The House Shuffle
Putting your house to work
A taxpayers principal residence is a tax free zone; gains in the value of a principal residence are tax-exempt during the year so designated. A remedy for personal tax is to utilize the value of your house to invest in business. The key is that income borrowed to invest in a business or income producing activity is deductible.
Payments on a mortgage secured by your principal residence, provided the proceeds are used to fund your business or taxable investments, will be tax deductible. That is to say payments on a loan to acquire a tax exempt asset, such as your principal residence, are not deductible: If the loan you used to acquire the house is paid off from your business, and then the taxpayer borrows to invest in the business, the interest is deductible.
If a taxpayer borrows say 1 million against the house at 5%, and invests it in shares of the business, the 50,000 yearly interest cost will be deductible against other income. Accessing the cash to pay the mortgage may be a taxable event, if, for example the business pays the mortgage on the taxpayers behalf, such payments would be taxable income to the borrowing taxpayer.
If the taxpayer in the above example had sufficient capital from previous injections into the business, this capital could be accessed tax free as a reduction in capital in the business to keep interest payments current. In the alternative, the taxpayer could increase the mortgage every year to cover the interest payments and the original amount would remain deductible. Note that the principal amounts of any mortgage payment would not be tax deductible and any “accrued interest” would not be deductible until actually paid.
The interest on the original 1,000,000 would be deductible, but not the interest on the 50,000 borrowed to pay the original interest (in this example 2500 in the second year), until it was actually paid. At a certain point the loan could be novated and re-advanced at the higher amount including interest, which would then allow the deduction of the “interest on interest”, in this example the 2500 in the second year. The original amount of the mortgage and the investment would remain tax free when paid out of the business, and on to to retire the mortgage. Any reimbursement by the business of the ongoing interest on the mortgage, previously deducted, would be subject to tax in the hands of the borrowing taxpayer when received. In this sense it could be said that this strategy is simply a long term deferral. However, provided the house appreciates by more than 50,000 per year, there would be no tax to pay when the structure was unwound, as the increase in the value of the principal residence is tax exempt.
If the taxpayer has a mortgage, as many do, on their house, liquidating other assets to retire the mortgage and borrowing again to replenish those liquidated assets, investing the new loan’s proceeds in a form that was to earn income, previously nondeductible interest income would become deductible.
By the same token virtually any capital asset can be borrowed against tax free, as tax is only paid when assets are disposed of. Although recently there have been some changes to try to eliminate certain egregious forms of monetization, generally speaking one can borrow against one’s assets with no tax penalty on the borrowings. This could even occur when such borrowings are “non-recourse”, that is to say, that there is no recourse to the borrower beyond the posted security. Of course if the lender realizes on the posted security, any appreciated gains that the borrower taxpayer had in the security would crystallize and be taxable in the year the security was realized.
