It is imperative that an investor comprehend the deductibility of interest paid on portfolio loans before taking action in any investment opportunity. Investors who do not fully understand the tax law could potentially create a tax bill substantially higher than expected. Interest expense from portfolio loans raise many questions in this area.
The Rule of Interest Tracing
The most important rule to understand first is the interest tracing rule. This rule allocates debt and interest according to the use of the proceeds from the loan, not the property used to secure the loan. Simply put, if an individual secures a loan with business property but uses the loan to buy a personal vehicle, the interest is not deductible.
When is Interest Expense Deductible?
Investment interest is interest paid on money borrowed to purchase investments or securities. Interest expense is only deductible for investments that produce income. For example, interest on a loan to purchase stock is considered deductible, but interest from a loan used to purchase tax-exempt municipal bonds is not.
The easiest way to trace disbursements is to keep the proceeds separate from any other funds. This way, more complicated tracing rules will not apply.
Determining If Interest Deductible Will Produce A Tax Benefit
Even if investment interest expense is deductible, there are still other factors as to determine whether it will produce a tax benefit. The first consideration is if the individual itemized deductions. The next factor is more complex.
Investment interest expense is only deductible to the extent of investment income.
Investment income includes taxable interest, non-qualified dividends, annuities, royalties and short-term capital gains. Qualified dividends and long term capital gains are not considered as investment income for these purposes (due to their favorable tax rate). It is possible to make an election to tax these items at ordinary income tax rates to include them as investment income and therefore use the expense. In a few cases, this could be beneficial. The IRS does allow any disallowed investment interest expense to be carried forward indefinitely.
Using a portfolio loan instead of a traditional mortgage can cause issues.
Using a portfolio loan instead of a traditional mortgage loan raises significant issues. A personal residence is not considered an investment and, therefore, the interest expense would not be considered deductible. Another issue to consider is that a mortgage must be secured by the home in order to be qualified mortgage interest so a portfolio loan would not qualify as mortgage interest either.