A strategic use of credit for U.S. taxpayers may be to use loan proceeds for investment purposes. Here’s why.
As interest rates remain low, but are soon to rise, opportunities continue to exist now for investors to take advantage of inexpensive credit. Prudent and strategic use of credit adds flexibility to your portfolio and may allow you to quickly deploy capital into high-conviction investments without disrupting your broader portfolio allocation. On top of this, U.S. law provides U.S. taxpayers with another benefit: in many cases, investment interest is tax-deductible.
A quick thumbnail—investment interest expense is:
- Interest paid on debt used to purchase taxable assets (excludes municipal bonds, annuities, and any other tax-free or tax-deferred investments).
- Deductible against your net investment income1, which includes taxable interest, short-term capital gain, and non-qualified dividends. An election has to be made to deduct the expense against long-term capital gain and/or qualified dividends. The expense cannot be used to offset earned income or taxable distributions from retirement accounts. Any unused deduction is carried forward into future years.
Like many parts of the U.S. tax code, the investment interest expense deduction is nuanced, investors should speak with their tax advisors before making a decision. A best practice is to hold the loan proceeds in a separate account.
Here are key considerations to keep in mind.
1. You can potentially deduct investment interest against capital gains.
By default, your short-term capital gains are included in the amount of net investment income against which you may deduct in the income.
Long-term capital gains (and QDI) are not included in net investment income. However, if you still have extra deductible interest to use, you can speak to your tax advisor about making an election on your tax return that may allow you to deduct interest against these as well.
2. You can potentially deduct the interest against income from more than just the debt-financed investment you are making.
Some investors are surprised to learn that investment interest is deductible against net investment income from anywhere in their portfolio.2 Therefore, even if the investment you finance with debt has little or no yield, you may still be able to deduct all of the interest if you have sufficient net investment income from other accounts.
This feature can create the opportunity for “tax arbitrage.” For instance, you borrow to purchase preferred shares paying dividends taxed at a 20% rate, but deduct the interest you pay against income from your bond portfolio taxed at a 37% rate.
3. You can potentially deduct interest on debt that you use to purchase dividend-paying stocks.
Most stock dividends receive “qualified dividend income” (QDI) treatment, meaning that the federal government taxes them at up to a top rate of 20%.
Even though qualified dividends are taxed at a lower rate than ordinary income, they are still a type of taxable portfolio income. Therefore, the interest on debt you use to purchase dividend-paying stocks, common or preferred, is an allowable deduction against net investment income.
In fact, the IRS has even allowed a deduction for borrowing to invest in non-dividend-paying stocks (because of the potential that they will one day pay a dividend).
4. If you pledge your municipal bond portfolio to support your borrowing, the bond coupons are still tax-exempt income.
When you pledge tax-exempt municipal bonds to secure a debt, the interest you pay on that debt is nondeductible, regardless of where you deploy the funds.
However, borrowing against municipal bonds has absolutely no impact on the tax treatment of the bond coupons, which remain tax-exempt.
Therefore, it would not make sense to use municipal bonds as collateral when using debt for a deductible purpose. But if you need to meet a nondeductible expense, you can borrow against your municipal bonds without adverse tax consequences.3
5. Even if your state of residence doesn’t have an interest deduction, borrowing to invest may be valuable for you.
In addition to the federal deduction, some but not all states offer a similar deduction for interest paid, or limit them for high-income taxpayers. Yet even if you live in one of these states, the strategic use of credit may make sense for you because of the federal tax benefits.
We can help
Interested in finding ways that tax-efficient credit could enhance your portfolio? Speak with your J.P. Morgan team member. In partnership with you and your tax advisors, our lending and investing teams can help you identify the right solution for your long-term goals.
1 Source: Internal Revenue Code §163d with reference to §469. Net investment income is gross income from interest, ordinary dividends, annuities and royalties (unless derived in the ordinary course of a trade or business), plus net short-term capital gains, reduced by a taxpayer’s investment expenses.
2 An exception applies when you use debt to purchase or carry a straddle (i.e., two or more offsetting positions). In that case, the interest is deductible only up to the amount of income produced by the straddle position, and the excess is added to your cost basis. This most commonly occurs when you pledge stock to support the borrowing, and write a collar (a type of tax straddle) around the stock as a hedge.
3 Speak to your tax advisor about whether an allocation to municipal bonds as part of your overall portfolio allocation could result in some loss of deductibility, even if the debt is not directly collateralized by the municipal bonds.