To avoid capital gains taxes from a stock sale, one tactic is to borrow against stocks’ value and pay only the significantly cheaper interest rate.
“One of the main benefits ... is allowing the client to remain invested in the market while leveraging their portfolio to create a line of credit,” said Kristina Mello, financial planner and advisor at StrategicPoint Investment Advisors in Providence and E. Greenwich, R.I. “By borrowing instead of selling, not only do you avoid sacrificing potential growth on your money, but you also don’t have to generate cash and create capital gains on appreciated assets.”
“Investors are able to borrow a percentage of their portfolio value based on the underlying holdings,” said Ryan Kenny, director, portfolio manager at Crestwood Advisors in Boston. “This gives investors purchasing power to buy more securities, make a large purchase or use as a bridge loan for short-term liquidity needs.
But potential risks generally make this only a short-term strategy.
“On the surface this might appear to be one of the cheapest sources of short-term financing, but investors should be aware that the cons might outweigh the pros,” said Lisa Cappiello, director at Personal Wealth Advisors at EisnerAmper in New York.
A big risk is one common to such loans. “There are the carrying costs associated with borrowing against the assets but, more importantly, if you’re using the funds to make further investments, the leverage can magnify losses. You’re also exposed to the risks of a margin call [if] the value of the collateralized securities fall below a stipulated level,” said Chris Murray, practice leader in tax services and partner at Aspiriant LLC. “A margin call would require additional capital to be put in the account or the brokerage house might need to sell securities at what could be an inopportune time.”
“During a volatile environment, as the asset values fluctuate, if the assets dip below the threshold, investors may be required to either deposit additional funds or sell a portion of the portfolio to repay some of the loan,” Cappiello said. “It’s important to understand the details of a margin loan, not over-leverage yourself and have a payment plan in place should there be a need.”
These loans are usually variable rate products where required monthly payments can change fast.
“As we’ve seen this year, markets have declined significantly and interest rates are materially higher,” Kenny said. “Both developments heighten the risks.”
Borrowing against your investment account is a margin loan against the value in the account but “it does not create a taxable event,” said Murray.
“Interest paid on margin loans is deductible as an itemized deduction to the extent of net investment income,” Cappiello said.
Establishing a margin loan can be as easy as going online, setting up the loan with your brokerage account and withdrawing via electronic fund transfer.
Only non-retirement assets can be used as collateral to pledge, Mello said.
“Minimum line sizes can vary among banks, but assuming you have sufficient collateral in the underlying brokerage account, the setup can be very easy,” she added. “The custodian where the brokerage account is held will typically work with a program bank to offer the line of credit.”
Additional advantages of borrowing against your portfolio: no initial required draw amount, relatively quick setup with low or no costs. “There is generally no defined maturity date where the loan needs to be repaid,” Kenny added.
The brokerage account pledged to the line of credit will be restricted and cash withdrawals limited to only the free amount not used to support the outstanding loan balance, Mello said. “If cash flow is a concern and the clients can’t make the interest payments or they anticipate needing the brokerage account assets before they’re able to pay off the loan, this would not be a good fit.”
“The required monthly payments are interest only [but] it is important to have a plan to pay down principal as well,” she added.