Taxpayers and politicians in high property states cried “foul” when the property tax deduction was capped at $10,000 . . . but not a whimper was heard with respect to a mortgage interest deduction tax savings technique.
Current Mortgage Interest Limitations
The tax code limits the mortgage interest deduction to $750,000 (for married filing joint (MFJ) taxpayers) of all debt on a primary residence and vacation home. For homes bought on or before Dec. 15, 2017, interest can be deducted on $1 million of home debt by MFJ taxpayers.
As residential and vacation home prices skyrocket, the mortgage interest tax savings of owning a home are capped by the $750,000 ceiling limitation.
An Example of the Limitation
Let’s assume an individual wants to buy a $4 million vacation home and is required to make a down payment of 20% ($800,000). Thus, he/she has a $3.2 million mortgage. The individual is limited to deducting interest each year up to $750,000 of the loan.
Investment Interest Deduction
If a taxpayer itemizes their deductions, they may be able to claim a deduction for their investment interest expense. Investment interest expense is the interest paid on money borrowed to purchase taxable investments. This includes margin loans for buying stock in a brokerage account. It does not include interest to purchase tax-advantaged investments such as municipal bonds.
The amount that one can deduct is capped at their net taxable investment income for the year. Any leftover interest expense gets carried forward to the next year and potentially can be used to reduce taxes in the future.
Wealthy individuals who invest and hold significant amounts of stocks and bonds, after consulting and working closely with their investment advisor, real estate attorney and tax professional, may be able to circumvent the $750,000 mortgage loan limitation by borrowing on their investment portfolio and using that cash to put down on their newly acquired real estate investment. For example, up to $4 million of investments could be sold to generate the funds for the purchase of the investment property and thus avoiding exceeding the $750,000 threshold. If unsuccessful investments are included in the sale along with successful investments, the individual could possibly have no tax liability resulting from the sale of his investments. If there is tax liability and the sales are structured properly for tax efficiency, the investor would be subject to the lower long-term capital gains rate. The investor could then reenter the stock market by purchasing his investments on margin. If the individual took out a loan on his investment property, not secured by the investment property, and invests the loan proceeds in his investment portfolio, he has converted the interest on the loan to an investment interest tax deduction.
Tax Tip #1
Before implementing such a plan, a number crunching exercise is needed along with a review of long-term financial planning considerations. While tax planning should be a part of every financial decision, the tax savings should not be the driving force – sound financial planning is of upmost importance. Tax savings are the cherry on the top of a great financial plan.
Since investment expense is limited to investment income, how much investment income will the individual generate? Will sufficient investment income be generated to make this tax strategy effective? What costs (consulting fees, taxes on stock sales, optimization of investment portfolio, etc.) will be incurred to implement this strategy? Will those costs be recovered? Over what time period?
Investment income that qualifies for the interest deduction on borrowed money includes bank interest, dividends taxed at ordinary rates and annuity income. It doesn’t include so-called qualified dividends, like those paid in company stock under an incentive compensation plan, or long-term capital gains.
Tax Tip #2
This strategy also works for home refinancings that are limited by the tax law that states that a new loan cannot be greater than the existing loan for interest deduction purposes. Say an investor wants to refinance a $1 million mortgage and increase their home debt to $1.6 million, using the extra $600,000 to invest in stocks. The interest on the $1 million mortgage remains deductible since the loan amount has not increased. In addition, the interest on the $600,000 that’s invested in taxable investments is tax deductible.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
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About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS licensed Enrolled Agent and who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
A Certified Tax Resolution Specialist, Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems.