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.
