Aug 22, 2024
If you think the U.S. tax system is complicated, you’re not alone.
Scott Galloway, professor of marketing at NYU Stern School of Business, believes the complications are the result of various loopholes designed to help wealthy people.
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“The tax code has gone from 400 pages to 4,000, and that extra 3600 pages are to turn rich people into super rich,” he told Steven Bartlett on a recent episode of his podcast “The Diary Of A CEO.” "Tax avoidance is a key skill to building wealth."
One of the many tax loopholes, according to Galloway, is the use of securities-based lines of credit (SBLOCs). He said when wealthy people want to buy something, they borrow against their capital assets, such as stocks and bonds, instead of selling them. This allows them to avoid paying capital gains taxes on the appreciated value of their assets.
In fact, this loophole could allow some individuals to avoid taxes in perpetuity. “Basically it's invest, borrow against it and die, put it into a trust and then pass it on to your kids,” he said.
This tool can be used by anyone who owns the minimum required stocks, bonds and mutual funds in a fully paid-for cash account at a brokerage. FINRA says it’s not uncommon for a firm to require that your assets have a market value of $100,000 or more to qualify. The initial withdrawal on an SBLOC would also have to meet certain minimum requirements. Your interest rate on the loan will be based on the amount of assets you have at the firm.
The average investor may need to consider the pros and cons of this maneuver before deploying it to make a big purchase. Here are a few of them:
Pros
The biggest advantage of a SBLOC is that it offers you liquidity without creating a taxable event. It's also a revolving line of credit, which means you can repay the loan and borrow against your assets once again. FINRA says you can usually borrow anywhere from 50% to 95% of the value of the assets in your investment account.
In other words, you can access your wealth without paying capital gains taxes. You may also be able to continue enjoying the benefits of your assets — such as dividends or interest — while using the cash value of the asset for other purposes.
Elon Musk, for instance, has pledged around 238 million Tesla shares out of the 411 million he owns to finance his various ventures, according to The New York Times. If he sold millions of shares he would owe capital gains taxes worth billions of dollars.
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According to FINRA, interest rates on SBLOCs are often lower than other forms of debt such as personal loans and credit cards. Depending on your tax bracket, the interest could also be lower than the capital gains you would have paid while selling the assets. Depending on the lender and your personal net worth, you could have favorable flexible repayment terms as well.
However, this financial tool isn’t without drawbacks.
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Cons
In many ways, a SBLOC is similar to a home equity line of credit (HELOC). Both forms of revolving debt are relatively cheaper because they’re secured by the value of an underlying asset.
This means the lender can seize your assets, whether it’s a house on a HELOC or stocks on a SBLOC, if you fail to make interest payments on time. There are also limits on how much of the market value of your collateral you can borrow.
Another factor worth considering is market risk. The stock market is volatile and if a sudden market crash pushes the value of your assets below a certain threshold, the lender could require cash payment to cover the difference right away or more collateral. FINRA says if you’re unable to repay the required portion of the loan or post the additional collateral, the firm may sell some or all of your securities.
Borrowers are also subject to interest rate risk. SBLOCs are floating-rate debt, which means the interest rate changes over time and you may have to pay higher rates than anticipated.
Conclusion
Borrowing against your shares is an attractive strategy to minimize taxes. However, in many ways this tool is better suited to wealthy individuals who have excess cash and a well-diversified portfolio of different assets to weather the downside risks.
For individuals in a lower tax bracket who have less cash and assets at a brokerage firm, the risks might outweigh the benefits of this strategy.
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Vishesh Raisinghani is a financial journalist covering personal finance, investing and the global economy. He's also the founder of Sharpe Ascension Inc., a content marketing agency focused on investment firms. His work has appeared in Moneywise, Yahoo Finance!, Motley Fool, Seeking Alpha, Mergers & Acquisitions Magazine and Piggybank.
