Think leveraged investing in down markets

Given the market setbacks of recent months and the gloomy economic news that still dominates the headlines, it is not surprising that many investors simply want to sit on the sidelines for the time being. But many of your clients might be better advised to try to recapture the mood and the method that prevailed before last fall’s market meltdown.

It wasn’t so long ago when people optimistically sought above-average returns and used leveraged investing strategies to get them. Currently, share prices are at, or near, cyclical lows, signaling good buying opportunities, and borrowing costs are at the bottom of the cycle. For clients with the temperament, resources and knowledge of their risk tolerances, leveraged investing could be a worthwhile strategy.

Reviewing the basics

The traditional approach to investing is to make regular contributions to a portfolio, gradually purchasing equities and other investments over a long period of time. Leveraged investing, which essentially means borrowing to invest, speeds up the process. By using other people’s money, your client can make a much larger initial investment that, thanks to compounding, may generate greater returns in the near and long term than could be achieved by gradually making cash contributions.

Ideally, the loan taken out to make the initial investment would be repaid (interest and possibly principal) by a regular amount, equal to the sum your client would have regularly contributed to investments. In other words, your client’s regular out-of-pocket costs will be the same as they would have been using the traditional investment approach. Another point that is sure to resonate with investors is that the interest on the loan used to invest could well be tax deductible, but I’ll say more about that shortly.

Is it right for your clients?

At the outset, I mentioned the need for temperament and resources. Leveraged investing requires steady nerves, commitment and faith as much as it does cash. If a client is leery because of the weak market conditions, leveraged investing likely won’t be palatable. If, on the other hand, the person can see through the malaise and relishes a historic chance to buy low and generate superior gains, then leveraging will be attractive.

As an advisor, you should point out to clients that leveraged investing actually works best as a long-term option. Realistically, a minimum 10-year time horizon is advisable, because winding down this strategy much sooner poses the risk of incurring a loss. You also need to tell clients that they’ll have to be prepared to continue investing over those 10 or more years regardless of the periods of market volatility along the way.

That last point about the potential risk of this strategy is worth stressing, particularly in the current bearish environment. Markets may deteriorate from today’s levels before they get better. Equally, margin calls can be made that could stretch clients’ resources. However, risk can be mitigated by placing the borrowed funds in diversified investments.

The tax advantage

As I mentioned, the interest on a loan made for investment (with the exception of registered investments including RRSPs and TFSAs) is tax deductible, provided you can meet four stipulations, three of which are relatively straightforward and easy to comply with. First, the interest must be paid or payable starting in the year the investment is made; second, there must be a legal obligation to repay the interest; and third, the interest in question must be reasonable. These criteria are easily met when negotiated with a third party, such as a bank.

That leaves the fourth rule, which requires that the borrowed money be used for the purpose of earning income from a business or property. The way it’s written in the Income Tax Act, it appears to be one test, but in reality there are two concepts to consider — the “use” test and the “purpose” test.

To meet the “use” test, an investor will have to establish a paper trail linking the loan to the investment; otherwise a claim for a deduction could be challenged by the CRA. As to “purpose,” the loan must be used to earn income, including interest and dividends (but generally not exclusively capital gains). Purchases of shares and mutual funds will qualify, provided the shares or units involved do not have stated policies of not paying dividends and/or interest payments. Mutual funds that distribute capital gains may qualify, as long as they have the potential to pay dividends or interest. In other words, in order to qualify under the “purpose” test, there should be a reasonable expectation when an investment is made that it will generate dividends or interest income.

How it works

Let’s run through a simplified example (addressed in the accompanying exhibit) to see how leveraged investing could benefit your clients. Suppose an investor in the 40% marginal tax bracket takes out a one-year loan of $1,000 at an interest rate of 5%, and uses it to invest. At the end of the year, this individual receives a $20 interest payment on her investment and sells the investment at a gain for $1,030, making a profit of $50.

