For some reason, lately my news feed has had an article or two on the Buy-Borrow-Die strategy. I’m not at all sure I understand the nitty-gritty on it.
Suppose Lee owns $1 million dollars in stock from Fortune 500 companies. So that’s the Buy part taken care of.
Lee borrows, say, $500,000 using that stock as collateral. So Lee has spendable money that is not taxable, and still has the stock. That’s the borrow part.
After some years, Lee dies. Lee’s heirs receive the stock at the stepped-up rate – its value when Lee dies, not what Lee paid for it. If the heirs sell the stock immediately, they pay no taxes since they have no taxable gain.
My issue is how does that $500,000 loan get paid off? It’s not like the bank just forgets about it. Say you get a nice 3% interest rate on that loan. The bank wants that interest paid, as well as the capital. Over the course of time you’ll pay the bank more than $500,000. Or the heirs will have to pay off the loan, leaving them with less (and perhaps much less) than $1 million. Yeah, you’ve avoided taxes, but how do you (and/or your heirs) end up richer by this strategy?
Suppose instead Lee invests the $1 million in stocks that pay dividends, and Lee averages 2.5% per year. Yes, Lee pays tax on that $25,000 – but Lee has cash left over after tax and of course still owns the $1 million in stock. How does the Borrow strategy work out better?
It doesn’t work for everyone, though. The biggest obstacle to everyone using the buy, borrow, die strategy is that you need to have a large amount of wealth to start with.
And a large amount of wealth accumulating that you can use to pay off the loans while you live off the interest. Which is laughable, of course. IOW, it works only if you don’t need the loan in the first place, a mere tax avoidance gimmick for the already wealthy. Also known as “never use your own money.”
Yes, the collateral would get sold to collect the arrears on the loan. If some of the loan is paid off and the stock has increased in value they will get closer to the $1,000,000 invested, or even exceed it. And if they get less they should complain to the parent who made the arrangement and see what kind of response they get.
Well, that’s the whole point. That money is invested in stocks (or in the person’s own company). Rather than sell off the stock, they take a loan.
The stock market typically has better returns than the kind of interest rate that such a qualified borrower would pay, so by keeping their money invested and taking out a loan instead, they come out ahead. They also come out ahead when it comes to taxes, in not having to sell their investments and pay capital gains on them.
That said, your scenario is not how it typically plays out. It is not someone with a one million dollar net worth borrowing half of that, it’s someone with hundreds of millions of dollars of worth borrowing at most 10% against it.
The dividend or return rate is usually a bit higher than that, and that is how most people* prepare for retirement.
*by most, I mean most people who are prepared for retirement.
What you describe is called “securities based lending”. As others have pointed out, the stock would be sold to pay off the loan. Typically you can only borrow against a percentage of the stock or other securities you pledge as collateral. And you don’t need to pledge all of it. Lee might only need to have $750k in stock for his $500k loan. It depends on the bank’s credit policies.
I’m not sure how dividends play into this. Basically whoever owns the stock when the dividends are paid out just pays taxes on them.
Note that if the value of the stocks dips enough over the term of the loan and before Lee dies, Lee may face a margin call and be required to add additional securities as collateral, pay back a portion of the loan, or the bank may sell off the stocks for him.
But the trick is to use the borrowed $500,000 in cash to buy assets like a house, boat, car, anything except more stocks/securities and then pass those on to your heir. So instead of having to pay capital gains on the step-up basis of $1 million, Lee’s heir would pay it on $500k plus have $500k in cash or other assets subject to inheritance taxes (which many states don’t have).
To keep the math easy, let’s assume no interest or growth of assets after the strategy is implemented, or that any interest is exactly matched by asset growth.
Lee owns an asset that has appreciated in value to $1m, he has not paid tax on this increase of wealth, as it is not considered “income”.
Lee borrows $500k against that asset and uses it as he would any other source of cash, like income, but still doesn’t pay tax.
Lee dies, his heirs can sell the asset, pay back the $500k, get the remaining $500k, which they don’t have to pay taxes on either.
