Personal Finance | 056 How to Save Taxes with Buy-Borrow-Die

Summary: The stock market is inherently volatile, experiencing both increases and decreases in value. Consequently, investing with the mindset of "borrow and die" poses a high risk, particularly for middle-class investors. Additionally, when using stocks as collateral to borrow money, lenders typically allow you to borrow only 50% to 70% of the stock's value due to the associated risk margin. Therefore, it’s essential to carefully consider this approach before proceeding.

Today, we will learn about the Buy-Borrow-Die strategy used by the ultra-rich to minimize taxes while maximizing investment growth. Here's how it works:

• Buy (Acquire Appreciating Assets) Wealthy individuals invest in assets expected to appreciate over time, such as Stocks, Real estate, Private equity, Fine art, collectibles, or other alternative investments. Unlike earned income (taxed at high rates), appreciation in asset value is not taxed until the asset is sold.
• Borrowing (Accessing Cash Without Selling) Instead of selling assets and incurring capital gains taxes, wealthy individuals often choose to borrow against their assets. This involves taking out loans with their investments, such as stocks or real estate, serving as collateral. The debt proceeds are not taxed because the IRS does not consider borrowed money income. These funds can support their lifestyle, reinvest, or purchase additional assets. Typically, these loans, such as Securities-Backed Lines of Credit (SBLOCs) or home equity loans, come with low interest rates.
• Die (Avoid Capital Gains Taxes) When the investor passes away, their heirs inherit the assets with a stepped-up cost basis. This means The cost basis of the asset is adjusted to its **market value at the time of inheritance. Capital gains taxes are erased as the new cost basis is the current market value, not the original purchase price. Heirs can then keep the asset, sell it tax-free (if they sell immediately), or repeat the cycle.

In summary, this approach benefits the wealthy for several reasons. First, it defers or eliminates capital gains tax. As long as assets are not sold, taxes can be deferred indefinitely. Wealthy individuals can secure loans at low interest rates without liquidating their investments. Additionally, heirs inherit assets on a stepped-up basis, which allows them to avoid capital gains tax altogether. However, the potential risks remain that borrowing costs could become expensive if interest rates rise. If the asset used as collateral loses value, lenders may demand additional funds or liquidation. While capital gains taxes can be avoided, estate taxes (40% on estates above the exemption threshold) could still apply.

Let's examine an example: We own $200,000 in stock and would like to use this to invest in real estate. There are two scenarios: one is to sell the stock to obtain cash, and the other is to borrow money using the stock as collateral. Let's assume the stock increases in value by 5% per year while the loan interest rate is also 5%. The strategy is to repay the loan quickly, utilizing tax savings and rental income.

• Selling the Stock
• Net Cash After Paying Capital Gains Tax: $180,000 
• Total Tax Paid: $20,000 (Capital gains tax on a $100,000 profit)  
• Future Stock Growth: None, as the asset has been sold.
• Borrowing Against the Stock
• Total Interest Paid Over 10 Years: $120,000 (6% annual loan interest)  
• Stock Value After 10 Years (5% Growth Per Year): $325,779  
• Net Profit After Loan Interest: $205,779  
• Total Tax Savings from Not Selling: $20,000  ​

This comparison illustrates how choosing between selling an asset and borrowing against it can have substantial implications for financial growth and tax obligations.