Maximizing Deductible Interest Expense

The tax treatment of interest for an individual taxpayer may range from fully deductible to partially deductible to not deductible at all, depending on the category of interest.

As you optimize your cash flow and debt, you can specifically seek opportunities to save based on the deductibility of interest costs. Here are a few guidelines to show how lending structures and terms may have a direct impact on your bottom line.

Investment interest expense deduction

The interest you pay from loans used to invest in stocks, bonds, private funds or companies—as well as to exercise stock options—is generally tax-deductible as long as you follow interest tracing rules that track how you spend the loan proceeds. Interest tracing rules are governed by the IRS, and they dictate the order of allocation of debt proceeds and repayments. Following this order keeps you in compliance and may increase your deductions.

If you have net investment income in any one year, you may use the investment interest expense deduction up to the amount of any net investment income.

Investment income includes:

• Taxable interest—as opposed to the interest earned from tax-exempt bonds
• Nonqualified dividends
• Annuity income
• Certain royalties
• Short-term capital gains
• Qualified dividends and long-term capital gains—if you treat them as investment income

Investment interest expense is reported on Schedule A of your tax return. It's deductible only if you itemize deductions and is limited to the amount of reported net investment income.

A real-world example

The following example illustrates how nondeductible interest may be converted into deductible investment interest—and its potential impact on your tax situation.

An investor couple with a diverse balance sheet has $3 million in cash they intend on investing in a diversified portfolio. However, as high-income earners, they want to maximize deductions and utilize their debt in an efficient way. They have a $2.5 million mortgage against a home valued at $5 million, and their CPA recommends using an interest tracing strategy on the incremental amount of the mortgage that exceeds their standard mortgage deduction.

To convert the nondeductible mortgage interest on their mortgage balance to deductible interest, they'll need to create a trail that keeps the deductible portion of the mortgage separate from the portion they wish to use for interest tracing. They'll also need to create a definitive trail tying the additional debt to their investment portfolio. This will be a multistep process guided by their financial advisor and CPA.

The process

Their first step is to use the cash they're holding to pay the mortgage down to the deductible amount—let's assume it's $750,000. Next comes a period of waiting based on their CPA's recommendation—often called a seasoning period. Once the proper amount of time has passed, they'll do a cash-out refinance, pulling out an additional $1.75 million, which is directly transferred to an investment account and deployed into a diversified portfolio. It's important to note that these must be taxable investments, so municipal bonds aren't allowed.

Now that the trail has been set, the interest from the additional $1.75 million can be used to offset any net investment income the couple generates. If we assume the new mortgage rate is 6.80%, the additional interest over the deductible mortgage amount is $119,000. If they can offset the entire amount and their blended tax rate on the offsetting net investment income is 40%, then the additional savings for the couple is $47,600.

Important considerations

There's an interest rate risk during the time they pay down the mortgage and refinance the mortgage. Also, the trail needs to be clear, so this investment portfolio will need to be held in a separate account from any of their other investments. They should also make sure their CPA has a clear understanding of the impact this will have, as it's only useful if they have enough net investment income to offset a majority of the interest.

A few things to note

While this same process can be used against many types of debt or investment contributions, there are several important things to remember in these transactions.

The cash-out proceeds should be directed to a public or private taxable investment account, such as a securities, bonds or money market account—or a partnership commitment. The loan interest on the purchase of tax-exempt securities like municipal bonds isn't tax deductible.

In addition, you should watch closing costs and interest rates to ensure the result is beneficial from an after-tax perspective. And for interest tracing purposes, it's generally recommended to keep the funds separated from other investments and personal expenditures. If the borrowed funds are comingled with funds or investments that weren't borrowed, then potential interest deductions on the loan may be lost.

Finally, to best optimize this strategy, borrowed monies shouldn't be used for personal expenditures.

Potential risks with leveraging interest

Leveraging investment interest through loans may be a strategic opportunity to save money, but the strategy carries some risks. These may include:

• Market risks, such as the decrease in the value of your investments
• Interest rate risks, such as increased borrowing costs
• Liquidity risks, such as the sale of assets for needed cash at the wrong time

The consequences associated with these and other potential risks could mitigate the effectiveness of this strategy. Be sure to discuss the importance of minimizing and managing risk with your advisers when considering investment interest strategies.

Review regularly with your relationship manager

With today's complex rules, deducting interest expense isn't simple or automatic, so it's important to consult with your CPA and financial team before implementing any strategies designed to maximize your tax deductions.

In addition, it's a good idea to routinely evaluate your leverage ratios, structure and costs with your financial team and ask them to regularly review a statement of your liabilities. Be sure to collaborate with your tax advisor or CPA to ensure you're getting the maximum value and lowest costs from the liabilities on your balance sheet.