Buy, borrow, die: Not best for everyone
With interest rates near historic lows and the market near all-time highs, more people than ever before are borrowing against their portfolios. Using debt wisely to increase wealth and reduce taxes is not a new concept, but the concept has enjoyed renewed interest since articles in the Wall Street Journal and ProPublica highlighted how billionaires use loans to fund their lifestyles, thereby significantly reducing their taxes.
Both articles point to a strategy that takes advantage of two key aspects of the tax code:
- Unrealized gains are only taxed when sold: If you hold investments in a taxable account and those investments have increased in value, you control when and how much you are taxed.
- Step up in basis at death: When you pass away, any appreciation in a taxable account is forgiven. For example, if your account value grew from $1 to $100 and you pass that account onto your heirs at your death, the $99 is forgiven (basis is stepped up).
Understanding these tax provisions is and has been foundational to the planning we do for all of our clients.
There are trading strategies built to create “tax alpha,” which is a fancy term for minimizing taxes by managing the portfolio at the individual lot level, while looking for opportunities to tax loss harvest and sell strategically. That trading strategy is then tailored to your personal situation—your tax rate now vs. in the future, your cash flow needs, the types of accounts you own, and how much to take from each—all to minimize the taxes you and your heirs pay today and in the future.
Using a portfolio loan
Portfolio debt fits into this equation as well, albeit only for short-term planning needs. If you have a taxable portfolio, you likely have the option to take out a loan against your investments—and currently the rate is very attractive due to the low interest rate environment. So why and when should you think about using this?
The short answer is anytime you need to generate capital gains to raise the cash in your portfolio and you are able to pay the assets back within a year. For example, if you have a home purchase and a home sale where the closing dates don’t line up perfectly, a portfolio loan can be used as a short-term bridge to bring a cash offer, close on a purchase while waiting for your sale proceeds to come in and pay off the debt. This avoids selling any investments at a gain and therefore avoids taxes as well. It could also be used as a bridge to push taxable income into a different tax year where the tax rate is lower.
The focus of the ProPublica article was billionaires borrowing against their wealth as a long-term strategy. However, this not only brings a lot more risk, but it could also be cost-ineffective. Consider that:
- Leverage comes with risk: With portfolio loans, there is a certain amount of collateral required (generally 2x the loan value). If the market falls, your investments fall, reducing your collateral and resulting in either the forced selling of securities at depressed market prices or the need to deposit more assets to satisfy the loan.
- Rates are variable: We are in a low-rate environment now, but as the economy recovers, rates will rise and the costs of the loans increase.
- Tax law changes: One current proposal by the Biden Administration is removal of the step-up in cost basis, which would cripple the strategy described in number 2 above.
- Margin for error: It may be obvious, but billionaires have more margin for error to absorb all these risks and often have concentrated wealth in one stock or companies where gains are disproportionately high.
Tax mitigation and optimizing the use of debt are keys to a well thought out financial plan. If you have questions on how this applies to your specific financial situation, please do not hesitate to reach out to your team.
ABOUT THE AUTHOR
BDF LLC is a private wealth management firm. We provide personalized investment management and financial planning. We manage approximately $5.9 billion in assets for business owners, women, individuals and families, and institutions.
We also have Practice Groups that specialize in the unique needs of:
- Financial Professionals
- Insurance Brokers and Agency Owners
This information is for educational purposes and is not intended to provide, and should not be relied upon for, accounting, legal, tax, insurance, or investment advice. This does not constitute an offer to provide any services, nor a solicitation to purchase securities. The contents are not intended to be advice tailored to any particular person or situation. We believe the information provided is accurate and reliable, but do not warrant it as to completeness or accuracy. This information may include opinions or forecasts, including investment strategies and economic and market conditions; however, there is no guarantee that such opinions or forecasts will prove to be correct, and they also may change without notice. We encourage you to speak with a qualified professional regarding your scenario and the then-current applicable laws and rules.
Different types of investments involve degrees of risk. Future performance of any investment or wealth management strategy, including those recommended by us, may not be profitable, suitable, or prove successful. Past performance is not indicative of future results. One cannot invest directly in an index or benchmark, and those do not reflect the deduction of various fees which would diminish results. Any index or benchmark performance figures are for comparison purposes only, and client account holdings will not directly correspond to any such data.
Our clients must, in writing, advise us of personal, financial, or investment objective changes and any restrictions desired on our services so that we may re-evaluate any previous recommendations and adjust our advisory services as needed. For current clients, please advise us immediately if you are not receiving monthly account statements from your custodian. We encourage you to compare your custodial statements to any information we provide to you.