cashing out gains on leveraged investment - how to calculate amount to pay down LOC

[lowent]

Scenario:

Let's say on January 1, 2010, I borrowed from a line of credit $8,000 and invested in 800 shares of a stock at $10/share.

Since that time, a deduction was claimed on the interest payments associated with the revolving balance of the LOC. The LOC of credit was used to fund other investments as well (the LOC was not used for any other purpose).

In June of 2012, the shares of the stock had risen to $20/share and I decided to cash out some of the capital gains by selling 600 shares for proceeds of $12000.


Questions:

Am I correct that, leaving aside the cost of commissions, I have capital gains of $6000 on the sale of the shares, and that half of this amount is taxable at my marginal tax rate?

How much do I pay back to the LOC of credit from the proceeds of the stock sale so as to maintain the tax deductibility of the interest on the LOC ? (My thinking is $6000 (i.e. (600/800)*$8000), the fraction of the original withdrawal from the LOC).

Assume my marginal tax rate is 40%, am I correct that I would owe $1200 ($6000*50%*40%) in taxes on the share sale? If so, do I need to make a payment to the CRA now or at the time of my taxes next April?

Thanks in advance for any response.

[FrugalTrader]

@lowent, your capital gains tax calculation is correct. When you file for 2012, you will report your capital gains, and you may or may not owe depending on your other deductions. As for your LOC, providing that you do not withdraw the cap gains from your portfolio, you should be ok with not paying down the LOC.

[lowent]

Thanks for your response FT.

As for your LOC, providing that you do not withdraw the cap gains from your portfolio, you should be ok with not paying down the LOC.

In this instance, I am withdrawing the capital gains, hence my concern about paying down the proper amount to retain the deductibility of the interest.

[doctrine]

If you sell $12k of a $18k investment, then my take is that you have sold 2/3rds of your original investment. Therefore, if you withdraw the money from your account, your LOC deductibility has been reduced by 2/3rds, to $2666.67. You could not deduct interest on the remainder.

Taxes would be due when you file next year.

I believe the only way to restore deductibility is to pay off the entire loan and then re-borrow for a new investment.

[lowent]

I believe the only way to restore deductibility is to pay off the entire loan and then re-borrow for a new investment.

@doctrin. Thanks for the response.

Ugh, I sincerely hope that is not the case. To give another hypothetical, say one borrowed $100K and invested $10K at different times in 10 different stocks and one wished to cash out capital gains for one particular stock that had risen, then, according to your suggestion, one would need to liquidate the entire portfolio of stocks and pay down the loan. How can that be?

[doctrine]

The only way I know that you maintain full eligibility is to either pay down the loan with any proceeds that are removed from the account, or keep the money in an investment which qualifies. For example, if you sold only $4k of shares, then withdrew it, and paid down your loan, the remaining $4k on your loan would remain fully eligible, and you would still have $12k of stock.

[Cal]

Don't pay any taxes until you file net year. Don't give the gov't any $ any sooner than you have to. Use it to make some more.

[cardhu]

How much do I pay back to the LOC of credit from the proceeds of the stock sale so as to maintain the tax deductibility of the interest on the LOC ? (My thinking is $6000 (i.e. (600/800)*$8000), the fraction of the original withdrawal from the LOC).

Your thinking is correct ... there would be no need to pay off the entire loan and reborrow ... 75% of the shares corresponds exactly to 75% of the original leverage debt. Therefore, if you sold 600 shares for proceeds of $12000, and if you paid back $6000 toward the LOC, then the deductibility on the remaining balance would be unaffected. The fact that this LOC was also used to fund other investments is of no consequence. Those are separate and independent borrowings.

[lowent]

Your thinking is correct ... there would be no need to pay off the entire loan and reborrow ... 75% of the shares corresponds exactly to 75% of the original leverage debt. Therefore, if you sold 600 shares for proceeds of $12000, and if you paid back $6000 toward the LOC, then the deductibility on the remaining balance would be unaffected. The fact that this LOC was also used to fund other investments is of no consequence. Those are separate and independent borrowings.

Thanks @cardhu. This makes sense.