Lee gets $500k to spend, tax free. Lee’s heirs get $500k to spend, tax free.
At the $1m level, the heirs were always going to be tax free, the only change is that Lee gets to dip into the tax free inheritance while he’s alive. At the $1B level, the heirs were theoretically going to be heavily taxed on most of the inheritance, but Lee gets to live the $500m lavish lifestyle without paying any income tax at all for his whole life, and that money stays untaxed even after his death.
And at those levels, there are other ways of manipulating wealth.
Donating hundreds of millions to a foundation means that you and your heirs don’t have to pay taxes on it, but you still get to control how that money is spent, and even, to some extent, get personal benefit from it.
I know I’m coming off as extraordinarily dense, but I still don’t get the “borrow” part.
Let’s up Lee’s net worth here. (Although the point of one article I read was that folks with only $1-2 million could use this strategy.) So Lee started a tech firm which was sold for big bucks when Lee was forty. Lee now has $100 million invested in stocks.
Lee borrows $50 million, using the stock as collateral. Lee lives to be 80. Surely the bank or brokerage that made the loan is going to want payments made on it, right? Where is the money for those payments coming from?
Is Lee borrowing more money to make the payments? Is the assumption that Lee’s portfolio will increase in value enough to support those additional loans? If so, how is this different from the Subprime Mortgage Crisis of ca. 2008?
It’s coming from either some other income stream or from selling a small amount of his portfolio. It’s not that there are no costs to this strategy, but done correctly the interest payments are going to total up to a lot less than the tax bill would be if he sold $50 million of assets.
The loan holder will keep a close eye on the value of his portfolio, and will retain the right to call in the loan if the value falls too far, forcing Lee to sell his shares and pay off the loan. They can setup the loan to be able to call it in when there’s still plenty of value in the shares.
$100M in investments paying dividends of just 2.5% per year would generate a revenue stream of $2.5M per year. Less 20% in capital gains tax leaves $2M a year that can be used to make payments on that $50M loan, with any remaining balance at time of death to be paid off by a lump sum from the estate.
You’re being overly conservative about some numbers. Let’s say that Lee borrows $500k (though, as most people point out, it’s typically around 10%). If Lee spreads that out and lives off $100k a year, she’s only got to pay the interest (not the capital) on the loan while her investment compounds at 10% a year. Five years later, she’d have $1.65M. If she borrows another $500k and lets the investment ride, five years later she’s got $2.7M and owes $1M - she’s spent a million bucks and still has $1.7M in assets. Do it again and she owes $1.5M but her assets are now $4.4M.
Twenty years in, she finally kicks the bucket. Her portfolio is now worth $7.2M and she owes $2M to the lender, leaving $5.2M - fives times what she started with.
Not necessarily, as long as the total balance of the loan is less than the collateral. I can get a “liquidity asset line” from my brokerage, and they don’t demand a single dime from me for a fixed duration, which might be a few years. Afterward, I can roll the balance into a new loan (for a higher amount due to interest). I can keep this up as long as I have collateral, which for the most part grows faster than interest rate of the loan.
I have my doubts that you can borrow $50 million using stock worth $50 million today as collateral. The stock can have the Bluest of Chips and still go down in value tomorrow and stay that way for months. All sorts of things could happen to the borrower in that time that would leave the lender with a loss. I just don’t think they’d do it. It’s the kind of deal for someone in excellent financial condition who should have some real estate to use for part of the collateral, and if that real estate is heavily mortgaged they’re not getting a loan. A 40 year term may be impossible also. And the lenders in a deal like this will be looking to sell that loan so they’ll want to make some profit right up front which will be a substantial amount. I’m sure somebody will make that loan if gets sweetened with better collateral and up front fees.
If Lee sells the stock now, it’s income, and he has to pay income tax on it.
If the stock isn’t sold until Lee dies, then it’s not income, and nobody has to pay income tax on it.
It’s a tax avoidance strategy. That’s it. No money goes to the government, and so the money that would have gone to the government is available to be spread around between Lee, his heirs, and the bank. Everyone wins, except for everyone else.