By default we set up every taxable (i.e. non-retirement) account to have margin but we almost never use it. (You don’t want retirement accounts to have debt at the account level because it gives rise to UBTI – unrelated business taxable income – which is taxed at the high trust rates, but you get no basis in the IRA for it. In essence you end up getting taxed twice on the income. Leverage in the underlying investment – debt that a company holds, or a leveraged ETF – is This is why leveraged ETFs are sometimes used (but not y us): leverage in the underlying investment is fine from a tax perspective.)
If you have a diversified portfolio with both stocks and bonds (as almost everyone should) and then you add leverage through margin interest you are essentially long fixed-income and short fixed-income but almost certainly paying on the spread. It is far better to liquidate bonds (for temporary needs) or a portion of the portfolio as a whole (for longer-term needs). Nonetheless we occasionally have clients in margin for the following reasons:
- The client needs/wants funds right away and it is worth a few days of margin interest expense to them rather than waiting for the trade to settle.
- The client needs/wants funds and all the positions in the account have large short-term gains. This usually only happens when it has been less than a year since the client came on board or tax loss harvesting was done and the market subsequently moved up nicely. If the gain will be long-term in 10 days (for example) it might make sense to send them the funds, putting the account into margin for the 10 days, and then liquidate the position to repay the margin loan after the taxes are more favorable. For example, assume a 10% unrecognized gain, a 20% differential in long and short term tax rates, and 7% margin interest rate, and a need for $100,000. 20% of the $10,000 gain is $2,000. 7% of $100,000 for 10/365 of a year is $192. Obviously the larger the gain and the shorter the period until it becomes long-term the more this makes sense.
- Similar to the previous item, if it is December and the client’s tax rate will be lower the following year it might make sense to use margin. For example, suppose the gains are long-term, but they are in the 15% LTCG bracket this year, but will be in the 0% LTCG braket next year. There is a 15% difference in the rate by waiting until the next year to sell.
- The client anticipates putting the funds back before too long and doesn’t want to disturb their asset allocation (paying transaction fees to sell and then repurchase later) and paying taxes on gains. For example, suppose a client has a bonus coming (with very high probability) in 60 days, but they find the “perfect” house to buy now and don’t want the opportunity to get away. It might make sense to take funds out of the account (causing it to go into margin) to purchase it and then replace the funds shortly when the bonus arrives.
In most cases, there are even better sources of short-term funds than margin interest – a HELOC (Home Equity Line Of Credit) for example – but sometimes it does make sense to use margin, temporarily.