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Chapter 42 Leveraging investment assets.


Leveraging is the use of techniques that permit investors to control or benefit from an investment with a given dollar value while using less than that given dollar value of the investor's own money. Essentially, as the name implies, it is similar to the action of a lever that permits a person to move a boulder larger than he could move with his hands alone. Leveraging permits investors to control more or larger investment assets than they could control with their own equity alone.

Essentially, there are three types of leverage:

1. Financial leverage

2. Inherent leverage

3. Tax leverage

Financial leverage is the use of borrowed funds to supplement the investor's own dollar investment (equity) to increase the scale of investment. For example, an investor can purchase stocks, bonds, and other marketable securities, real estate, business assets, and the like using some combination of investor and borrowed funds. If the investment return on the asset exceeds the interest rate paid on the loan, the investor's return on his equity will rise above the return on the underlying asset (positive leverage). Conversely, if the return on the asset is less than the interest rate paid on the loan, the investor's return will fall below the return on the underlying asset (reverse or negative leverage). Investors may be able to deduct the interest expense against investment income on their tax returns, subject to limitations. (See "What Are the Tax Implications?" below.)

Inherent leverage (which is often also referred to as financial leverage, although it involves no borrowing) refers to the leverage inherently created by the investment asset itself. Generally, no borrowed funds are involved. For instance, derivative securities such as options contracts and futures contracts require investors to deposit only a fraction of the value of the assets underlying the contract. Similar to financial leverage, if the value of the underlying asset moves the right way, investors' returns are potentially much greater than the returns they would earn by taking a similar position directly in the underlying assets themselves, and vice versa.

Tax leverage is similar to the concept of financial leverage, except that the money is implicitly borrowed from the government rather than from an actual lender. These implicit loans are created when the U.S. government (and/or other tax entities) provides tax incentives for employing various tools and techniques (e.g., IRAs) that allow taxpayers to defer the payment of taxes. Generally, if a taxpayer remains in the same tax bracket, the taxpayer will pay the deferred taxes in full at a later date, but with no increase or adjustment for the lapse in time. In other words, the ability to defer the payment of tax is essentially an interest-free loan from the government. In some situations, such as when an investor moves into a higher tax bracket, the amount of tax that must ultimately be repaid may be greater than the amount originally deferred. But even in this case the investor may still benefit. The tax leverage involved is essentially equivalent to a subsidized or below-market discount loan rather than a fully interest-free loan. In some other cases, the amount of tax paid in the future may be less than the amount of tax originally deferred. This is essentially equivalent to an interest-free loan where part of the debt is forgiven. (See "Questions and Answers," below, for additional discussions on tax leverage.)

Securities traded on organized exchanges or in the over-the-counter market are subject to minimum investor equity requirements, called margin requirements, as set by the Federal Reserve Board's Regulation T. These rules apply to the amount of equity investors must have and maintain in both securities purchased with financial leverage (e.g., stocks) and those that are inherently leveraged (e.g., futures contracts). These limitations apply regardless of the source of borrowing--brokerage firm, bank, or even family members. The National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE), and other exchanges have their own rules that generally match the Reg. T requirements, but which may be more restrictive.

If investors borrow money to leverage their investments from their brokerage firm, or trade in securities with inherent leverage, they must set up a margin account. The minimum portion of the purchase price that the customer must deposit is called the initial margin and is the customer's initial equity in the account. Subsequently, investors must maintain a specified minimum level of equity relative to the market value of the investment called the maintenance margin. The maintenance margin requirement is generally lower than the initial margin requirement. If an investor's margin falls below the required maintenance level, the brokerage firm will issue a margin call requiring the investor to deposit additional funds within a specified period of time. If the investor fails to do so, the brokerage firm will sell the assets and close out the investor's position. Brokerage firms may have their own margin requirements that are more restrictive than those spelled out in Reg. T or the NYSE or NASD guidelines. (See "Questions and Answers," below, for further discussion of margin requirements and how margin accounts operate.)

Margin requirements or borrowing limitations for real estate, business assets, private placements, non-publicly-traded limited partnership interests, and other non-exchange-traded investments are generally not subject to regulation. The equity requirements are generally determined by mutual agreement among the parties to the transaction and the lenders.


