Maximizing tax efficiency on loans

Effective loan structuring can lead to significant tax savings. By reducing borrowing costs, you can free up capital for other investments. With strategic leverage and understanding of the tax rules for interest deductions, you can lower tax liabilities and improve your overall financial position. Here we’ll further discuss key points, including rules and strategies for maximizing tax efficiency on loans, focusing on deductible interest, mortgage debt limits and investment interest.

Deductible interest

Interest paid on certain loans can be deducted from taxable income, subject to certain limitations. This principle is known as interest tracing, and it involves determining how borrowed funds were used to classify the interest. Interest can be classified as personal, investment interest, residential interest, passive interest or trade/business interest.

While it may seem intuitive to assume that the deductibility of interest expense depends on what the loan is secured by (such as a mortgage secured by a home or a line of credit secured by investments), it is the tracing of the use of funds that often dictates how the interest will be classified.

Home mortgage interest deduction

For mortgages on primary or secondary residences, interest can be deductible up to $750,000 of debt if the mortgage loan was taken out after December 15, 2017. For mortgages secured before this date, the limit is $1 million. The mortgage proceeds must be used to buy, build or improve the home, otherwise the interest will not be classified as qualified mortgage interest.

Investment interest expense

If you borrow funds and trace the loan proceeds to investments that generate taxable income, the interest paid on that loan may be deductible, helping to reduce your overall tax liability. The deduction is limited to your net investment income, which includes taxable interest, non-qualified dividends, certain annuities, royalties and net short-term capital gain. Should your investment interest expense exceed your net investment income in a given tax year, the excess can be carried forward to future years.

Note you may also elect to include qualified dividends and net long-term capital gain taxed at preferential rates. We recommend consulting with your tax advisor on this election.

Tax efficiency: A practical example

Consider this example: An individual is looking to purchase a $6 million home and has the financial means to do so in an all-cash purchase. However, they prefer to purchase the property with $3 million of debt. Under the current rules, if they purchase the property with a mortgage, only up to $750,000 of mortgage debt and associated interest can be deducted as qualified mortgage interest. If we assume a 6% interest rate, the deduction will be limited to $45,000.

If the individual purchases the home with cash, takes out a mortgage after closing, and uses the loan proceeds to purchase taxable securities, the interest on that mortgage will not qualify as mortgage interest and instead will be classified as investment interest expense. If net investment income exceeds the interest expense, the entire interest expense of $180,000 may be deductible. In both cases, the taxpayer has borrowed $3 million against the value of the home, but the tax savings could be much greater with an investment interest expense.

Seek the guidance of an advisor

Interest tracing rules can be complex. For additional guidance on wealth planning strategies, contact an advisor from Citizens Private Wealth or consult your tax professional.