On the face of it, this investor has merely broken even. To get the full picture, however, you have to consider the transactions’ after-tax cash flows and interest deductibility. First, on the $20 in interest income received, the investor will owe $8 in tax, for an after-tax gain of $12. As for the $30 capital gain, 50% of which is taxable, a 40% marginal tax rate would mean a tax bill of $6 and the investor will keep $24. Finally, because the $50 interest paid on the loan is deductible, the investor will get back 40% or $20. In all, the after-tax interest cost is $30, while the after-tax profit is $36 ($12 in interest income and the $24 capital gain), leaving the investor $6 ahead.

Exhibit:

Marginal tax rate 40%	LOAN	INVESTMENT
Principal	$1,000$	$1,000
Interest expense (5%)	$50
Interest income (2%)		$20
Capital gain		$30
Pre-tax profit	($50)	$50 = $0

The income statement:

Income

Interest income	$20
Tax on income	($8)
Net after-tax income	$12

Capital gain

Realized capital gain	$30
Taxable capital gain	$15
Tax on capital gain	($6)
Net after-tax capital gain	$24

Interest expense

Interest expense payable	$50
Interest tax reduction	($20)
Net after-tax interest expense	$24

After-tax profit

Net after-tax income + net after-tax capital gain + net after-tax interest expense = $6

Life, of course, is rarely so simple, and there are many situations that could derail an investor’s best-laid plans, including the following:

• Investments made as the result of leveraging are sold at a loss, leaving proceeds that won’t be sufficient to pay off the loan. However, interest on the outstanding portion of the loan remains deductible;
• Leveraged investments are sold at a loss and the proceeds are used to buy other investments. Loan interest will still be deductible if the investor can establish a paper trail from the loan to the new investment;
• Part of a leveraged investment is used for an RRSP contribution. Interest on the portion of the loan used for the RRSP is not deductible (more on this below) although the portion dedicated to the non-registered investment is deductible; and
• A leveraged investment is made in a “tax-efficient” product, where there is a distribution of capital, part of which is not reinvested. The interest on the portion of the loan represented by the return of capital that is not reinvested will not be deductible.

Some caveats

Generally, investors will want to eliminate non-deductible debt ahead of tax-deductible debt. Take the case of an investor who has both a non-deductible mortgage and a non-registered portfolio. It would make sense to sell the portfolio (keeping an eye on possible capital gains and losses) and use the proceeds to pay down or eliminate the mortgage altogether. The investor could then borrow funds to repurchase the portfolio, one complication being that if any of the original investments had been sold at a loss and were being repurchased within 30 days, superficial loss rules might apply and deny the loss. And as we’ve noted before, there would have to be a paper trail between the new loan and the repurchased investments.

The merits of this type of tax planning are not impacted by the recent Lipson court decision; however, if your client is contemplating a more complex series of transactions, tax advice should be sought on that specific transaction.

I mentioned that interest on loans used to invest in registered accounts (such as RRSPs and TFSAs) is not deductible, but there are other factors to consider on this score. It might make sense to forego interest deductibility, depending on the interest rate and duration of the RRSP loan, the rate of return on the RRSP investment, and the investor’s marginal tax rate. If the interest on the loan is comparably high and the rate of return on the RRSP investment on the low side, an RRSP loan would likely not make sense. If the reverse is true, and the investor has both a high marginal tax rate and the capability of paying back the loan quickly, an RRSP loan may be advisable.

Buying low is desirable for any investor, and equity prices have retreated considerably from their peak early last summer, though no one knows, of course, whether they have bottomed. Regardless of where we are in the market cycle, though, some clients will benefit from examining and possibly pursuing leveraged investing. The investment proposition itself is reasonably straightforward. But, as I said earlier, clients should have the right temperament as well as the resources to sustain a 10-year leveraged investing strategy. Not all will fit the profile, but for those who do, the potential rewards could be significant.