looking to borrow money to do so at very little cost, which not only allowed businesses to enact expansion plans, but also helped fuel a rebound in the housing market as homes became more affordable to individuals.
Since that time, it's been a guessing game for economists to predict when interest rates will begin to rise. At its April meeting, the Fed indicated it may be at least the third quarter before it considers a rate increase. Meanwhile, consumer lending rates aren't at 0%, but they're low enough to continue enticing those who want to borrow to do so. When you add in that the interest paid is tax deductible, it makes borrowing even more enticing.
Or is it deductible?
In talking with advisers and investors, it's clear there's a lot of misunderstanding regarding the rules on deducting the interest paid on a loan. Many borrowers assume that as long as debt is secured by an investment portfolio, the interest on that loan is deductible. In fact, that's not the case, thanks to something called the interest tracing rule — a rule that basically says the deductibility of interest paid on a loan is determined by the use of the loan proceeds, not what secures the loan.
Say, for example, you have a client who uses their investment portfolio as security for a loan. The client may receive a statement from the brokerage firm referring to the “margin interest” they paid, but that interest isn't automatically deductible. For margin interest to be deductible, the loan proceeds must have been used to purchase property held for investment — meaning property that generates interest, dividends or an annuity, or that produces a gain or loss upon its sale. In addition, the investment can't produce tax-exempt income, so while buying stock, corporate or government bonds, or some mutual funds is an investment for these purposes, buying municipal bonds is not.
If the margin loan proceeds are instead used for non-investment purposes — such as to purchase a car, pay for a vacation or make a gift — it falls in the category of personal interest. Personal interest is never deductible for tax purposes, regardless of how the debt is secured.
Even if the interest is considered deductible investment interest, it doesn't mean the borrower will automatically get a tax benefit for the expense. First, the taxpayer must itemize their deductions; those who claim the standard deduction get no tax benefit from the interest.
Secondly, investment interest can only be deducted to the extent the borrower has net investment income. Investment income is generally defined as taxable interest, nonqualified dividends (meaning dividends taxed as ordinary income), annuities, royalties and short-term capital gains. If the interest expense exceeds net investment income, the excess can be carried over to the next year.
Why aren't qualified dividends or long-term capital gains considered investment income? The tax code figures taxpayers already get a break on that income by it being taxed at a lower rate. They can elect to include those items as investment income in order to offset it with the interest expense, but they must forgo that lower tax rate and instead allow it to be taxed as ordinary income. In other words, investors have to decide if it makes sense to use the interest expense now to offset income that otherwise would be taxed at 15%, or carry it into the future to offset income taxed at a higher rate.
Another approach some investors try is to use margin in place of, or to supplement, a traditional mortgage. For those investors, a bank loan may not be feasible because of other credit issues, or they're trying to avoid fees associated with a larger traditional mortgage. Instead, they hope to deduct the interest on the margin loan as mortgage interest.
Here again, the interest tracing rules come back to bite the investor. A personal residence (primary or secondary) is not considered an investment, and therefore the interest on the loan can't be deducted as investment interest. It also can't be deducted as mortgage interest, as the first requirement under those rules is that a mortgage must be secured by the home itself.
The point of this isn't to say that margin loans are a bad thing. Borrowing, used appropriately, can be a great way to participate in otherwise unavailable investment opportunities. However, advisers must be careful about touting the tax benefits of those loans without knowing their clients' full tax situation.
Tim Steffen is director of financial planning for Robert W. Baird & Co. Follow him on Twitter .