The operations of a commercial bank provide a good illustration of the day-to-day use of leverage. The owners of the bank use their own funds to provide approximately 10% of the bank's assets. For simplicity, assume that the bank obtains the balance of its cash needs through the following sources:

Checking accounts           0%-3%
Savings accounts            4%-6%
Certificates of Deposit     5%-7%

If these funds (90% of which are someone else's money) are lent or invested at a 14% average return, it is easy to see how the bank makes money.

Leveraging also enables an investor to purchase a larger asset than his own available funds will permit. For example, if an individual wishes to purchase a $100,000 real estate investment that he expects to appreciate by 20% over the next year, but he has only $20,000 available to invest, the individual would leverage the investment by borrowing the other $80,000 he needs for the investment.

The application of leveraging to personal financial planning can best be explained by way of an example. Assume an investor wishes to purchase undeveloped land at a price of $50,000. The investor believes he can have the zoning for the property changed within a year, allowing him to sell the land for $75,000. The investor has arranged with his bank to borrow $40,000 of the purchase price for the needed one year at a fixed rate of 5%, with all interest payable with the principal at the end of the one-year term. The investor will therefore be required to invest only $10,000 of his own funds. In deciding whether to invest $50,000 of his own funds or to invest only $10,000 and borrow the balance under the terms provided by the bank, the investor would make the following analysis:
Purchase Price: $50,000
Expected Sale Price: $75,000
Holding Period: one year
Investor's Tax Bracket: 28%

                              Leverage          Financing

(1) Initial Equity                $50,000            $10,000
(2) Loan Principal                     --             40,000
(3) Sales Price                    75,000             75,000
(4) Gain on Sale
[(3)--(1)--(2)]                    25,000             25,000
(5) Interest Cost
[.05 x (2)]                            --              2,000
(6) Tax on Sale
[.28 x (4)]                         7,000              7,000
(7) Tax benefit of
interest [.28 x (5)]                   --                560
(8) Net Return
[(4)--(5)--(6) + (7)]              18,000             16,560
Return on Investor's              $18,000            $16,560
Equity [(8)/(1)]            $50,000 = 36%     $10,000 = 166%

In evaluating whether leveraging is appropriate for this investment, the investor must review not only the potential rewards of leveraging, but also the associated risks. What if he is not able to obtain the expected zoning change and can sell the property in one year for only $35,000? The investor must still repay the bank the $40,000 borrowed plus the interest of $2,000. The results of this investment would look like this:
Purchase Price: $50,000
Sale Price: $35,000
Holding Period: one year
Investor's Tax Bracket: 28% (loss on sale will be a
capital loss, offsetting other gains of investor.)

                                Leverage         Financing

(1) Initial Equity                 $50,000           $10,000
(2) Loan Principal                      --            40,000
(3) Sales Price                     35,000            35,000
(4) Gain on Sale
[(3)--(1)--(2)]                   (15,000)          (15,000)
(5) Interest Cost
[.05 x (2)]                             --             2,000
(6) Tax Benefit of loss
[.28 x (4)]                          4,200             4,200
(7) Tax benefit of
interest [.28 x (5)]                    --               560
(8) Net Loss
[(4)--(5) + (6) + (7)]            (10,800)          (12,240)
Return on Investor's              (10,800)          (12.240)
Equity [(8)/(1)]             $50,000 = -22%   $10,000 = -122%

This example illustrates the concept of "negative leverage," the risk that the investment will not generate enough cash income to pay off the debt. The result could be the loss of the entire investment, including not only the capital put into the investment, but also the cash needed to repay the borrowed money.

Even if the investor can afford to lose only $10,000, if he believes the risk of loss is small, then leveraging may still make sense. However, a loss in such a case could be devastating to the investor, if he can sell the land for only $35,000. Where will he get the $12,240 to cover his net loss?


1. When the investor does not have the available cash to finance the purchase of a particular asset.

2. When the investor can borrow money at a rate lower than the expected return on an investment. Leveraged debt should be incurred only when the investment will earn more than the cost of borrowing.

3. When the investment itself can generate sufficient "cash flow" to cover "debt service" (the annual cost of interest and any principal payable on the debt).

