As interest rates increase, so does the allure of optimizing your U.S. income tax deductions. But be careful, the devil is in the details.
Are you a U.S. taxpayer looking to buy a new home? Expand your portfolio? Grow your business?
If you’re interested in financing for these purposes, you’d be well advised to look into the tax strategies that could reduce the real cost of borrowing—especially as interest rates in general and mortgage rates in particular keep rising.
Interesting opportunities are available because U.S. tax laws do not treat all forms of interest equally. Individuals are allowed to deduct the interest on their:
- Qualified residential home mortgages (to a certain amount)
- Loans used to make taxable investments
- Loans taken for capital commitments to an operating trade or business1
But, as with most matters concerning U.S. taxes, the devil is in the details. So here, we offer a quick guide to key tax-savvy borrowing strategies, including rate swaps used to lock in lower rates.
Rates are on the rise
Rates have risen significantly since the first quarter of 2022, and when rates are higher, how you borrow may make an ever greater difference to your real, final costs.
Mortgages: How much interest can you deduct?
U.S. taxpayers are allowed to deduct the interest on up to $750,000 of the principal indebtedness that is secured by one of their primary and one of their secondary residences.
This deduction is also available for mortgage refinancing (subject to certain limitations, so be sure to consult your tax advisor).
The rules for older mortgages are slightly different: Mortgage interest due on debt incurred before December 16, 2017, is deductible on up to $1 million of indebtedness. This deduction is also for refinancing debt (again, subject to certain limits).2
Note that the mortgage deduction is available only if loan proceeds are used to build, acquire or make capital improvements on a qualified property.
Also, be very careful to ensure that your loan proceeds can be traced to an identifiable deductible use (the so-called “tracing doctrine”) and that you maintain evidence of this use. Consult your tax advisor to confirm you have the proper documentation.
Borrowing to make taxable investments
As good as the mortgage interest deduction might be, it does not offer a lot of help to those who are buying a more expensive home. For them, it’s helpful to know that borrowing for investment purposes is better, tax-wise, than borrowing to purchase a home.
The reason: You can deduct interest paid on debt proceeds that can be traced to the acquisition of taxable investments (again, evidence is required), up to all of your investment income for that year.
Also (and very importantly): Unlike with mortgages, there is no cap on the amount of principal indebtedness against which you can take this deduction, as long as you have enough investment income (from all sources) to use it against.
Better still: If the investment interest paid in a given year is more than your investment income, any excess deduction can be carried forward indefinitely.
For these purposes, “investment income” generally includes:
- Interest (such as from corporate bonds)
- Dividends that do not qualify for the preferential 20% top tax rate
- Annuities and royalties
- Preferentially taxed qualified dividends and long-term capital gains (to the extent the taxpayer elects to have them taxed at ordinary income rates)
- Possibly income from private equity investments and hedge funds
However, rental income is generally not considered investment income.
Borrowing to invest in your business
Of the three types of interest deductions, it is the interest paid on business debt that is the most broadly deductible, and thus generally considered the most valuable form of interest expense.
Individuals can deduct interest on the debt they incur to purchase equity or make additional capital contributions to an operating trade or a business organized as a “flow-through” entity for tax purposes (e.g., partnerships, S corporations and certain LLCs).
If the debt proceeds trace directly to operating business use, the principal’s business interest expense should be deductible directly against all of the taxpayer’s income, including non-business income. Again, substantiation is required to qualify for this deduction.
Here, too, deductibility carries forward: Excess business expenses, including business interest, may be carried forward until fully absorbed against the taxpayer’s income in subsequent years.
Caveats: The taxpayer has to materially participate in the operating business as a principal, which makes this type of interest expense the hardest for which to qualify. Moreover, the business’s assets and debt proceeds must be used solely in the conduct of for-profit operations. And once again, substantiation is required.
Strategize your debt wisely: Basic options
Assume someone wants to buy a $10 million residence and is thinking about borrowing to fund a portion of the purchase price. She has two options:
- Get a $4 million mortgage. But then she could deduct the interest on only $750,000 of the mortgage.
- Liquidate $4 million in investments, offsetting gains and losses. Let’s assume this purchaser uses the cash proceeds from the sale of investments to buy the house, incurring no capital gains in making those sales. Then, at a later date—and, this is important, unrelated to the home closing—she borrows $4 million and invests the proceeds in taxable securities. Result: All of the interest on her loan may be deductible.3
The difference in the tax savings between these two options is potentially significant.
What a difference a tax strategy can make4
Advanced strategy: Integrating rate swaps
Investors and business owners who have either existing debt or who are considering borrowing long-term may wish to fix the interest rate, rather than leave themselves vulnerable to “floating,” or changing, interest rates that are likely to increase.
If you adopt this strategy, you’d be well advised to make sure your loan actually qualifies as a tax-deductible interest expense.
Some people incorrectly believe that if they simply acquire an interest rate “swap” contract that exchanges a floating rate on a loan for fixed-rate periodic payments, they have automatically preserved the deductibility of the interest that will be paid on the new, fixed-rate debt they have.
But that’s not necessarily true.
To effectively fix a rate for tax purposes and to ensure the deductibility of the interest paid, the swap must comply with a variety of additional legal requirements, including the contemporaneous execution of the floating-rate borrowing with the fixed-interest rate contract, as well as similar economic terms in both contracts.
It can be complicated to ensure these conditions are met. However, the tax savings often make the effort very worthwhile.
We can help
All these strategies should be thoroughly discussed with your tax advisors. Your J.P. Morgan team is available to work closely with them and you to help you assess your borrowing (both your needs and the loan’s structuring) so that you put yourself in the best possible position.
Be prepared—no matter where interest rates are.
1 Interest on student loans may also be deductible if your adjusted gross income (AGI) is below a modest threshold. In sharp contrast, no deductions are available for interest paid on personal loans, such as car loans and credit card interest.
2 Also grandfathered into the mortgage interest deduction up to the $1 million limit: taxpayers who entered into binding contracts on or before December 15, 2017, to close on the purchase of a principal residence before January 1, 2018, and who purchased the residence before April 1, 2018.
3 Figures are based on the 2023 tax year; actual rates are subject to change.
4 This chart assumes the property meets the Internal Revenue Code’s definition of a qualified residence. Mortgage interest on a qualified residence is only deductible if the mortgage proceeds are used to acquire, construct or substantially improve the property. The purchaser uses cash proceeds from investment sales to buy the house. After a lapse of time with exposure to market and interest rate risk, the taxpayer takes out a $4 million mortgage on the property and elects for tax purposes to treat the loan as not secured by the qualified residence. Mortgage proceeds are invested in a portfolio of taxable securities, and interest is deducted as an investment expense. This scenario also assumes, for the sake of simplicity, that the purchaser incurs no capital gains in the process of selling investments to raise liquidity.
Both scenarios assume an interest-only payment structure. If mortgage payments are amortized, the taxpayer’s interest deduction would vary each tax year.
Option 1 assumes interest on $750,000 of principal is deductible. Option 2 assumes that interest on the full amount of principal ($4 million) is deductible.
Both scenarios assume a standard deduction of $27,700 for married joint filers in 2023. The taxpayer is assumed to have other itemized deductions higher than the standard deduction.
Both scenarios assume a 37% U.S. ordinary income tax rate. The investment interest expense deduction also offsets income with respect to the 3.8% Medicare surtax on net investment income. Also assumed: The taxpayer realizes sufficient ordinary investment income in her portfolio to claim the entire investment interest expense deduction.