"Can I catch a tax break?" Private Bank clients seek liquidity and tax deductions every day. This month, Lorraine Monick and Mary Toomey, provide our Private Bank clients with guidelines and examples, which prove that lending structures and terms can have a direct impact on their bottom line.
Today's rules for deducting interest expenses are not simple nor automatic, and it is important to consult with your CPA or tax advisor before implementing these strategies. The tax treatment of interest for an individual taxpayer can range from fully deductible, to partially deductible, to not deductible at all, depending on the category of interest. For example, interest expenses associated with mortgage balances above the deductible limit of $1.1 million are not deductible expenses.
In general, investment interest expenses from loans used to invest in stocks, bonds, private funds or companies, and to exercise stock options, are deductible as long as the investor follows interest tracing rules to track how they spend the loan proceeds. Investors with net investment income in any one year can use the investment interest expense deduction up to the amount of their net investment income. Matthew Wheeler, CPA of LMGW in Saratoga, CA adds that "the IRS has a strict set of rules governing the order in which debt proceeds or repayments are allocated for purposes of determining deductible interest expense. Following proper form can maximize your deductible interest expense amount."
Investment income includes:
- Taxable interest (i.e. not 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 the taxpayer elects to treat them as investment income
Interest expense is deductible only if the taxpayer itemizes deductions and is limited to the amount of reported net investment income. Any excess investment interest expense can be carried forward indefinitely and be used in future years when there is net investment income. Investment interest expense is reported on Schedule A of your tax return.
- Aim to keep investment accounts and personal expenditure accounts separate. If the borrowed funds are commingled with other funds that were not borrowed, then a complex set of interest allocation or "tracing" rules comes into play and potential interest deductions on the loan can be lost. Try not to use the borrowed monies for personal expenditures or to invest in tax-exempt bonds.
- For home-equity loans up to $100k it makes no difference how the funds are used; the related interest expense is an itemized deduction on Schedule A, though the interest may not be deductible for Alternative Minimum Tax purposes unless certain requirements are met.
Case Study: VC with diverse assets seeking to maximize interest expense deductions
This investor is a GP with a venture firm. She has a $3 million mortgage, secured by her home which is valued at $8 million, and a $4 million taxable investment account. She decides to convert the nondeductible mortgage interest on her mortgage balance above $1.1million to deductible interest expense by:
- Using her investment account assets to pay down the mortgage balance to $1.1 million
- Waiting a seasoning period to avoid the step transaction doctrine or any proposed reallocation by the IRS, (confirm the waiting period with your CPA) then refinancing the mortgage with a balance of $3 million (the original mortgage amount)
- Taking the cash out from the refinance ($3 million - $1.1 million = $1.9 million), and transferring it directly into a separate taxable investment account
Her interest expense from her $3 million mortgage is fully deductible: mortgage interest on $1.1 million is deductible through the qualified residence interest rules, and mortgage interest of $1.9 million is deductible through investment interest expense (to the extent that she has investment income). If the investment interest expense is higher than her taxable net investment income in the tax year, the unused interest expense can be carried forward to use in future years against investment income.
- Make sure the cash proceeds are invested in stocks and/or taxable securities (bonds or money market accounts). The loan interest on the purchase of tax exempt securities is not tax deductible.
- Watch closing costs and interest rates to ensure the end result is beneficial from an after tax perspective.
Case study: Company founder seeking to exercise stock options
This investor is a founder of a young growing private company. In addition to founder stock which qualifies for the Qualified Small Business Stock Exemption, he has incentive stock options (ISOs) and nonqualified stock options (NSOs). In order to minimize taxes, he wants to exercise the options (preferably while the value of the company is low) to start the clock on long-term capital gains.
The cost to exercise is $500k. He decides to raise the $500k to support the cost of the option exercise by:
- Accessing his home equity through a line of credit, cash out mortgage refinance or other loan structure
- Directing the loan proceeds to the company to fund the option exercise
The $500k in proceeds from the loan used to acquire the stock would be classified under the investment interest bucket and any interest paid on the loan would qualify as investment interest expense. The investment interest expense deduction can be used up to the amount of net investment income in any given year. (Note: it does not need to be investment income from the sale of the stock that was acquired, it could be any investment income). If investment interest expense is greater than the net investment income, it carries forward indefinitely until there is net investment income.
- There could be taxes due from exercising ISOs and NSOs. If possible, do not direct the cash from the refinance to pay taxes because then the interest expense would not be tax deductible.
- Ordinarily long-term capital gains are not considered investment income but investors have an option to make an election to treat them as investment income and offset them with investment interest expense. It's important to work closely with your CPA/tax advisor when utilizing such strategies.
Individual investors can benefit from regularly evaluating their leverage ratios, structure and costs. Ask your advisor to compile a statement of liabilities and review it with you regularly. In conjunction with a cash flow analysis, you can proactively structure leverage to enhance your balance sheet. Be sure to work together with your advisor and your CPA to ensure you are getting maximum value at the lowest costs from the liabilities on your balance sheet.
Neither SVB Wealth Advisory, Silicon Valley Bank nor its affiliates provide tax or legal advice. Each taxpayer has different circumstance to consider before implementing any tax strategy. Please consult your tax or legal advisors for guidance.
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