One of the biggest problems with investing is taxes. Aside from Roth accounts, the tax man will eventually come for his share. Either yearly or when you withdraw funds, the IRS will take its piece. Navigating taxes is a constant battle and there are numerous strategies in place to help mitigate the effects of taxation on one’s portfolio. And there’s one strategy that could be particularly advantageous in the current environment – we’re talking about a portfolio line of credit.
Given the overall low interest rate environment and record gains over the last decade or so, many investors are sitting on some large tax bills. A portfolio line of credit could be used to tap those gains while staying invested and avoiding taxes.
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Borrowing Rather Than Selling
The SPDR S&P 500 ETF Trust (SPY) is up by a staggering 70% since the lows reached during the grip of the pandemic. Stretching back further to the depths of the Great Recession, the market-tracking ETF is up by more than 500%. Those are some serious gains for investors. The problem is accessing those gains without triggering nasty tax consequences.
The answer may lie in borrowing rather than selling those shares.
Investors may be familiar with a so-called margin loan. Here, securities are pledged as collateral in order for investors to buy additional shares or assets. This leverage effect can produce outsized gains for a portfolio. However, margin loans do have some drawbacks. One being that they come with relatively high interest rates. Afterall, there’s risk for the lending institution since they know you’re going to buy more stock or derivatives with the shares.
Margin loans have a potentially better cousin that can allow investors to use the gains in their portfolios more effectively. Called a portfolio line of credit, this sort of loan works in a similar yet different manner.
Like a margin loan, a portfolio line of credit allows investors to pledge assets as collateral for cash. They retain ownership of shares. The beauty is two-fold.
- First, interest rates for portfolio lines of credit are lower than margin loans since you are not permitted to buy stock with them. Interest rates are often lower than other forms of credit, including credit cards, HELOCs, student loans and even mortgages.
- Secondly, there is a real tax savings available by not having to sell your investments. For example, selling $2 million worth of investments to buy a vacation home comes with a nasty $476,000 tax bill, assuming the long-term cap gains rate of 20% and the 3.8% Medicare surcharge. Under President Biden’s current tax proposals that number would be closer to $876,000. The real win is that investors still own their shares. Assuming a conservative 6% annual return, the $2 million in our example will turn into more than $3.5 million in about a decade.
With a portfolio line of credit, investors can potentially have their cake and eat it too.
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Two Major Risks
Now there are some risks with using one of these loans. The biggest one is the value of pledged assets declines significantly. Given the volatility in the market over short periods of time, this can happen. Similar to a margin call, a borrower would be required to replenish the collateral and add assets to their account to cover the loan. This could be difficult if you have other obligations or are already paying back the loan in the first place.
This could trigger the second risk with portfolio lines of credit – default risk. If you fail to add more collateral or miss payments on the loan, the brokerage firm or bank can begin selling off the pledged assets to repay the loan. This can trigger capital gains taxes, additional collateral calls, fees and other nasty surprises. Ultimately reducing the benefit of using a portfolio loan in the first place.
How To Use a Portfolio Line of Credit
Could a portfolio line of credit be a good choice for investors? The answer could be yes.
If you are sitting on a ton of gains but still want to access that potential, using a line of credit could work to your benefit. The loan could help you mitigate taxes and stay invested. This could be particularly advantageous if you’re planning on using the line for other non-stock investments, starting a business or buying a second home.
Now, given the potential for volatility, someone with a huge portfolio of small-cap tech stocks or similar high-growth investments may want to think twice about using a portfolio line of credit. The risk of having a portfolio drop in the short-term and being required to pledge more assets of collateral is far greater. Those investors holding bonds or dividend stocks are better suited for using such a loan. There’s less risk with portfolio volatility.
Another benefit in using dividend stocks or bonds is that you can use their distributions to help pay off the loan. And that’s a strategy that many wealthy families use to access stock gains and take advantage of step-up basis strategies for heirs when the original owner dies.
The Bottom Line
A portfolio line of credit is a great tool for many investors with large gains. By using one, investors have the potential to save on taxes while still enjoying the benefits of their gains. The key is not to borrow too much and pledge assets that aren’t too volatile.
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