4. Where the goal of the investment is long-term appreciation rather than a current return, and the investor has other available resources to cover the annual cost of debt service.

5. During periods of high inflation. At such times, borrowing money enables an investor to purchase an asset immediately. The appreciation in that asset offsets the effects of inflation. The investor can pay off the debt in the future with dollars that have been "cheapened" by the effects of inflation.


1. Leveraging makes it possible to purchase an asset the investor might not otherwise be able to afford.

2. Leveraging may significantly increase the return on the investor's equity.

3. When used to obtain depreciable property, leveraging increases the tax benefits to the investor. This is because depreciation may be based on the full purchase price of the asset, and not just the amount of the investor's equity. For example, if David Kurt purchased an office building costing $100,000 (exclusive of land), his depreciation will be computed on the full $100,000, even though he may have used only $20,000 of his own funds.

4. Leveraging permits the investor to spread a limited amount of available funds throughout a number of investments. This enhanced diversification adds to the safety of principal.

5. The creditor will have an interest in the financial soundness of the investment. In order to protect that interest, before a loan is made, most lenders will make an independent investigation of the underlying value of the property and the borrower's ability to pay both interest and principal. This may provide the investor with an objective evaluation of the appropriateness of the venture.


1. "Reverse leverage" is the most serious disadvantage of borrowing money to purchase an investment. Reverse leverage means that the cost of servicing the debt (both interest and principal) exceeds the total return (both cash flow and appreciation). For example, if the annual debt service for a $100,000 loan is $15,000 and the annual cash flow from the investment is only $8,000, the investor must fund the $7,000 shortfall from other income or assets.

2. If the primary purpose of the investment is to obtain appreciation, and there is little or no current income generated, the annual debt service payment requirements may place significant cash flow pressures on the investor.

3. Leveraging automatically increases the risks of an investment since the debt must be repaid, regardless of the return the investor receives.

4. The creditor, as a "partner" in the venture, may impose certain restrictions on the investor. For example, a bank may limit the amount of salary that can be paid to the sole shareholder of a corporation borrowing funds to finance the purchase of a new manufacturing facility. Similarly, a brokerage firm lending money to a customer to help him purchase securities may require him to provide other securities as collateral. Therefore, the cost of this "margin account" is not only the interest on the borrowed funds, but also the limitations on the free use of the securities used as additional collateral.

5. Borrowing to finance the purchase of an investment asset may restrict an individual's ability to borrow for other purposes. Other potential creditors may determine that the individual cannot safely handle any further indebtedness.


Once it is determined that an investment may be appropriate for leveraging:

1. Determine the investor's borrowing capacity--No matter how much the investor may want to borrow, prospective lenders will impose limitations on the amount they are willing to lend.

2. Determine the appropriate amount of leverage--The factors that should be examined include:

a) The availability of future funds to meet debt service requirements. An investor's borrowing should be limited to his ability to meet debt payments as they come due. The future funds needed may be derived from the cash flow of the investment itself ("self-funding") or from outside sources such as other investments, the investor's personal income, or other borrowed funds.

b) The spread between the expected return on the investment and the cost to borrow. The higher the expected rate of return, the greater is the advantage of leverage (and therefore the greater the risk the investor should be willing to take). For example, if the investor expects to earn 20% on his money and it costs him only 14% to borrow, he would tend to borrow more than if the money cost him 18%. The 2% spread between the 18% cost to borrow and the 20% expected return may still make leveraging worthwhile, but the spread is only 2%. In other words, there is little margin for error. With the 6% spread between 14% and 20%, even if the return on the investment drops 3% below the projected 20%, the investor still has positive leverage.

c) The greater the tax advantages of borrowing (all other things being equal), the more the investor should borrow. Subject to limitations imposed by the tax law on deductions and other tax benefits relating to investment property (see Chapter 43, "Taxation of Investment Vehicles"), the investor receives the same type and level of tax benefits from borrowed funds as he does from the use of his own capital. Therefore, financial leveraging is also tax leveraging. For example, an investor who purchases an office building for $100,000 of his own funds receives depreciation deductions based on that amount. He obtains neither financial nor tax leverage. But if the same individual had purchased a $500,000 building using his $100,000 and $400,000 of borrowed money, his depreciation deductions would be five times higher.

