This questions comes up from clients now and then. Here’s a scenario I dealt with a few years ago.
SCENARIO: Client has their eye on a piece of property they want to buy. They take out a line of credit against their house in order to purchase the property. Then the deal falls through. The LOC exists but the client hasn’t used it.
The client gets the idea that they should purchase stocks with it.
What are the tax implications?
ANSWER:
First of all, let’s set aside the financial aspect of whether or not it’s good to borrow like this to purchase investments (a totally different topic worthy of its own blog post) and just focus on the tax consequences.
Line of credit debt is deductible as mortgage interest if the total amount borrowed on the LOC is less than $100,000. This is true regardless of what you do with the money. (One exception: if you purchase tax-exempt securities, no deduction is allowed.)
If the LOC is more than $100,000, I would take the interest on the first $100,000 as mortgage interest, and any remaining interest as investment interest. Whether the remaining interest qualifies as investment interest would depend on what, exactly, you bought with the LOC.
One big catch to all this: you’d need to take Alternative Minimum Tax into consideration, because the interest likely wouldn’t be deductible for AMT purposes. If AMT applies, it may be advantageous to elect out of treating the LOC as mortgage interest and instead treat it all as investment interest.
As you can see, this is just just scratching the surface of something that seems like it should have a simple answer.
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