I’ve seen several times the claim in passing that the wealthy avoid income taxes by simply taking out loans on their assets. And I suppose that this is a nefarious and bad thing.
Ok so Rich Guy owns some property, he needs some liquid cash so he gets a loan with the property as collateral and now he has some money that isn’t income. So now he has spent this money on hookers and blow and needs to repay the loan, so he either sells some of his property(and he might pay capital gains here) or takes out another loan to pay back the first. But of course you can’t keep taking out loans forever.
How does this work and what is the problem with it exactly?
No doubt it hugely depends on what tax jurisdictions you live in - you haven’t told us. Here in Australia, interest paid on loans taken for the purpose of generating income (say buying shares, investment properties, or businesses themselves) are a deductible expense; if the interest payments exceed the income from that source you can do negative gearing, which means the deduction applies to your own personal income, not just that from the investment.
But the loan must be for that purpose, not just general life expenses.
Continuously taxed income grows at a slower rate than income that is only taxed once, even if all of it is taxed and taxed at the same rate. (For instance, $100 growing at 5% and taxed at 10% will grow to $252 if taxed just at the end of 19 years, but $241 if taxed continuously, even if none of it is tax exempt.) So if you can delay the taxation as long as possible, you come out ahead.
The problem with this is that it is inefficient. If you think that low tax rates are appropriate, the efficient thing to do is to enshrine them in the tax code. Allowing this loophole will cause resources to be spent on avoiding taxes, resources that could have been spent on more productivity (or just goofing off.)
I would be interested in seeing an example of one such reference, because I can’t see how taking a loan can possibly shelter income. What you describe is taking cash out of an asset which at its most optimistic can defer capital gains by deferring the sale of an asset. If your timing is right and you expect the asset’s value to decline then you can defer the sale to *lower *the capital gains. But reducing your income to reduce your taxes never makes sense.
I also don’t understand how Ludovic’s reference to “continuously taxed income” is relevant. That example relates to deferred income like IRAs and 401(k) accounts but I don’t see what is has to do with taking loans.
Am I wrong in my impression that the effect of this is to simply delay having to realize taxable gains (either income or capital), and not avoid them altogether? If so, then I think my assertion could still bear merit. If had $1,000,000 in stock and were leading a $100,000 lifestyle, then if your gains were taxed each time you withdraw you’d have to withdraw $111,111 to lead the same lifestyle at a %10 tax rate. Whereas if you could delay them then you’d only have to cash in $100,000 and the rest would continue to appreciate. At the end of 9 years, even if you cashed in the rest, you’d have by my calculations $145,000 left in the continuously taxed example but $177,000 in the taxed-only-at-end-end example.
Jimmy Carr did exactly this in the UK: I know that it’s a different jurisdiction than the US, but I presume the mechanics of the scheme would be similar. Details here.
That matches my understanding: you set up a company and then have the company loan you money, and since you manage the company you don’t really need to pay the loan back or charge yourself interest.
At the very basic level it’s like remortgaging the house. You can get a loan each year on your originally free-and-clear house. the principal, and possibly accrued interest piles up. At the end of this run, you sell the house and net just enough to pay capital gains and loans. meanwhile, you have lived in a really nice house. If you are really lucky, the value has gone up meanwhile, more cash in pocket. However, the value of laons outstanding on the house are irrelevant. Capital gains is sale minus purchase price. (OTOH, if the loan is a mortgage, the interest is tax deductible.)
What’s the alternative? Sell the house at the beginning, now pull the money out of the bank, and pay rent or mortgage on some other house.
Basically, the scheme treats a personal possesion as an ATM, so you can have your cake and eat it too. If there was a way to pay yourself cash and NOT pay taxes, the IRS has seen it and blocked it.
I agree that the strategy the OP refers to is for companies to make loans to their shareholders without insisting on repayment. You avoid paying tax on the “loan” as either interest or dividends. For example, this recent court case came up in CPE last week: http://www.ustaxcourt.gov/InOpHistoric/TODD.TCM.WPD.pdf - the guy tried to “loan” himself more than $400,000.
Even worse, they may recharacterize the loan as wages in some circumstances. Now you’ll owe FICA taxes, state payroll taxes and a whole boat full of penalties and late fees.
A liability does not offset capital gains, otherwise my mortgage could offset my gains on stock investments.
This is a great explanation. This is where the employer loans the employee money as part of a pension program, and the employee never really pays it back, so it’s de facto income that is never taxed: “There is a nod and a wink that the pension scheme will never ask for the money back, and the loan stays in place for perpetuity, until the person dies. At death, it disappears. The trustees of the pension scheme meet and agree to write it off.”