Author Topic: how the super wealthy avoid taxes  (Read 6497 times)

sol

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how the super wealthy avoid taxes
« on: January 25, 2013, 10:39:45 PM »
A recent CNN opinion piece was discussing the high marginal rates paid by very high earners vs the low marginal rates paid by very wealthy people. 

As an aside, he mentioned a tax planning strategy that I've heard is very common among the world's nouveau riche, like facebook billionaires and such.  With all of these vast sums of money, they actually fund all of their living expenses with debt, in order to avoid paying taxes, because they pay less in interest on the debt than they would pay in taxes on the equivalent income.

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Indeed, if you have wealth already, taxes are essentially optional under what I call tax Planning 101, the simple advice to buy/borrow/die.
In step one, you buy assets that rise in value without producing cash, such as growth stocks or real estate. In step two, you borrow to finance your lifestyle. In step three, you die, and your heirs get your assets, tax free, and with a "stepped up" basis that eliminates all capital gains. That's it.

This is a strategy I've heard mentioned a variety of other places, and I'm still trying to decide if it might be relevant to those of us with more modest means.  If I have four or five million in invested assets, rather than drawing down my nest egg by 4% per year I instead borrow the equivalent amount of money (ostensibly at low low rates because I don't need the money, I'm rich) and leave my nest egg fully invested.  When I die, my assets transfer to my heirs on a stepped-up basis that avoids the worst of the tax bite, and then they can sell off some assets to pay off my debts.  As long as the interest on my debt is less than the difference between my marginal tax rate and the long term capital gains rate, I think I come out ahead.

Too complicated?  I think it's only relevant for people who will have high marginal rates in retirement, which is probably not this crowd.

arebelspy

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Re: how the super wealthy avoid taxes
« Reply #1 on: January 25, 2013, 10:48:54 PM »
I'm familiar with the concept as well.

It's not very useful to me, as I'm planning on not accumulating much before I hit FIRE.

But were one to come into tens of millions and have no qualms about trying to evade taxes (or pay as little as possible, depending on how you look at it), it's definitely a viable strategy.  One just puts up the assets as collateral for the debt.
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cyclevillian

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Re: how the super wealthy avoid taxes
« Reply #2 on: January 26, 2013, 10:16:56 AM »
I read that article too and was intrigued by the buy/borrow/die comment as I had not heard about this strategy before (obviously I'm not uber rich). I was trying to figure out if this could apply to Mustachians but I don't have a full grasp of how it works yet.

Does it work like this? Say I have millions in real estate and stocks. I borrow money at a low interest rate because I'm well qualified due to my assets. I then make small payments on this debt for a while. Some time later my stocks/real estate have appreciated in value, allowing me to borrow more money which is used to pay the existing debt and continue to fund my lifestyle.


sol

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Re: how the super wealthy avoid taxes
« Reply #3 on: January 26, 2013, 10:40:40 AM »
Does it work like this? Say I have millions in real estate and stocks. I borrow money at a low interest rate because I'm well qualified due to my assets. I then make small payments on this debt for a while. Some time later my stocks/real estate have appreciated in value, allowing me to borrow more money which is used to pay the existing debt and continue to fund my lifestyle.

My understanding is that the idea is to avoid selling any of your assets while you are alive.  If you don't cash out, you don't pay taxes on realized gains.  Instead, you fund your lavish lifestyle with low interest debt, while leaving your assets invested, and when you die your assets pass to your heirs tax free.  They then sell a portion of your untaxed assets to pay off your debts.  The net effect is that you pay interest on your debt instead of income taxes.

While you're still alive you just continually roll over the interest payments on your outstanding debt into new debt, avoiding having to ever cash out  of your investments.  I've been reading up on the estate treatment of unrealized gains, and it looks to me like your heirs will only pay taxes on the purchase price of your assets, not the current value.  Over decades of life for the assets to grow, that's peanuts.

