By Pam Martens: June 3, 2013
The New York Stock Exchange has released data showing that the amount of borrowing against assets held in brokerage accounts as of April 30, 2013 has reached an all time record. Called margin loans, investors have borrowed $384 billion against their accounts, topping the prior record of $381.4 billion in margin debt set in July 2007 – just before the onset of the financial crisis.
The ramp up in margin debt has been occurring at a steady pace. It stood at $284.6 billion in June 2012; $330 billion at the end of December 2012; and has risen each month since then to reach $384 billion at the end of April 2013, according to the most recent data listed at the New York Stock Exchange.
But just who is it that is taking out of all these risky loans? If it’s the small, retail investor, that should set off alarm bells in Washington.
In January, a study by Morgan Stanley showed that hedge funds’ holdings versus the cash provided to them by investors stood at 153 percent versus 143 percent in early 2011.
But other reports suggest that Wall Street brokers may be recommending highly inappropriate margin loans to their customers to be used for personal reasons. Publication 550 from the IRS explains that when it comes to taking margin loans against your investment securities, “You cannot deduct any interest on money borrowed for personal reasons.” In other words, you can’t deduct the interest if you use the loan to pay for a vacation, to buy a new car, to pay for a wedding, etc.
Merrill Lynch gives this very limited tax advice on margin loans on its website: “Interest expenses may be tax-deductible up to net investment income earned in the account. Margin interest expense may also be exempt from the Alternative Minimum Tax (AMT).” That hardly suffices to tell the story. The net investment income must be from taxable securities. If a margin loan is taken out to purchase tax-free municipal bonds, the interest is not tax deductible.
Equally important, the interest rate fluctuates on margin loans, depriving borrowers of locking in a fixed rate at a time of historic low interest rates. If your stocks, bonds, or mutual funds that are securing the loan lose value, you can get a margin call requiring you to repay the loan or add additional collateral to the account – collateral you may not have.
The New York Stock Exchange offers some additional caveats, including this very unattractive heads up on how your preferential tax treatment on stock dividends could turn into ordinary income for tax purposes as a result of a margin loan:
“A similar issue is raised with regard to dividends when a customer’s securities in a margin account are lent. In this case, a margin customer is at risk of receiving payments-in-lieu of dividends when shares are lent past the ex-dividend date. When shares are lent out to facilitate margin lending, the person borrowing the shares receives the dividend, and the margin customer receives a cash payment from his or her brokerage firm in an amount identical to the dividend. However, the cash payment is not a dividend for tax purposes. When a customer receives the cash payment, the broker must reflect it as ordinary income on the year-end tax statement. It is not eligible for preferential tax treatment. Many member organizations make extraordinary efforts to avoid having customers receive payments in lieu of dividends, and some go so far as to “gross up” such payments to reflect the loss of preferential tax treatment when payments in lieu are unavoidable. Check with your broker to see what your brokerage firm’s policy is on this issue.”
Better yet, avoid margin loans unless you have done your own research and checked with a trusted accountant.