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What to know about tax-aware borrowing

March 13, 2024

Individuals can choose to take out loans in a way that may minimize their tax liability – this is called tax-aware borrowing. Learn more about it.

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Key takeaways

Individuals can choose to take out loans in a way that may minimize their tax liability – this is called tax-aware borrowing.
Qualifying interest paid on mortgage debt and debt used for investments can be deducted.
Taxpayers may want to consider paying special attention to their borrowing strategies so they’re able to deduct the highest amount of interest possible.

Contributors

Josh Warren

Vice President, High Net Worth Mortgage Product Owner

Debt isn’t always a bad thing. Actually, it can be quite positive in the scheme of things. As many investors know, borrowing to finance the purchase of an asset such as a house can help secure long-term financial stability and even profitability.

Tax-aware borrowing is when you take on debt in a way that may allow you to deduct the interest expenses. Because there are rules surrounding what and how much you can deduct, borrowers may consider coming up with a debt strategy that makes the most of these allowances.

When done effectively, borrowing could help lower your tax obligations, increase your cash flow and reduce your total borrowing costs. Here’s a breakdown.

Taking tax deductions for loans: The rules

Borrowers can deduct the interest paid on qualifying loans, but they must itemize their taxes to do so. Here are some of the rules and limits that apply to this process.

Mortgage debt

The interest you pay on up to $750,000 of mortgage debt is deductible. This applies to your primary home or second home – it cannot be a rental or investment property. If you secured the mortgage before December 15, 2017, it falls under prior law and interest is deductible on up to $1 million of debt.

The mortgage interest is also only deductible if you used the loan to buy, build or make improvements to the property/residence.

Investment interest

If you borrow money for taxable investments, the interest you pay can be deductible. Unlike with mortgage interest, there’s no cap on the amount of investment interest you can deduct as long as your investment income equals or surpasses your borrowing costs.

The types of investment income that qualify for interest deduction include interest, annuity income, certain royalties and dividends that don’t qualify for the preferential long-term capital gains tax rate. Tax-exempt bonds do not qualify.

Structuring your borrowing to minimize taxes

Let’s look at an example of tax-aware borrowing.

Say a taxpayer wants to buy a $10 million residence and is considering taking out a loan to fund part of the purchase. They can do this in multiple ways, but being intentional about how they borrow can help minimize their tax liability.

Scenario 1: Taking out a large mortgage

In this scenario, they take out a $5 million mortgage. This funds half of the purchase from the jump, but the borrower will only be able to deduct interest on $750,000, as that is the limit.

Scenario 2: Paying cash and later taking out a loan using the home as collateral

In this scenario, the borrower pays all cash for the residence. Later, they take out a $5 million mortgage loan against the home and invest it in taxable securities. In doing this, the whole carrying cost of the loan may be deductible as an investment interest expense, which has no limit (as long as the borrower’s investment income qualifies).

Dos and don’ts

Here are some things to remember with borrowing for investments.

If tax-exempt investments are used as collateral for the loan, or the loan is used to pay for tax-exempt investments, then none of the interest paid/incurred will be deductible.
Even if you use the loan to invest in qualified securities, but your portfolio includes tax-exempt bonds, this may lead the IRS to disallow part of your interest expense.

Some good rules of thumb include not collateralizing debt with tax-exempt bonds; not purchasing tax-exempt bonds with the loan proceeds; and depositing borrowed funds into a separate account that’s not associated with tax-exempt bonds.

Of course, depending on your personal financial situation, your tax strategy could be different. Speaking with a J.P. Morgan advisor can help you determine whether a tax-aware borrowing strategy is right for you.

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Key takeaways

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