As an aside, this is starting to look like a viable strategy for Mustachians, too.  Worried about your 4% SWR hitting a bad stretch of market returns?  Borrow your living expenses at a fixed rate instead of withdrawing in down years and locking in your losses.  Even without the tax benefits afforded to folks in higher brackets, it would at least even out the returns. 
« Last Edit: January 26, 2013, 10:44:56 AM by sol »

James

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Re: how the super wealthy avoid taxes
« Reply #4 on: January 26, 2013, 11:00:28 AM »
I don't think it applies to mustachians since their income taken out is presumably such a small amount.  Even taking $30,000 in income, with a standard deduction (married couple), the effective rate is down around 8%.  If you have a small business and can work out a way to write off some of your expenses like MMM, you could probably figure out a way not to pay a dime.  For the uber wealthy spending huge sums it works, and they don't mind the complexity because they pay accountants to take care of the paperwork and keep on top of everything.  But for me I wouldn't want the complexity, simplicity would be worth the small extra cost of paying taxes.  And in the end I think paying some taxes isn't such a bad thing.

MooreBonds

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Re: how the super wealthy avoid taxes
« Reply #5 on: January 26, 2013, 11:24:15 AM »
Does it work like this? Say I have millions in real estate and stocks. I borrow money at a low interest rate because I'm well qualified due to my assets. I then make small payments on this debt for a while. Some time later my stocks/real estate have appreciated in value, allowing me to borrow more money which is used to pay the existing debt and continue to fund my lifestyle.

My understanding is that the idea is to avoid selling any of your assets while you are alive.  If you don't cash out, you don't pay taxes on realized gains.  Instead, you fund your lavish lifestyle with low interest debt, while leaving your assets invested, and when you die your assets pass to your heirs tax free.  They then sell a portion of your untaxed assets to pay off your debts.  The net effect is that you pay interest on your debt instead of income taxes.

While you're still alive you just continually roll over the interest payments on your outstanding debt into new debt, avoiding having to ever cash out  of your investments.  I've been reading up on the estate treatment of unrealized gains, and it looks to me like your heirs will only pay taxes on the purchase price of your assets, not the current value.  Over decades of life for the assets to grow, that's peanuts.

As an aside, this is starting to look like a viable strategy for Mustachians, too.  Worried about your 4% SWR hitting a bad stretch of market returns?  Borrow your living expenses at a fixed rate instead of withdrawing in down years and locking in your losses.  Even without the tax benefits afforded to folks in higher brackets, it would at least even out the returns.

From the big picture, your understanding is somewhat correct....but there are a few details that need to be clarified/adjusted:

Only for the undiversified uber rich - This strategy doesn't really work if you have a diversified portfolio in Mutual Funds/stocks/ETFs, since they will pay out capital gains and dividends - and even if they distribute out only 2%/year, if you have a $10M portfolio, that's $200k in income you are taxed on. It works more for someone with a $100MM+ net worth that is concentrated mostly in one or a handful of growth assets that don't distribute taxable cash flow (dividends and/or capital gains).

Inheritance stepped-up basis - You are correct that the heirs will receive the estate with a stepped-up basis (with current estate tax laws). HOWEVER - the estate must sell off assets to pay off all of those loans that were accrued over the years, and those assets are sold BEFORE the heirs take possession...and as such, the asset sales are part of the estate's tax return, and must use the uber rich's cost basis. The reason is that when the uber rich are alive, they receive loans in their name. When the uber rich die, the loans are still in their name, and must be paid off by the estate prior to the assets being distributed (and step-up-cost-basis applied) to the heirs.

So it's great if an uber rich person does this while they are alive, but really sucks for their heir because if the estate has giant loans to pay off, that means giant slugs of assets must be liquidated to pay off the loans all at once. In 9 months' time (to pay the estate and/or income taxes). Which would really produce massive taxable income in one year. And if you have illiquid investments (or even if you have a luxury mansion), 9 months from the date of death is NOT a long time - especially for a high dollar property or private business. Given the current income tax rates, it would make sense to have income while you're alive and use up the $400,000 bracket to not pay the 3.9% surcharges, etc., rather than make your estate incur a taxable income of many millions in one year.

