SUPPOSE YOU’RE LOOKING AT a significant upcoming expenditure — a new vehicle, a major home renovation, a business opportunity. It’s one you have the means to meet through your existing income and assets. In that case, why would you consider taking out a loan?

Because doing so can make financial sense. “Borrowing can help you pursue your financial goals without having to unwind your long-term wealth planning strategy,” says Merrill Private Wealth Management Wealth Advisor Nic Grala. Approached strategically, borrowing can not only fund major expenditures but also improve liquidity, amplify investment returns and help diversify your portfolio. Grala adds, “Smart borrowing is about using credit to enhance the structure and flexibility of your overall financial plan.”

It also has the potential to deliver meaningful tax benefits — after all, one of the core advantages of borrowing is that, subject to certain conditions, interest payments may be tax-deductible. But the rules governing deductibility are complex and there is some risk involved, so a conversation with your advisor and tax professional regarding the basics of tax-aware borrowing is a smart first step if you want to maximize the loan’s possible benefits.

Key benefits of tax-aware borrowing

Done thoughtfully, borrowing can both strengthen your finances and may help you minimize federal income taxes. Consider these potential advantages:

An estate planning strategy.

Borrowing can result in lower taxes for your beneficiaries. By using credit to meet expenses or generate funds to invest, you can keep highly appreciated assets in your estate. When those appreciated assets are eventually passed to your beneficiaries, they receive a step-up in cost basis to fair market value at the time of death, which is favorable for federal income tax purposes. If you’re planning on gifting assets in your lifetime, borrowing could enable you to gift cash rather than investments that might produce a high income tax liability for the recipients (who would receive a carryover cost basis if the gift is made in your lifetime).

A way to enhance investment returns.

One of the most common ways to employ debt strategically is to invest with borrowed funds. Because the interest you pay on a loan used for investment purposes may be tax-deductible — learn more about the rules below — you may be able to earn higher returns than your after-tax cost of borrowing.

A short-term bridge.

Say you’re anticipating the sale of a business, a large bonus or another major liquidity event. In the meantime, you would have to sell appreciated assets to meet expenses or pursue a financial goal. Borrowing can tide you over and may lower your federal income tax liability associated with that sale. The same strategy could apply if you are holding stock options in a company that has not yet gone public, and selling now to raise cash might mean sacrificing potential gains later.

Understanding when interest is deductible

It’s easy to overlook the potential federal income tax advantages of borrowing because certain types of interest — on credit cards, for instance — are not tax-deductible. A well-known exception is mortgage interest, but that deduction is limited (see “2 ways to borrow against a home” below).

However, it may be helpful to consider the deductibility of interest payments when borrowing money to invest. One thing that often catches people off guard is how interest deductibility changes based on how you use the loan proceeds, according to the National Wealth Strategies team.

That’s because tax deductibility doesn’t hinge on the type of loan. Loan management accounts (LMAs),¹ personal loans and mortgages should each be considered for potential eligibility. Instead, what matters is how the funds are used — what the IRS calls the traceability rule. (See more below.) Broadly speaking, if you invest borrowed money in taxable investments like stocks, bonds and mutual funds, the interest may qualify as a deductible investment expense.

That said, certain rules apply.

• There are generally annual limits. The amount of interest you can deduct each year as an investment expense cannot exceed your net investment income, including taxable interest, non-qualified dividends and short-term capital gains. Be realistic about the amount of net investment income that your portfolio is likely to generate. For example, equity portfolios with long holding periods tend not to have much net investment income.  If your net investment income is $25,000 but your interest expenses are $35,000, you may only be able to deduct $25,000. The remaining $10,000 may be carried forward and potentially deducted in future tax years.
  
  
• Not all investments are allowed. Interest isn’t deductible if you use the loan proceeds to invest in or to facilitate your continued ownership of tax-deferred or tax-free accounts. Similarly, because municipal bond interest is generally tax-exempt, you cannot deduct interest payments on borrowed funds used to buy or to facilitate your continued ownership of muni bonds.
  
  
• Tracing can be complex. The IRS requires a clear and traceable link between the money you borrow and the taxable investment. “Any time borrowing is involved, especially when you’re trying to claim a federal income tax benefit, documentation is critical,” says Grala. “You need a paper trail that clearly links the loan proceeds to a qualified use.”

How to integrate borrowing into your investment approach

Not only are investment interest payments potentially tax-deductible, but borrowing may give you more flexibility to adjust your portfolio while potentially avoiding incurring capital gains taxes. Say you want to diversify a portfolio or balance out a concentrated stock position. By taking out a loan, such as an LMA, you can make additional investments to round out your portfolio without selling any of your other holdings. “Rather than triggering capital gain tax by selling, you can borrow against those assets and stay invested,” Grala says.

What’s more, by borrowing against an asset such as a home, you can unlock value from property that otherwise isn’t generating income. A classic example of this strategy is when an investor buys a home with cash, then takes out a mortgage on the property and invests the proceeds in a diversified portfolio.

As an example, Grala points to a client who recently sold a portion of a business for $10 million and was able to buy a $8 million beach home with cash. The client then took out a $6 million mortgage at 5.5% interest and invested the funds in a diversified portfolio. This allows for a much larger interest deduction than using a mortgage to purchase the home would have. “There’s enough net investment income to offset the interest expense,” says Grala.

However, such benefits will vary based on individual circumstances. Before considering your options, a conversation with your advisor and tax professional regarding the basics of tax-aware borrowing is a smart first step if you want to maximize benefits.

What to discuss with your advisor

Before employing any of these strategies, you should discuss the potential risks with your advisor and tax professional. These risks include the potential for interest rate increases and a drop in the value of your investments, which could require you to sell assets at an inopportune time or raise cash to cover a margin call if the loan is secured by your investment portfolio. Work with your advisor to anticipate and prepare for different scenarios.

Borrowing isn’t the right choice for every investor and scenario, but it can play an important role in your financial decision-making. Because of the complexities around the effective use of borrowing, working closely with your advisor and tax professional is crucial. “When borrowing is done strategically, it’s not just a financing decision — it becomes part of how you grow, protect and pass on wealth,” says Grala.