3. Determine the alternative sources for leverage borrowing--Such alternatives might include (a) bank financing (either secured by the investment property, other personal assets, or possibly unsecured), (b) margin borrowing from a brokerage house (secured by the investor's portfolio of securities), (c) the cash value of insurance policies, (d) seller financing (often called "purchase-money" financing), and (e) borrowing from friends and family.


Interest paid on debt to finance investments may be tax deductible, but the deduction is subject to limitations. In a nutshell, interest paid on debt to finance investments (other than passive activity investments) is deductible only to the extent of net investment income. Net investment income means the excess of investment income over investment expenses associated with the investments producing the income. Investment income includes dividends, interest, royalties, rents (except from passive activities), net short-term and long-term capital gains, and ordinary income gains from the sale of investment property.

However, under the tax rules until 2010, taxpayers may include dividends and long-term capital gains qualifying for the reduced rate (maximum rate of 15%) in the computation of their net investment income only if they elect to forgo the reduced rate on those dividends and gains. Normally this is not a good choice, because the interest expense not deductible by reason of this limitation may be carried over indefinitely and applied against net investment income in future years. Effectively, interest expense is deductible only to the extent of investment interest income on instruments such as bonds and other categories of ordinary income.

Borrowing may still make sense in two circumstances. If the lending rate is less than the dividend coupon rate, this is a positive after-tax leverage position for the investor. If the investment interest expense for the year exceeds the net investment income (computed by excluding the qualifying dividends and long-term capital gains), investors may choose to include in net investment income just so much of their qualifying dividends and long-term capital as is necessary to zero-out the investment interest expense. Investors who have substantial income from bond portfolios may also be able to borrow up to the amount that generates interest expense that when aggregated with existing investment interest equals the investment income from the bonds alone.

Another strategy is to borrow against the personal residence. Such interest is not deductible as investment interest even though the proceeds of the loan may be traced to the acquisition of investment property. However, a deduction may be available for qualified residence interest. (1) (See Chapter 43, "Taxation of Investment Vehicles" for a more complete discussion of the investment interest expense limitation and other investment tax issues.)


1. Tax Facts on Investments (formerly Tax Facts 2) (Cincinnati, OH: The National Underwriter Company, updated annually).

2. Lilian Chew, Managing Derivative Risks: The Use and Abuse of Leverage (Chichester, NY: Wiley, 1996).

3. David Sirota, Essentials of Real Estate Investment (Chicago, IL: Dearborn Real Estate Education, 2004).

4. Friedman and Harris, Keys to Investing in Real Estate (Hauppauge, NY: Barron's, 2000).

5. Lawrence Gitman, Personal Financial Planning with Financial Planning Software and Worksheets (Mason, OH: South-Western/Thomson Learning, 2004).


Question--What is a margin account?

Answer--A margin account enables an investor to use unencumbered securities to borrow cash that in turn is used to purchase additional securities. Essentially, a margin account with a broker is one that provides loans secured by stocks and other securities held by the brokerage firm.

Question--What are the advantages of a margin account?

Answer--A margin account enables an investor to borrow cash readily, with a minimum of paperwork and without the need to sell or transfer stocks to finance the loan. The investor pays a competitive rate of interest to the broker on this "secured loan."

Borrowing funds to purchase stocks may increase the size of the profit the investor may realize beyond what would be possible if only personal funds were used. This is a classic example of the enhancement of purchasing power available through leveraging; by buying more stocks with the additional money borrowed from the brokerage firm, the investor increases his potential gain as well as possible dividends.

Example: Assume an investor buys 750 shares of the Martin-Stephans Corporation at $50 a share. He uses his own money and pays $37,500.

Assume the stock appreciates $10 a share. It is then worth a total of $45,000, for a gain of $7,500. If the investor had used leverage through a margin account, the gain could have been increased significantly. For instance, he could have bought one-third more shares at a 75% margin. Although he would still have invested $37,500 of his own money for 750 shares, he can borrow $12,500 to purchase an additional 250 shares. If the 1,000 share total appreciates $10 a share, his profit is $10,000. As a result of leveraging, his profit has increased by $2,500 (before the after-tax interest cost of borrowing the $12,500).

Question--How does a maintenance margin call work?

