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October 2022
Knowing how to strategically structure a mortgage to ensure interest is deductible can help maximize tax alpha.
Mortgage Considerations
By utilizing mortgage proceeds judiciously, it’s possible to fund major expenses, keep assets invested in the market to create value, and increase the probability of achieving long-term goals and objectives. Furthermore, an understanding of the tax laws and benefits they provide through a properly structured mortgage can also create value by increasing tax alpha. Mortgage proceeds can be used in a variety of ways beyond solely buying a home or purchasing real estate. Some of the other uses, which are sometimes overlooked, include funding a trust, helping with short-term spending needs or investment opportunities, making tax payments, growing a business, or addressing unforeseen life events like divorce proceedings. Whether you decide to borrow or not typically depends on a number of factors, including:
- your sensitivity to borrowing
- the nature of your collateral
- your ability to cover the loan and pay for the costs of borrowing (e.g., interest expense)
- the intended use of your borrowed funds
Maximizing Tax Alpha
Structuring mortgages to get the maximum tax deduction on interest payments can lead to significant reductions in the cost of borrowing and increase total wealth. This requires 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 mortgage is structured and how the proceeds are used. Investors must also be aware of the interest tracing rules that can change the character of interest expense. Knowing how to strategically structure a mortgage is therefore critical to maximizing the tax alpha of using debt. While mortgages can be an effective tool to save on taxes, the way they are structured as well as how the loan proceeds are used determines what you can ultimately write off. For example, mortgages can be used to acquire a home, allowing homeowners to deduct qualified resident interest expense (up to $750,000 of mortgage interest), but a lesser-known strategy may be more advantageous in particular circumstances. You might fund your home purchase with cash and do a cash-out refinance afterward, using the proceeds for investing. This way you can write off interest expense as investment income as long as you can trace it back to a taxable investment. While this is often done with a line of credit, the cash-out refinance option provides the ability to achieve a fixed rate on an illiquid asset; and in some circumstances, it can be preferable from an overall cost perspective while providing additional flexibility.Maximizing Tax Alpha Structuring mortgages to get the maximum tax deduction on interest payments can lead to significant reductions in the cost of borrowing and increase total wealth. This requires 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 mortgage is structured and how the proceeds are used. Investors must also be aware of the interest tracing rules that can change the character of interest expense. Knowing how to strategically structure a mortgage is therefore critical to maximizing the tax alpha of using debt. While mortgages can be an effective tool to save on taxes, the way they are structured as well as how the loan proceeds are used determines what you can ultimately write off. For example, mortgages can be used to acquire a home, allowing homeowners to deduct qualified resident interest expense (up to $750,000 of mortgage interest), but a lesser-known strategy may be more advantageous in particular circumstances. You might fund your home purchase with cash and do a cash-out refinance afterward, using the proceeds for investing. This way you can write off interest expense as investment income as long as you can trace it back to a taxable investment. While this is often done with a line of credit, the cash-out refinance option provides the ability to achieve a fixed rate on an illiquid asset; and in some circumstances, it can be preferable from an overall cost perspective while providing additional flexibility.
Investment Interest Expense
Investment interest expense is interest paid on mortgage proceeds used for investing. This type of interest is generally deductible up to the amount of net investment income1 the taxpayer recognizes in any given year. There is no cap on how much they can deduct as long as their net investment income equals or exceeds their borrowing costs. Qualifying investment income that can be used for interest deduction includes:
- Interest
- Non-qualified dividends2
- Annuity Income
- Private Equity Investment Income
- Hedge Fund Income
Keep in mind that qualified dividends or net long-term capital gains do not qualify unless an election is made by the taxpayer.3 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 mortgage proceeds are used. Merely securing the mortgage with securities or a personal residence does not qualify the interest as investment interest. Rather, the proceeds have to be traced to the investments. Should the proceeds be used for more than one purpose, then the interest must be allocated to both purposes. Interest tracing rules provide opportunities to structure a mortgage so that interest can be deductible. Separately, if a taxpayer also generates tax-exempt income, additional limitations could apply as interest incurred to acquire or hold such investments would be non-deductible. For example, if tax-exempt investments are used as collateral for a loan, or the proceeds of borrowing are directly traceable to a tax-exempt bond portfolio, the IRS will determine that interest paid or incurred on that mortgage cannot be deducted. Additionally, if the taxpayer has an outstanding loan for taxable investments, but their aggregate investments also include tax-exempt securities, the IRS may deem the allocable portion of the taxpayer’s interest expense to the tax-exempt portion as nondeductible.
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.
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 interest rates higher than they were last year, but still low by historic standards, it’s more important than ever to manage your finances strategically. That’s why maximizing tax alpha with interest expense deductions is more important than ever. Customized financing can allow for convenient access to liquidity. Whether the objective is to grow a business or pursue an investment opportunity, the effective use of a mortgage is one way to seize an opportunity without disrupting a 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 minimize taxes and generate a return that is greater than the interest while providing the ability to generate liquidity without disrupting investment plans. Your dedicated BNY Mellon team can help develop and implement a comprehensive financing strategy that is tailored to unique tax, financial and personal situations. This strategy will also be aligned with long-term wealth plans through objective-driven asset/liability management and the use of our various financing options, competitive interest rates, and relationship pricing considerations.
Footnotes
1 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.
2 Dividends that do not qualify for the preferential 20% top tax rate.
3 Taxpayers can elect to include a portion or all qualifying dividend income and capital gains as investment income, but this may result in less marginal value from the deduction.
The information provided is for illustrative/educational purposes only. All investment strategies referenced in this material come with investment risks, including loss of value and/or loss of anticipated income. Past performance does not guarantee future results. No investment strategy or risk management technique can guarantee returns in any market environment. This material is not intended to constitute legal, tax, 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 the law in any area or of all of the tax, 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. BNY Mellon Wealth Management may refer clients to certain of its affiliates offering expertise, products and services which may be of interest to the client. Use of an affiliate after such a referral remains the sole decision of the client. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.
Mortgages, provided by BNY Mellon, N.A., are subjected to application and credit approval. NMLS# 764464
WPB-312319-2022-10-20