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A method of financing an investment by which an investor pays only a small percentage of the purchase price in cash, with the balance supplemented by borrowed funds, in order to generate a greater rate of return than would be produced by paying primarily cash for the investment; the economic benefit gained by such financing.
Real estate syndicates and promoters commonly use leverage financing. A leveraged investor builds up Equity or ownership in the investment by making payments on the amount of principal borrowed from a third person. The money allotted to the repayment of interest charged on the borrowed principal is treated typically as a deduction that reduces taxable income. The greater the amount of principal borrowed, the larger the interest payments and the resulting deductions. Obviously, a taxpayer who pays cash is not entitled to deductions for interest payments. In many cases, deductions for the depreciation of thecapital asset constituting the investment are also permitted.
Any investor receives an anticipated rate of return from the investment although the rate may fluctuate depending upon the economic climate and the management of the investment. Because of the favorable tax treatment enjoyed as a result of this method of financing, the leveraged investor keeps more of the income generated by the investment than an investor who financed the investment mainly through cash. There is, however, risk involved in leverage financing. If the income generated by the investment decreases, there might not be adequate funds available to meet payment of the outstanding principal and interest, leading to substantial losses for the investor.
1) n. the use of borrowed money to purchase real estate or business assets, usually involving money equaling a high percentage of the value of the purchased property. 2) v. to borrow most of the funds necessary as a loan against real estate to buy other real estate or business assets. The dangers of high leverage are over-appraisal of the property to satisfy a lender, a decline in the value of the property (which may have been purchased during a period of high inflation), high carrying costs (interest, insurance, taxes, maintenance) which exceed income, vacancies, and/or inability to finance improvements to increase profits. Too often the result is the collapse of "paper" real estate empires which have been created by risky leveraging.