Answer--First, a simple example. If a customer buys $100,000 of securities on Day 1, Regulation T would require the customer to deposit a margin of 50%, or $50,000, in payment for the securities. As a result, the customer's equity in the margin account is $50,000, and the customer has received a margin loan of $50,000 from the firm. Assume that on Day 2 the market value of the securities falls to $60,000. Under this scenario, the customer's margin loan from the firm would remain at $50,000, and the customer's account equity would fall to $10,000 ($60,000 market value less $50,000 loan amount). However, the minimum maintenance margin requirement for the account is 25%, meaning that the customer's equity must not fall below $15,000 ($60,000 market value multiplied by 25%). Since the required equity is $15,000, the customer would receive a maintenance margin call for $5,000 ($15,000 less existing equity of $10,000). Because of the way the margin rules operate, if the firm liquidated securities in the account to meet the maintenance margin call, it would need to liquidate $20,000 of securities ($5,000 maintenance margin call / 25% maintenance margin).

Here are a few more examples, showing Long Market, Short Market, Debit Balance, Credit Balance, and Equity numbers for various situations. Equity is defined as the Long Market Value plus the Credit Balance, less any Short Market Value and Debit Balance. (The Current Market Value of securities is the Long Market value less the Short Market value.) The Credit Balance is cash--money that is left over after everything is paid and all margin requirements are satisfied.

In the first example, a customer buys $100,000 worth of some stock on margin. The 50% margin requirement (Regulation T) can be met with either stock or cash. To satisfy the margin requirement with cash, the customer must deposit $50,000 in cash. The account will then appear as follows; the "Equity" reflects the cash deposit:
  Long      Short    Credit     Debit
 Market     Market   Balance   Balance   Equity

$100,000      $0       $0      $50,000   $50,000

To satisfy the margin requirement with stock, the customer must deposit marginable stock with a loan value of $50,000, i.e., a value of $100,000 ($50,000 maintenance margin call / 50% initial margin). The account will then appear as follows; the $200,000 of long market consists of $100,000 stock deposited to meet Regulation T and $100,000 of the stock purchased on margin:
   Long      Short    Credit     Debit
  Market     Market   Balance   Balance     Equity

$200,000       $0       $0      $100,000   $100,000

Here's a new example. What happens if the account looks like this?
  Long     Short    Credit     Debit
 Market    Market   Balance   Balance   Equity

$20,000      $0       $0      $17,000   $3,000

The maintenance requirement calls for an equity position that is 25% of $20,000, which is $5,000, but the equity is only $3,000. Because the equity is less than 25% of the market value, a maintenance margin call is triggered. The call is for the difference between the requirement and actual equity, which is $5,000 - $3,000, or $2,000. To meet the call, either $2,000 of cash or $4,000 ($2,000 maintenance margin call + 50% initial margin) of stock must be deposited. Here is what would happen if the account holder deposits $2,000 in cash; note that the cash deposit pays down the loan.
  Long     Short    Credit     Debit
 Market    Market   Balance   Balance   Equity

$20,000      $0       $0      $15,000   $5,000

Here is what would happen if the account holder deposits $4,000 of stock:
  Long      Short    Credit     Debit
 Market     Market   Balance   Balance   Equity

$24,000       $0       $0      $17,000   $7,000

Ok, now what happens if the account holder does not meet the call? To meet the maintenance margin requirement, the brokerage firm must sell four times the amount of the call ($2,000 maintenance margin call / 25% maintenance margin = $8,000). So stock in the amount of $8,000 will be sold and the account will look like this:
  Long     Short    Credit     Debit
 Market    Market   Balance   Balance    Equity

$12,000      $0       $0       $9,000    $3,000

In the case of short sales, Regulation T imposes an initial margin requirement of 150%. This sounds extreme, but the first 100% of the requirement can be satisfied by the proceeds of the short sale, leaving just 50% for the customer to maintain in margin (so it looks much like the situation for going long). To maintain a short position, rule 2520 requires a margin of $5 per share or 30% of the current market value (whichever is greater).

