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Buying real estate is a great investment for many people, but without tax-aware borrowing, you could be throwing 'free money' to the IRS.
Understanding capital gains tax, the Tax Cuts and Jobs Act, and how to maneuver your investments to reduce your tax liabilities is important to your future net worth.
Why give the IRS money you don't have to pay?
Here's how to avoid it.
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What Is Tax Aware Borrowing
Tax-aware borrowing is a creative strategy to help investors maximize their tax deductions. Since the Tax Cuts and Jobs Act, homeowners have been limited to how much of the interest expense they pay that they can deduct.
The new law limits homeowners to deducting interest on up to $750,000. If you borrow a much larger mortgage, you lose the deductibility of the interest.
However, with tax-aware borrowing, you can liquidate your investment account and use the funds to buy a property. In a few months, you could then take out a cash-out refinance on the property, liquidating the capital and using it to invest in taxable investments.
This increases the amount of interest you can deduct, sometimes totaling the entire carrying cost of the loan, thanks to interest tracing or the IRS tracing where the funds went to determine their deductibility.
The Rise of Rates
With the higher interest rates we've experienced since the start of 2022, it's become much more expensive for investors to borrow against assets. In addition, the lower tax deductions allowed for the mortgage interest deduction, making it even more costly.
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What Consumers Should Do and Consider
Consider tax-aware borrowing to increase your deductions and allow you to invest in real estate and taxable securities.
It may feel strange at first, paying cash for your home and liquidating your investment accounts to do it. However, in the long run, you'll be able to deduct interest paid on the loan if you invest the funds in taxable securities rather than tying it up in your home.
Deducting Mortgage Interest
The mortgage interest deduction is limited to the first $750,000 in mortgage loans. So, to make the most of tax-aware borrowing, you can finance the first $750,000 of the home's cost and pay cash for the rest by liquidating your investment accounts.
Taxable Investments Through Borrowing
The mortgage investment interest deduction is great for those who buy a home with a mortgage lower than $750,000. Anything above that, though, homeowners lose.
Borrowing for investment income, however, is a better option for tax purposes because you can deduct the interest expense for money borrowed for taxable investments. Now, you must prove how you used the funds, but if you buy taxable investments, you may be able to deduct more interest.
Even better, there isn't a maximum amount you can deduct, like when you take the mortgage interest deduction. You can also carry forward any excess into future years.
Investment income may include interest from bonds, dividends, annuities, and long-term capital gains. However, any income earned on a rental property isn't considered investment income.
Business Investments Through Borrowing
If you use the funds to invest in interest, you'll have the highest form of interest expense deductions. For example, you can deduct interest paid on loans borrowed to buy a business or make capital contributions to an existing business.
As long as the funds from the loan can be traced directly to operating a business, the interest expense should be fully deductible. Like the deductions on investment income, you can carry forward any excess business expense deductions.
There's one downfall. You must materially participate in the business to get the deduction, and the business must be for-profit.
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Strategizing Your Debt
Strategizing your debt is the key to minimizing your tax liabilities. While you could likely borrow what you need to buy a house, it's not a smart tax strategy. Instead, consider tax-aware borrowing.
Basic Strategy Option
The basic way to strategize your debt is to liquidate your investment accounts to buy the house in cash. You don't incur any capital gains when you do this, so there aren't any tax liabilities yet.
You can withdraw the funds a few months later using a cash-out refinance. This refinance must be unrelated to the house purchase. You can then use the funds to invest in taxable investments, making all of the interest paid deductible.
Advanced Strategy Option
If you've done this before or are ready to take an advanced step, consider interest rate swapping.
Integrating Rate Swapping
If you're an investor or business owner with a floating interest rate debt, you may qualify to swap it for a fixed rate and benefit if the loan qualifies as a tax-deductible expense. This strategy is risky and should only be done under the supervision of a financial professional to ensure it's handled properly.
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FAQs
How Much Interest Can Be Deducted With Tax Aware Borrowing?
With tax-aware borrowing, there's no limit to how much interest can be deducted from your tax bill. So, for example, you aren't subject to the $750,000 limit when buying a house as long as the interest tracing leads to proof that you used the funds for taxable investments.
Are Tax Aware Borrowing and Interest Tracing the Same Thing?
Tax-aware borrowing is the strategy used to minimize your tax liabilities. Interest tracing is the procedure the IRS uses to ensure the funds you withdrew from the house were used for taxable investments.
Who Is Tax Aware Borrowing Good Option For?
Tax-aware borrowing is good for investors who plan to buy homes that greatly exceed the $750,000 limit. You'll maximize your tax deductions and have more money to invest.
The Bottom Line: Tax-Aware Borrowing
Tax-aware borrowing is a complicated strategy that should be done under the supervision of a financial professional. When done right, you can maximize your tax deductions by getting around the $750,000 limit on tax deductions for mortgage interest. Then, with the right steps, you can buy your house and get the full tax deductions you deserve.
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