Strategic Leverage and Maximizing Tax Alpha

The effective use of credit is one way to seize an opportunity without disrupting your long-term investment plan. Your wealth manager can also help you create value by increasing tax alpha.

With interest rates at historical lows, leverage has become more attractive as a way to generate cash flow and fund various opportunities, such as a home, investments, or a business.  Knowing how to strategically structure your debt to ensure that the interest is deductible is also important as a way to maximize your tax alpha from the use of leverage.

By utilizing leverage judiciously, such as a mortgage or a secured line of credit, you can enable the equitable funding of major expenses, keep assets invested in the market to create value, and increase the probability of achieving your long-term goals and objectives. Furthermore, an understanding of the tax laws and benefits they provide through properly structured leverage can also create value by increasing tax alpha.  With market prices down and interest rates at historic lows, now is a great time to consider what your strategic lending options may be.

Credit and Lending Considerations

There are a number of reasons why people use leverage.  Maybe it is to buy a home or purchase real estate, finance life insurance premiums, help them with short-term spending needs or investment opportunities, make tax payments, or grow a business.  Whether a person borrows or not typically depends on a number of factors including, their sensitivity to borrowing, the nature of their collateral, their ability to cover the loan and pay for the costs of borrowing (i.e., Interest expense), and the intended use of their borrowed funds. 

Your dedicated BNY Mellon team will work with you to develop and implement a comprehensive financing strategy that is tailored to your unique tax, financial and personal situation.  This strategy will also be aligned with your long-term wealth plan through objective-driven asset/liability management and the use of our various financing options, competitive interest rates, and relationship pricing considerations.

Interest Rates

As noted, your appetite for borrowing is determined by a combination of considerations. One such consideration is the cost of carrying the debt, i.e., interest expense, and whether it makes financial sense over the long term.  When funds can be borrowed at a lower interest rate than the projected or potential return on an investment, or when the debt can offer benefits such as a mortgage’s tax deductibility, use of credit can make sense.  Currently, this unprecedented interest rate environment offers investors with an opportunity to borrow at incredibly low interest rates.

Maximizing Tax Alpha

Structuring your leverage to get the maximum tax deduction on interest payments can lead to significant reductions in the cost of borrowing and in turn increase your total wealth.  This requires having an understanding of how tax laws work regarding interest expenses as not all interest expense is deductible. The deductibility of interest expense depends on the character of the interest, which is determined based on how the loan is structured and what the proceeds are used for. Investors must also be aware of the interest tracing rules that can change the character of interest expense.  Knowing how to strategically structure leverage is therefore critical to maximizing the Tax Alpha from using debt.   

Personal Interest Expense

Personal interest expense is non-deductible.  Personal interest typically includes interest you pay on a credit card to buy personal items, such as clothes, food, and entertainment, or a loan used for the purchase of an automobile.

Qualified Residence Interest Expense

Qualified Residence Interest includes interest from a mortgage that is on a qualified residence owned by the taxpayer, such as a first and/or second home, and is either acquisition indebtedness, or for tax years beginning before 2018, home equity indebtedness.  For tax years beginning 2018 through 2025, home equity indebtedness is not deductible Qualified Residence Interest expense unless it otherwise qualifies as acquisition indebtedness and is within the deductibility limits.

Acquisition indebtedness is debt incurred in acquiring, constructing or substantially improving a qualified residence and is secured by that residence.  For acquisition debt incurred on or before December 15, 2017, the total amount of debt may not exceed $1,000,000 ($500,000 for a married taxpayer filing separately).  The $1 million limitation is grandfathered for debt incurred on or before December 15, 2017 or for the refinancing of such debt.  The amount that can be refinanced is limited to the principal amount at the time of refinancing.  For debt incurred after December 15, 2017, but before January 1, 2026, the total amount of acquisition indebtedness may not exceed $750,000 ($375,000 for a married taxpayer filing separately).  To the extent the debt exceeds the applicable limitations, a prorated portion interest expense is allowed and the excess is disallowed.  Unmarried taxpayers who co-own a home are each entitled to deduct mortgage interest on up to $750,000 of acquisition indebtedness.  There is no carryforward of such disallowed amounts.

Investment Interest Expense

Individuals generally can deduct investment interest expense to the extent of their net investment income. Investment interest expense is interest on debt allocable to property held for investment.  Net investment income is the excess of investment income over investment expenses.  Investment income generally means the sum of gross income from property held for investment purposes plus ordinary gains attributable to the disposition of such property so long as such amounts are not derived from the conduct of a trade or business.  Investment income also includes capital gains and qualified dividend income to the extent the taxpayer elects to treat such income as investment income.  Capital gains and qualified dividends for which the election is made, however, will no longer qualify for the favorable income tax rates.  Where a taxpayer also generates tax-exempt income, additional limitations could apply as interest incurred to acquire or hold such investments would be non-deductible.

Any investment interest expense not deducted in the current tax year is carried forward to the next taxable year, subject to the same limitation calculations.  The carryforward is indefinite while the taxpayers are alive. In addition, the allocation of interest expense to a particular class, such as investments, is dependent upon how the debt proceeds are used.  Merely securing the loan with securities does not qualify the interest as investment interest.  Rather, the loan proceeds have to be traced to the investments.  Should the debt proceeds be used for more than one purpose, then the interest must be allocated to both purposes.  The interest tracing rules provide opportunities to structure debt so that interest can be deductible.

Business Interest Expense

Interest expense on indebtedness allocable to a trade or business is generally deductible as business Interest.  Business interest is subject to limitations under the Tax Cuts & Jobs Act and passive activity loss rules, so one should be aware of those rules when structuring loans to qualify as business related. Businesses may also generate investment interest expenses.  Where there is material participation by the business partner/owner, the interest attributable to that person should not be subject to the investment interest expense limitations.

Summary

With customized financing, such as a secured line of credit, mortgage or commercial real estate financing, you gain convenient access to liquidity in the event you need it. Whether the objective is to pay off a large expense, grow a business or pursue an investment opportunity, the effective use of credit is one way to seize an opportunity without disrupting your long-term investment plan.

By utilizing BNY Mellon’s capital market assumptions and strategically applying leverage when the cost of capital is relatively low, we can help you minimize taxes and generate a return that is greater than the interest, while providing you with the ability to generate liquidity without interrupting your investment strategy so you can accomplish your individual goals and objectives. 

  • This material is provided for illustrative/educational purposes only. This material is not intended to constitute investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of all of the investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.

    Credit services, which are subject to application and credit approval, are provided by BNY Mellon, N.A., a wholly owned subsidiary of The Bank of New York Mellon Corporation. Member FDIC. Hedging strategies, which are subject to credit approval, are provided by The Bank of New York Mellon. Mortgage services, provided by BNY Mellon, N.A. are subject to credit approval.