Assume a person shorts $10,000 worth of stock. The investor must have securities with a loan value of at least $5,000 to comply with Regulation T. In this example, to keep things simple, the customer deposits cash. So the Credit Balance consists of the $10,000 in proceeds from the short sale plus the $5,000 Regulation T deposit. Remember that market value is long market value minus short market value, and because the customer owns no securities long in this example, the "long market" value is zero, making the market value of the account negative.
  Long      Short     Credit     Debit
 Market    Market    Balance    Balance   Equity

$0         $10,000   $15,000      $0      $5,000

What about being short against the box? When an individual is long on a stock position and then shorts the same stock, a separate margin requirement is applicable. When shorting a position that is long in an account, the margin requirement is 5% of the market value of the underlying stock. Let's say the original stock holding of $100,000 was purchased on margin (with a corresponding 50% requirement). And the same holding is sold short against the box, yielding $100,000 of proceeds that is shown in the Credit Balance column, plus a cash deposit of $5,000. The account would look like this:
                 Long      Short      Credit     Debit
                Market     Market    Balance    Balance    Equity

position       $100,000                         $50,000    $50,000
Sell short          $0    $100,000   $105,000   $100,000   $5,000
Net            $100,000   $100,000   $105,000   150,000    $55,000

Question--What are the some of the risks involved with margin trading?

Answer--There are a number of risks that all investors need to consider in deciding to trade securities on margin. These risks include the following:

* Investors can lose more funds than they deposit in the margin account. A decline in the value of securities that are purchased on margin may require investors to provide additional funds to the firm that has made the loan to avoid the forced sale of those securities or other securities in their account.

* The firm can force the sale of securities in investors' accounts. If the equity in the account falls below the maintenance margin requirements under the law--or the firm's higher "house" requirements--the firm can sell the securities in the account to cover the margin deficiency. Investors will also be responsible for any shortfall in the account after such a sale.

* The firm can sell investors' securities without contacting the investors. Some investors mistakenly believe that a firm must contact them for a margin call to be valid, and that the firm cannot liquidate securities in their accounts to meet the call unless the firm has contacted them first. This is not the case. As a matter of good customer relations, most firms will attempt to notify their customers of margin calls, but they are not required to do so.

* Investors are not entitled to an extension of time on a margin call. While an extension of time to meet initial margin requirements may be available to customers under certain conditions, a customer does not have a right to the extension. In addition, a customer does not have a right to an extension of time to meet a maintenance margin call.

Question--How do margin requirements vary among different securities?

Answer--Margin requirements tend to vary somewhat depending upon each brokerage firm's own "house" rules, but competition tends to keep them quite close to Regulation T requirements and the NASD guidelines.

Question--What is a concentrated account?

Answer--An account is considered to be concentrated when one position accounts for a significant proportion of the entire balance in the account. Brokerage firms typically require higher margins for greater concentrations or larger balances of concentrated accounts, which vary from firm to firm.

Question--What is a pattern day trader?

Answer--Investors are considered pattern day traders if they trade 4 or more times in 5 business days and their day-trading activities are greater than 6% of their total trading activity for that same five-day period.

A brokerage firm also may designate an investor as a pattern day trader if it knows or has a reasonable basis to believe that the investor is a pattern day trader. For example, if the firm provided day trading training to an investor before opening his account, it could designate the investor as a pattern day trader.

Question--What are the margin requirements for a pattern day trader?

Answer--A pattern day trader must maintain minimum equity of $25,000 on any day that the customer day trades. The required minimum equity must be in the account prior to any day-trading activities. If the account falls below the $25,000 requirement, the pattern day trader will not be permitted to day trade until the account is restored to the $25,000 minimum equity level.

The rules permit a pattern day trader to trade up to four times the maintenance margin excess in the account as of the close of business of the previous day. If a pattern day trader exceeds the day-trading buying power limitation, the firm will issue a day-trading margin call to the pattern day trader. The pattern day trader will then have, at most, five business days to deposit funds to meet this day-trading margin call. Until the margin call is met, the day-trading account will be restricted to day-trading buying power of only two times maintenance margin excess based on the customer's daily total trading commitment. If the day-trading margin call is not met by the fifth business day, the account will be further restricted to trading only on a cash available basis for 90 days or until the call is met.

In addition, the rules require that any funds used to meet the day-trading minimum equity requirement or to meet any day-trading margin calls remain in the pattern day trader's account for two business days following the close of business on any day when the deposit is required.

