Buy, borrow, die

In short

A friend of mine once asked why a billionaire could pay so little tax while he paid so much on his paycheck. The honest answer is a three step habit that wealthy families have used for a long time. They buy assets that grow, they borrow against those assets for spending money, and they hold the assets until death. Under current federal law, a gain that has not been sold is not taxed. Loan proceeds are not income. And an heir who inherits an asset usually gets a new, higher cost basis, which is the starting price used to measure future gain. Congress has set rules that can limit or change each piece, so check the current law with a tax professional before acting on any of it. Nothing here is advice to buy, sell, or hold anything.

The whole of it

What it is

I once watched an old farmer refuse to sell his land, even when the price was handsome. He borrowed against it each spring to buy seed, and he paid the bank back from the harvest. He said selling would cost him more than borrowing. That is the whole idea in a single field.

Buy, borrow, die is a nickname, not a legal term. It describes how a person with a very large pile of appreciating assets can fund a comfortable life without ever selling them. The assets might be stock in a company, real estate, or a family business. The word appreciating just means rising in value over time.

If you hold wealth like this, or you are curious how others do, the logic is simple. A sale creates a tax bill. A loan does not. So the borrower swaps the first for the second, and lets the assets keep growing.

How it works

You have probably heard that the tax code taxes income, not wealth. That is close to the heart of it. A stock that climbs from $1 million to $10 million has made $9 million on paper. The Internal Revenue Code taxes that gain only when it is realized, meaning the owner sells. Until then, the gain sits untaxed. Tax people call it an unrealized gain.

Now the owner needs cash for living. Selling shares would realize the gain and trigger a capital gains tax. So the owner goes to a lender instead. The lender takes the shares as collateral, which is a pledge the lender can seize if the loan goes bad. The owner receives cash. Loan money is not income, so it is not taxed. The borrower has to repay it, and interest accrues along the way. Often the owner just lets the loan grow and pays interest from more borrowing.

Then comes the third step. When the owner dies, the heirs receive the assets. Under Internal Revenue Code Section 1014, inherited property generally gets a stepped up basis, which means its cost basis resets to the market value on the date of death. The old gain, which was never taxed, drops out of the picture for income tax purposes. The heirs can sell the assets and repay the loan with little or no capital gains tax on the growth that came before.

Estate tax is a separate matter. The estate of a very wealthy person can owe federal estate tax on the total value, above an exemption set by law. That exemption is the current figure, which the official source publishes each year. Loans are usually subtracted from the estate's value, since the estate must repay them. So the strategy trims income tax. It does not erase estate tax.

The numbers, and where to find yours

Several figures matter here, and each one changes. I will not guess at them for you. The federal estate tax exemption is the current figure, which the official source publishes each year. The top federal rate on long term capital gains is the current figure, which the official source publishes each year. The extra net investment income tax on high earners is the current figure, which the official source publishes each year. The top estate tax rate is the current figure, which the official source publishes each year.

Where do you find the real figures? The Internal Revenue Service publishes them at irs.gov. Look for the estate tax page and the capital gains page. The instructions for Form 709, the gift tax return, and Form 706, the estate tax return, also list current amounts. Your own loan terms, though, live in your loan agreement. The interest rate, the loan to value limit, and the margin call terms are all there. A margin call is a lender demanding more collateral or cash when asset prices fall. Read that document slowly.

A worked example

Let me tell you about a woman named Margaret. She founded a software company years ago and holds shares worth $40 million. Her cost basis is almost nothing, say $400,000, since she started the firm with little money.

Her unrealized gain is $40,000,000 minus $400,000, which is $39,600,000. Suppose she sold everything. For this example, take a made up combined gains tax rate of 23.8 percent, which is just a round figure for the story and not a quote of current law. The tax would be $39,600,000 times 0.238, which is $9,424,800. Let me say that again. Nearly $9.4 million would go to tax.

So Margaret borrows instead. A bank lends her $8 million against the shares at 5 percent interest. The first year of interest is $8,000,000 times 0.05, which is $400,000. She pays no income tax on the $8 million she received. She spends it on a home, a foundation gift, and living costs.

Say the shares grow 6 percent a year while she holds them. After one year, $40,000,000 times 1.06 is $42,400,000. Her wealth rose by $2,400,000, and she owed no tax on that gain.

When Margaret dies, her children inherit shares worth, in this story, $60 million. Her basis was $400,000. Under Section 1014 the children's basis becomes $60,000,000. If they sell the shares the next day, the gain is $60,000,000 minus $60,000,000, which is $0. The loan of $8,000,000 plus accrued interest gets repaid from the proceeds. The decades of growth were never taxed as income.

That is the trick. Still, the estate may owe estate tax if its value passes the exemption. Margaret's family would face that bill separately.

Where it goes wrong

I have a neighbor who learned this lesson the hard way. He borrowed against a stock that then fell by half. The lender called the loan. He had to sell at the bottom, and he owed tax on top of it. Prices fall. Loans do not care.

That is the first danger. A falling market can trigger a margin call and force a sale at the worst moment. The borrower has to repay, no matter how the shares are doing.

The second danger is interest. Loan costs add up, and rates can rise. If the assets grow slower than the interest, the plan loses money.

The third danger is the law itself. Congress can change the step up in basis, the treatment of loans, or the estate tax. Proposals to limit these rules have appeared in Congress more than once. Nobody can promise the rules will stay put for twenty years.

Fourth, the IRS can challenge a loan that is really a sale in disguise. A loan needs real terms, a real lender, and a real duty to repay. The tax code has rules aimed at sham arrangements. A good tax attorney can say where the line sits.

And last, family plans fail for plain reasons. A will goes stale. Heirs disagree. A trust is drafted badly. Money problems at the top of a family are often people problems underneath.

Questions to answer before you leave this page

Have you read your own loan agreement closely enough to know when a lender could demand repayment? If the assets fell by half next year, could you cover the loan without selling? Do you know what your cost basis is, and have you written it down somewhere your family can find it? Have you checked the current estate tax exemption at irs.gov, and does your total estate come near it? Who would repay the loan if you died tomorrow, and from what? Has a tax attorney or a certified public accountant looked at your plan in the last year, given that the law can change? And what does your family actually want from all this, apart from the tax savings?