Ask Matt on Tax Reform: What You May Not Remember About Margin Loans

 In Retirement Planning & Wealth Management

Retirement and wealth strategies expert Matt Sommer answers questions from advisors on market events, legislation and trends that may impact their clients’ investments.

What impact, if any, does the Tax Cuts and Jobs Act have on the deductibility of margin interest?

While the Tax Cuts and Jobs Act has either eliminated or has placed limits on many deductions, the deductibility of margin interest is not impacted. That said, the rules regarding margin interest regularly cause confusion in the marketplace, so a quick review may be helpful. Advisors and their clients must remember the interest tracing rule.

This rule essentially means that the deductibility of interest paid on a margin loan is determined by the use of the loan proceeds, not what secures the loan. For margin interest to be deductible, the loan proceeds must be used to purchase property held for investment – meaning property that generates interest, dividends or that produces a gain or loss upon its sale. Conversely, using a margin loan for a personal reason such as a car, gift or to pay an outstanding tax liability will not qualify for interest deductibility.

Margin Loan: Allows an investor to borrow money to purchase additional securities or to meet short-term financial needs while using shares or managed funds as security.

Even after following the interest tracing rule, two additional hurdles remain. First, the taxpayer must itemize his deductions. Beginning in 2018, fewer taxpayers are expected to itemize because of the higher $24,000 standard deduction ($12,000 if single) and the new $10,000 limit on state and property tax deductions.

Second, margin interest is deductible only to the extent the taxpayer has investment income. Investment income generally consists of interest, dividends and short-term capital gains. Qualified dividends and long-term capital gains are not considered investment income since they are subject to a lower, more-favorable tax rate of 0%, 15% or 20%. In some cases, it may make sense for taxpayers to forgo the favorable tax rate and treat qualified dividends and long-term capital gains as investment income, allowing a larger amount of margin interest to qualify for a deduction.

A second type of margin loan, called a non-purpose margin loan, is also unaffected by the new legislation. These loans may qualify for higher borrowing limits and lower interest rates than traditional margin arrangements, depending upon the broker/dealer, and can be used for almost any purpose other than investing the proceeds in marketable securities. One common fit for a non-purpose margin loan is a small-business owner in need of capital for expansion, but who otherwise may not qualify for traditional lending facilities. In this case, the loan interest will be a deductible business expense.

Take Pause

Of course, borrowing against marketable securities carries the risk that the portfolio declines in value. The borrower may face a margin call, and be required to add additional cash to the account or face the prospect of having to sell some of the securities at the worst possible time – immediately after they have declined in value. Margin loans and non-purpose margin loans can be an important tool when used properly, and advisors and investors should carefully explore all the risks involved before using these strategies.

Submit your retirement and wealth strategies questions to Matt Sommer, head of the Defined Contribution and Wealth Advisor Services team at Janus Henderson.

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