Effectively, for stock investments, this means pattern day traders can trade up to four times their maintenance margin in excess of $25,000 as of the close of business of the previous day.

It is important to note that the brokerage firm may impose a higher minimum equity requirement and/or may restrict trading to less than four times the day trader's maintenance margin excess.

Question--How is tax leverage created?

Answer--Typically, tax leverage is created in one or both of two ways: (1) by postponing the tax on earnings or benefits; and/or (2) by providing tax incentives that in effect reduce or subsidize the up-front cost of the investment.

Question--What are some of the tools and techniques that create tax leverage by postponing the tax on earnings or benefits?

Answer--Typical examples of the types of vehicles that postpone the tax on earnings or benefits are Series EE savings bonds, life insurance, annuities, pension and profit-sharing plans, ESOPs, stock-bonus plans, IRAs (traditional, Roth, SEP, and SIMPLE), IRC Section 401(k) plans, IRC Section 403(b) plans, and certain types of nonqualified deferred compensation plans. However, the most prevalent type of tax-deferral vehicle is appreciating assets, such as stocks or real estate. Under the current tax laws, the tax on capital gains is deferred until the gain is recognized, usually when the asset is sold.

In addition, techniques that may be employed to defer full recognition of capital gains even beyond the time of disposal include the use of installment sales, IRC Section 1031 like-kind exchanges, private annuities, and, in the case of personal residences, the lifetime gain exclusion provisions. IRC Section 1035 provides similar nonrecognition treatment for qualifying life insurance exchanges. Certain other transfers of life insurance policies between related parties also avoid recognition. In the area of corporate securities, recapitalizations, reorganizations, mergers, and acquisitions, there is an assortment of provisions allowing nonrecognition treatment.

Life insurance, capital gains, and Roth IRAs are special cases. In the case of life insurance, if the proceeds are paid in the form of death benefits, in effect the tax loan associated with the earnings on the cash value is generally completely forgiven. In the case of appreciated assets that are held at death, the step-up in basis effectively cancels the tax loan. [However, a modified carryover basis is scheduled to replace a step-up in basis in 2010.] Also, in the case of charitable gifts of appreciated property where the appreciation qualifies as long-term capital gain, the donor is generally able to take a deduction for the entire amount of the gift without recognizing or paying tax on the gain. (There may be alternative-minimum-tax implications, however.) Once again, the tax loan is essentially forgiven. Similarly, qualified distributions from Roth IRAs can be received tax-free.

Question--What are some of the tools and techniques that create tax leverage by providing up-front tax incentives?

Answer--Up-front tax incentives come from three sources: (1) acceleration (immediate deductibility) of expenses that would normally be deducted against later income; (2) tax deductibility or excludability of the initial payment or investment itself; or (3) direct tax credits or subsidies.

1. The Acceleration Principle--Examples of the acceleration principle include immediate expensing of up to $108,000 (as indexed, in 2006) per year for personal property under IRC Section 179, intangible drilling and development costs in oil and gas programs, accelerated expensing of certain pre-production period expenses in drilling and mining operations, a host of acceleration allowances for small farmers, and immediate expensing associated with certain research and development costs. Except for IRC Section 179 expensing (essentially the small business owner's tax shelter), acceleration of expenses is associated with what used to be called tax shelters and what are now known as passive activities. The passive-activity loss rules now severely restrict the use of the accelerated expenses to shelter income from other nonpassive activity sources. Therefore, with one notable exception, the acceleration principle is not as important a factor in the evaluation of tools and techniques employing tax leverage as before, except with respect to managing a client's portfolio of passive-activity investments.

However, the acceleration principle does enter, in part, into any decisions regarding depreciable or amortizable property where the allowable depreciation or amortization deductions may exceed actual economic deterioration or obsolescence. In these cases, the excess of the allowable deductions over the true economic deterioration or obsolescence creates tax leverage by reducing reported income below actual economic income. In most cases, this tax loan is repaid when the asset is later disposed of for more than its remaining basis (for a gain) or continues to generate income beyond its tax depreciable or amortizable life.

