How wealthy clients can turn a mortgage into a big tax deduction

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For well-heeled homebuyers scouring the red-hot housing market, acquiring a mountain lodge in Colorado or a coastal mansion in Florida would seem to automatically translate into both a bigger mortgage and proportionally smaller tax savings.

Why? Housing prices nationwide have skyrocketed—in Florida, Idaho and Arizona by more than 25% over 12 months through last November. Meanwhile, the increase doesn’t produce a lower tax bill. That’s because the IRS limits the mortgage interest deduction to $750,000 (half that for married couples filing separate returns) of all debt on a primary residence and vacation home. For homes bought on or before Dec. 15, 2017, interest can be deducted on $1 million of home debt ($500,000 for couples filing separately). Either way, the tax code caps the federal perk, and there’s seemingly nothing you can do about it.

Throw half of that calculation out the arched window. As property prices soar, some financial advisors and wealth managers with ultra-affluent clients are using an insider technique to maximize the tax savings of buying a new forever home or dream vacation getaway.

‘Tax-aware borrowing’
The technique makes unconventional use of another type of deduction, for interest paid on money that’s borrowed and then invested in stocks or other taxable assets.

That investment interest expense deduction can be more generous than the one for mortgage interest. An investor who takes out a loan to invest in stocks and has other profitable investments that aren’t tied to the loan can potentially deduct the loan’s entire interest. High net worth investors often generate the deduction when they take out margin loans at a brokerage, borrowing money to buy stocks or other investments. It’s part of the bag of legal tricks advisors help clients use to winnow their annual payments to Uncle Sam.

“Tax-aware borrowing is very, very popular with our clients,” said Amanda Lott, an executive director and head of wealth planning strategy at J.P. Morgan’s private bank. “We’re helping advisors have conversations with clients about ways to change mortgage interest to investment interest.”

In a 2022 “Planning Insights” paper, the Wall Street bank said that when it comes to buying a home, “the deduction for investment interest may do more than the mortgage interest deduction to minimize taxes.”

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It’s a little-known way of using mortgages to access cheap capital and generate tax deductions well above those enjoyed by ordinary homebuyers of middling income. “It sounds like a clever idea,” said Michael Repak, a vice president and senior estate planner at Janney Montgomery Scott in Philadelphia.

Works best for the really affluent
Say an investor wants to buy a $10 million lodge in the Rockies. He makes a traditional move, putting down $6 million and taking out a mortgage for the remaining $4 million. In an example from the J.P. Morgan paper, he could take out a home loan at 3.5% (rates are now around 4%). He can only deduct interest each year on up to $750,000 of the loan, a tax-reducing savings that translates into an effective mortgage rate of 3.4%, a tiny boost.

Instead, our rich investor could decide to bag a traditional mortgage and cash in on $4 million of his portfolio investments. He sells unsuccessful stocks whose losses offset the 23.8% capital gains levy due on winning shares, meaning he owes no tax on the sale. He then uses that cash, along with his $6 million down payment, to buy the $10 million house.

Next, he takes out a $4 million mortgage at 3.5% on the house and opts for the loan not to be secured by the property. He invests that borrowed money in stocks or other taxable securities (not tax-exempt bonds), which makes the interest on the loan an investment interest-expense deduction. Our investor has now functionally swapped an interest deduction capped at $750,000 of a much larger mortgage to a deduction on the full interest on a $4 million loan. That translates into an effective mortgage rate of just over 2.3%, according to J.P. Morgan’s example.

“You’ve got $4 million of someone else’s money in your house, and the interest is fully deductible,” said Repak—in contrast to the limited deductibility of interest on a $4 million mortgage.

Investment income that qualifies for the interest deduction on borrowed money includes bank interest, dividends taxed at ordinary rates and annuity income. It doesn’t include so-called qualified dividends, like those paid in company stock under an incentive compensation plan, or long-term capital gains. Those are due on shares that have been sold after one year. Very rich investors often have a hefty mix of both kinds of investment income. A 2021 academic paper found that individuals with an average net worth of about $11.5 million in 2016 had nearly 15% of their net worth tied up in their residences.

Not enough "qualified" investment income to use the full loan-interest deduction? You can roll forward the leftover amount indefinitely and use it to lower the taxable income on which federal taxes are owed, in turn reducing your tax bill to the IRS.

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The tax alchemy also works for home refinancings. Say an investor wants to refinance a $1 million mortgage and increase her home debt to $1.6 million, using the extra $600,000 to invest in stocks. The interest on the $1 million mortgage is deductible. So is the interest on the $600,000 that’s invested. “I know our clients are doing this,” Lott said. The refinancing move generally only works for homes bought after Dec. 15, 2017, when new tax law changes said that for deduction purposes, a new loan can’t be more than the existing loan.

Gray area
What about home equity lines? Are those deductible if used for something other than, say, a kitchen remodeling? The IRS states that interest on such loans is deductible only if the proceeds are used to buy, build or improve a primary or secondary residence. But the rule doesn’t square firmly with separate IRS rules on the investment interest expense deduction, Repak said.

The resulting gray area may create an opportunity to reduce tax bills with property, according to the J.P. Morgan paper. “While uncertain, it is possible that IRS guidance on HELOCs could be extrapolated to other deductible uses, such as purchasing taxable investments, which would result in no cap on the deductibility of proceeds.”