April 15, 2019

So they can grow their wealth in strategically tax-efficient ways.

 

More than any other segment of the population, the wealthy understand the power of leverage in today’s environment.  Borrowing against an investment portfolio not only has the possibility of boosting returns, but it can also provide liquidity in a tax-efficient way.  With relatively low current interest rates, investors may want to consider borrowing against their investment portfolios to fund major purchases and improve investment returns.  Margin loans and non-purpose lines of credit are two effective ways to do this.

Before using debt, however, investors must carefully consider how much leverage they can comfortably take on, from both a balance sheet and cash flow perspective. The degree of volatility of their portfolio, cash flow and net worth, as well as overall liquidity and risk tolerance should also be factors in deciding whether—and how much—to borrow. 

Margin: Optimal for buying publicly-traded equities

If the purpose of borrowing is to purchase publicly-traded stocks, then margin is the appropriate source of financing. When used prudently, margin can be an effective way to potentially enhance portfolio returns. 

A margin line allows investors to borrow up to 50% against the value of marketable securities held in their investment portfolio. The line can be used for any purpose, including buying margin-eligible securities such as publicly-traded stocks and convertible bonds. 

Bear in mind that leveraged investing can magnify both gains and losses. If the portfolio balance falls below a certain point, investors may be required to deposit additional funds or pay down their line of credit. Therefore, it’s best to lower the overall volatility of the portfolio where possible. One way to keep volatility in check is to ensure that any purchased assets have low correlation with the current portfolio; the higher the correlation among assets within a portfolio, the more volatile the returns are likely to be. Ideally investors should choose assets that increase diversification and therefore lower the expected volatility of the overall portfolio. 

But when considering leverage to help enhance portfolio returns, it’s important that the expected return on the purchased assets exceeds the cost of the debt. Investors should not take outsized risk in pursuit of only moderately higher returns. 

Non-purpose Lines

For a fast and flexible source of funds, many investors choose to establish non-purpose lines of credit (NPL) that are secured by their marketable securities portfolios. NPLs differ from conventional margin by offering better pricing and better advance rates. While they can be used for nearly any purpose, regulations prohibit their use for buying publicly-traded equities.

A recent survey by a top brokerage firm found that its most active NPL borrowers were clients who were among the top third in terms of assets under management. Further, their wealthiest clients were the most likely to maintain NPLs as a standby source of liquidity. Ready access to cash allows investors to seize opportunities and handle emergencies without disrupting their portfolios or triggering taxable events.

Easy to establish and implement

Unlike alternative sources of standby liquidity such as home equity lines of credit, NPLs can usually be set up quickly, with minimal paperwork and no closing or maintenance fees. What's more, advance rates are higher than margin, with investors generally able to borrow 65% to 85% of the market value of their portfolio, depending on the asset mix. 
In addition, interest rates tend to be far lower than for both HELOCs and margin—typically below Prime. And if used for investment purposes such as private equity, investment real estate and fixed-income securities, the interest paid can be used to offset investment income for tax purposes. The interest may also be deductible as business interest if it is used for a business investment. These tax advantages allow investors to enjoy potential returns that far exceed the cost of borrowing.

Advantages of NPLs for ultra-affluent clients

Many wealthy clients have incomes that are irregular, often in the form of lump-sum payments that are less frequent and reliable than those earned by salaried employees. Private equity investors, for example, typically receive periodic distributions. NPLs allow the wealthy to smooth out cash flow and meet short-term liquidity needs without being forced to sell at an inopportune time or incur the tax consequences that may arise from the sale of securities. They can be particularly useful for those who have a portfolio full of low-basis stocks or concentrated investment positions. 

NPLs provide a convenient, low-cost source of capital with rates that are typically well below expected investment returns. In today's low interest rate environment, investors have an excellent opportunity to take advantage of this expected return differential. 

In addition, NPLs offer quick access to cash, making them a good source of bridge financing to facilitate the purchase of big-ticket items like real estate, artwork and aircraft before securing permanent financing. NPLs provide all the advantages of cash acquisitions—more favorable pricing and terms—while allowing investors to remain fully invested and not sacrificing potential portfolio appreciation.

For those with concentrated investment positions, NPLs can provide an effective means of portfolio diversification. By leveraging the concentrated asset, investors can reinvest the proceeds into fixed income and/or alternative assets in order to diversify their holdings while slowly unwinding their concentrated positions over time.  

Interest deductibility considerations for investment-secured lines of credit

Interest on loans secured by investments may be deductible if the proceeds are used to purchase additional investments or to fund trade or business capital needs. Note that the amount of the investment interest expense that may be deducted when the loan proceeds are used to purchase additional investments is limited to the net investment income for the year. When the loan proceeds are used to meet business capital needs, the business expense deductions are limited to 30% of adjusted taxable income with an exception for small businesses and real estate companies. 

Bottom line

Whenever using leverage, there is a risk that the asset used as collateral will decline in value and the cost of borrowing could exceed the potential return of the acquired asset. While securities-based lines don’t typically have fixed repayment schedules, investors may be required to deposit funds or pay down their line of credit if the value of their portfolio drops below a certain point. For that reason, it's important to keep leverage to a manageable amount and maintain sufficient liquidity elsewhere as a cushion.

However, the prudent use of debt can allow investors to maximize their investment returns while meeting their liquidity needs. Work with an experienced lending professional to evaluate whether this option is right for you.

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