Also, people like to write articles and make this sound so easy and titillating...."just take out more and more loans and never repay them until you die!". It can easily be done the first few years, but if you are spending 4%-5% of your net worth every year, it won't take long until those loans pile up and total 25%-50% of your net worth. As it grows and grows, I'd imagine that few finance companies will loan you money with little (if any) interest repayments if your total debt to equity level is approaching 0.5 to 1, especially if it's secured by equity investments. Just imagine how screwed you are if your equity investments drop 20%, your debt:investment level breaches your loan covenants, and you have to sell everything to pay off your loans. You suddenly have a giant taxable income in one year, and then have to live off of a much smaller portfolio.

"Low interest loans" - Are you aware of what interest rates were in the 80s? 90s? Even the first half of the 00s? No finance company is going to give you a margin loan for 2% when 6 month Treasuries are paying 3% or 4% (or more!). The house of debt doesn't work for long when you're taking out loans of even just 3% of your net worth each year and your delayed interest payments rate of 5%++ keeps growing your stash of debt. Before long, your accumulated debt and interest has reached a big minority of your net worth (and you aren't paying the interest, are you? Because where are you getting that cash from to pay the interest on your debt?)

A much more intelligent maneuver for higher net worth individuals is to put a decent chunk of their portfolio into real estate and/or Master Limited Partnerships (such as many of the pipeline and other MLPs that are publicly traded). You get decent cash flow yields of 5%-8% AND it's mostly return of capital or non-taxable income, based on the tax laws. Or, in the case of real estate holdings, you depreciate the value of the building over time. The kicker is that when you sell, your cost basis has been reduced by the value of the cash flow you've received over the years (for the MLPs) or by the depreciation of the real estate. This is ideal for estate planning, since your heirs will inherit the MLPs with a zero cost basis, and then get a stepped-up basis.

THIS is true wealth transfer without paying capital gains taxes that the knowledgeable wealthy use to their advantage - not the "hey, let's just rack up debt and spend what we want until the day we die!". Sure, some like Paris Hilton might nonchalantly spend without caring what the debt to asset ratios are....but those that naturally live below their means and want to truly plan for wealth transfer are probably going to utilize methods like the MLP/Real Estate methods.
« Last Edit: January 26, 2013, 11:26:39 AM by MooreBonds »

Crash87

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Re: how the super wealthy avoid taxes
« Reply #6 on: January 26, 2013, 12:45:58 PM »
Damn good post MooreBonds!

+1 internets for you

smedleyb

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Re: how the super wealthy avoid taxes
« Reply #7 on: January 26, 2013, 09:15:15 PM »
Allow me to second Crash87 and commend MooreBonds on a thoroughly kick-ass post. 




sol

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Re: how the super wealthy avoid taxes
« Reply #8 on: January 26, 2013, 10:21:18 PM »
Damn good post MooreBonds!

+1 internets for you

Yes, exactly the kind of input I was looking for.  I still find myself surprised when anonymous internet strangers turn out to be helpful.

dragoncar

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Re: how the super wealthy avoid taxes
« Reply #9 on: January 28, 2013, 05:49:31 PM »
Here's a question for those with a mustachian level expenditure of, say $30k.  Should you be stepping up your cost basis annually?

For example, a married couple can earn $67,900 in long term capital gains and pay 0%.  Does it make sense to take profit each year on the full $67,900 (regardless of expenses) to hedge against the possibility of a higher future tax rate?  You'd may have to avoid the wash sale rule, but that's probably not too hard.

MooreBonds

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Re: how the super wealthy avoid taxes
« Reply #10 on: January 28, 2013, 08:33:43 PM »
Here's a question for those with a mustachian level expenditure of, say $30k.  Should you be stepping up your cost basis annually?

For example, a married couple can earn $67,900 in long term capital gains and pay 0%.  Does it make sense to take profit each year on the full $67,900 (regardless of expenses) to hedge against the possibility of a higher future tax rate?  You'd may have to avoid the wash sale rule, but that's probably not too hard.

If you project earning more than $67,900 most years in the foreseeable future (or think you'll have a huge capital gains one year in the hundreds of thousands), and you have an opportunity to sell stocks now and fill up most of the lowest capital gains tax rates, then it would definitely make sense to do so.

Also, the wash-sale rule only applies to realizing losses. You can sell a stock for a gain and buy it back 1 second later without any issues.