Turning A Mortgage Into A Tax Deduction For High Net-Worth Individuals

For homebuyers searching the housing market, acquiring a mountain lodge in Colorado or a waterfront mansion in Florida would seem to translate into a bigger mortgage and smaller tax savings. This is due to housing prices skyrocketing nationwide. However, the increase does not produce a lower tax bill because the IRS limits the mortgage interest deduction of all debt on a primary residence and vacation home. Furthermore, as property prices soar, some financial advisors and wealth managers with ultra-affluent clients are using an insider technique to maximize the tax savings of buying a new forever home or dream vacation getaway. This technique makes unconventional use of another type of deduction, for interest paid on money that is borrowed and then invested in stocks or other taxable assets.

Tax-aware borrowing. The investment interest expense deduction can be more generous than the one for mortgage interest. An investor who takes out a loan to invest in stocks and has other profitable investments that are not tied to the loan can potentially deduct the loan’s entire interest. High net worth investors often generate the deduction when they take out margin loans at a brokerage, borrowing money to buy stocks or other investments. It is a little-known way of using mortgages to access cheap capital and generate tax deductions well above those enjoyed by ordinary homebuyers of middling income. 

Works best for the really affluent. Say an investor wants to buy a $10 million home. If they make a traditional move by putting down $6 million and taking out a mortgage for the remaining $4 million they will only be able to deduct up to $750,000 interest each year. Instead, our rich investor could decide to ditch a traditional mortgage and cash in on $4 million of their portfolio investments. By selling unsuccessful stocks whose losses offset the 23.8% capital gains levy due on winning shares, they will owe no tax on the sale. They would use that cash, along with their $6 million down payment, to buy the $10 million house. Next, they would take out a $4 million mortgage at 3.5% on the house and opt for the loan not to be secured by the property. Now, they can invest that borrowed money in stocks or other taxable securities. This makes the interest on the loan an investment interest-expense deduction. Essentially, the investor has swapped an interest deduction capped at $750,000 of a much larger mortgage to a deduction on the full interest on a $4 million loan. 

It is important to note that investment income that qualifies for the interest deduction on borrowed money includes bank interest, dividends taxed at ordinary rates, and annuity income. However, it does not include so-called qualified dividends, such as paid in company stock under an incentive compensation plan, or long-term capital gains. Very rich investors often have a hefty mix of both kinds of investment income. If you do not have enough “qualified” investment income to use the full loan-interest deduction, you can roll forward the leftover amount indefinitely and use it to lower the taxable income on which federal taxes are owed, in turn reducing your tax bill to the IRS. This tax alchemy works for home refinancing as well.

The gray area. The IRS states that interest on home equity loans is deductible only if the proceeds are used to buy, build, or improve a primary or secondary residence. But the rule does not square firmly with separate IRS rules on the investment interest expense deduction. This gray area may create an opportunity to reduce tax bills with property.

Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.