In the event of a large cash need, the decision to liquidate investments to raise cash to cover or the use of financing usually comes down to the cost of capital (expected rate of return from the investments vs. the cost of borrowing). There are, however, tax implications for some financing, such as the ability to deduct certain interest from debt tied to one’s home if itemizing deductions. One of the major changes from the Tax Cuts and Jobs Act of 2017 was the limitation of itemized deductions. Home equity indebtedness was one of the deductions affected. Previously, one could deduct up to $100,000 in home equity debt regardless of the use of the funds. After 2017, only home equity debt used to acquire property or substantially improve the value of the property can be deducted.
As a result, from a tax perspective, alternate financing sources that may still be tax deductible should be considered. The use of margin within a taxable investment account provides this opportunity. Using margin is simply borrowing money from existing investments without selling those positions to realize a capital gain or loss. Since investment interest expenses (i.e. margin interest) are still deductible it is a route worth considering. There are a few caveats with borrowing on margin:
- We never want to take so much cash that may end up resulting in a margin call. Under the Federal Reserve Board’s Regulation T, one can take up to 50% of the value of the securities being borrowed from. A margin call can also occur when there is a steep market decline and the amount borrowed represents a much larger share of the overall account.
- In order to deduct the margin expenses, there must be enough margin interest to actually itemize deductions. The margin interest plus any other allowable itemized deductions (state and local taxes up to $10,000, mortgage interest, charitable donations, etc.) must be higher than the standard deduction – which is $24,400 for married couples and $12,200 for single filers in 2019.
- We must have a plan for repayment. If we end up selling securities down the road to cover the margin balance, we will be realizing the capital gains or losses that we were avoiding in the first place while taking money out of the market.
Whether or not to borrow on margin, as is the case with all questions in finance, depends on the situation. But given the change in the tax deductions landscape, it is an alternative financing route worth considering.