The notable exception mentioned earlier is in the area of charitable giving and, in particular, with respect to charitable remainder trusts. Charitable remainder trusts permit taxpayers to take an immediate tax deduction for property that will not pass to the charity until some later date.

2. Tax Deductibility or Excludability--A large number of tools and techniques permit tax deductibility or excludability of the up-front costs or investment. The most notable examples include contributions to qualified pension and profit-sharing plans, ESOPs, stock-bonus plans, Keogh plans, certain IRAs (traditional, SEP, and SIMPLE), IRC Section 401(k) plans, and IRC Section 403(b) tax-deferred annuities. Other examples of excludability include the gain on Series EE savings bonds that are exchanged for Series HH bonds, salary deferrals under certain types of nonqualified deferred compensation plans, the gain on exercise of incentive stock options, and built-in gain on distributions of employer stock from ESOPs and stock-bonus plans. In these cases, taxation of the benefit is deferred until the income is received or gains are realized by sale or taxable disposition of the stock or bond.

3. Tax credits and subsidies--Tax credits are a direct reduction of tax. The amount of the tax benefit is generally the same for every taxpayer regardless of the taxpayer's tax bracket. The premier example was the 10% investment tax credit for qualifying investments in business personal property. Like in so many other areas, tax policy on the investment tax credit has varied and the investment tax credit has currently fallen from favor. However, other tax credits survive. Examples include the low-income housing credit, certain credits for research and development expenditures, the childcare credit, and job creation credits. Tax credits are especially lucrative tax incentives since the interest-free tax loan (deferred tax) is typically forgiven in whole or in part if the taxpayer meets certain qualifying criteria or holding-period requirements. In some cases, tax credits are potentially subject to recapture (being added back to the amount of tax due on a later return).

Direct subsidies are unusual, but examples include low-interest mortgages in certain types of low-income housing projects and special development loans for preserving wetlands or ecological landscaping. Also included are various subsidies to farmers (such as for not growing crops). Indirect subsidies include loan guarantees and minimum rent guarantees for low-income housing, farm price supports, tariffs and import quotas, and the like.

The effects of indirect subsidies are generally difficult to measure and are frequently ignored in formal analyses. However, even if ignored, their presence should not be forgotten.

Question--How is tax leverage like financial leverage with interest-free borrowing?

Answer--If a person in a 33.3% combined federal and state tax bracket invests $1,000 for one year at a fully taxable 10% rate of return, she will have $1,066.70 after tax at the end of the year. The after-tax rate of return is 6.67%.

Now suppose the investor can borrow $500 at 0% interest and add it to her $1,000 investment. This $1,500 total investment will earn $150 before tax. The investor must pay $500 plus $0 interest back to the lender, so the investor is left with $1,150 before tax, or $1,100 after tax. The investor has increased the after-tax return on her equity from 6.67% to 10% through the use of financial leverage.

Assume the investor elects instead, to invest in the same instrument but inside a deductible IRA. Since the contribution to the IRA is tax-deductible, the investor will have $1,500 to invest before tax (assuming the contribution is also deductible for state tax purposes) for each $1,000 she would otherwise have to invest after tax [$1,500 x (1 - 33.3%) = $1,000]. The $1,500 investment inside the IRA will earn $150 before tax and have a balance of $1,650. If the investor now withdraws the money from the IRA (assuming no 10% early withdrawal penalty) she will pay a 33.3% tax on the entire amount, or $550 in tax, leaving her with $1,100 after tax. The result is exactly the same 10% after-tax rate of return she would earn by borrowing $500 (the amount of tax deferred on her original investment in the IRA) interest free.

Question--What is a "leveraged lease"?

Answer--A leveraged lease is one in which the lessor finances a portion of the purchase price of the leased property with debt. Sometimes this debt is "nonrecourse." This means that the borrower has no personal liability. A nonrecourse loan is secured by specific assets of the borrower. For example, in many real estate financing transactions, the lender may look only to the property itself as security for the loan.


(1.) IRC Sec. 163(h)(3).
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Title Annotation:Techniques of Investment Planning
Publication:Tools & Techniques of Investment Planning, 2nd ed.
Date:Jan 1, 2006
Previous Article:Chapter 41 Hedging and option strategies.
Next Article:Chapter 43 Taxation of investment vehicles.

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