Death to “Buy, Borrow, Die”

Every year millions of Americans begrudgingly file their taxes. Each household must spend countless hours deciding which deductions to take, bemoaning the complexity, and eventually sending off the precious dollars they must pay to fund our roads, bridges, firefighters, and military. At the end of the day, taxes serve as part of every American’s patriotic duty to their fellow citizen.

While the Inflation Reduction Act finally increased funding to go after wealthy tax cheats, the federal tax system’s Gordian Knot leaves enough legal loopholes for the unscrupulous, ultra-wealthy to reduce their effective tax rate far below that of the average wage earner. Clever accountants and wealth managers employ a wide variety of tactics to minimize tax burdens, one of the most successful ways to minimize a tax bill lies with the “buy, borrow, die” scheme. Pairing ending this workaround with increased enforcement will raise significant revenue while decreasing inequality and addressing the federal deficit.

Let’s pretend you’re a wealthy start-up founder, real estate magnate, or private equity manager. You’re sitting pretty on a sizable pile of wealth. You want to buy things. A house would be nice. Fancy cars seem fun. Who doesn’t want a yacht? Unfortunately, while you have a big pile of stock/real estate/stake in a fund, you do not have cash. You could sell some of your assets, but then you would incur capital gains tax. Instead, you ask your bank for a margin loan. The bank loans you money based on the value of your holdings that you pledge as collateral and charges you interest. You take your pile of money and buy your house, car, boat, or whatever. You can then deduct the interest on your loan from your taxes and you never have to pay capital gains taxes.

You’ve accumulated various houses, cars, and toys, but you also have kids who would love to inherit your “hard-won” gains. When you die and your heirs inherit your wealth, any unrealized gains reset to the price on the day they received the assets. If they ever decide to sell the assets, the IRS assesses capital gains based on the price at which they came into your possession. If the asset was $1 when you got it but $100 when you died, then the tax code now steps up the basis for the capital gain to the price of the day your heirs inherited the asset. If they ever sell the asset for $101, the capital gains will be based on a $1 profit, not a $100 profit. That said, your kids never have to pay capital gains because they can take out the same margin loan you did.

This sounds good for billionaires, but not so good for the U.S. Treasury. “Buy, borrow, die” essentially codifies a method for maintaining an aristocracy. The margin loan system may provide a way that both ends the practice and implements a wealth tax. The wealthy tend to have more illiquid or hard-to-price assets the IRS cannot assess the value of. Banks have armies of analysts focused entirely on valuing illiquid assets to calculate margin loans to ensure that the collateral they hold supports outstanding loans.

This valuation can come in very handy when it comes to tax time because it can act as a taxable event. Banks could report to the IRS all valuations used for margin loans as an annual taxable event. The loan recipient would then have to pay a capital gain (or take a capital loss) on the bank’s new valuation of the asset. This new plan would force high net-worth individuals to realize their taxable income annually for any margin loans. Banks must perform accurate valuations on these assets as any underreporting makes the loan look significantly less valuable lest they fail stress testing or fall below regulatory capital requirements. Either the IRS receives revenue from the annual capital gains, or the wealthy must incur the tax penalty through sales to raise cash.

Many wealth tax concepts run into issues with valuing illiquid assets as any true valuation inherently requires a subjective judgment. The margin loans in “buy, borrow, die” schemes force the bank to give a true valuation. Congress can close a critical loophole. The tax avoidance industry will surely find another one, but if policymakers can slowly but surely tighten each one, the wealthy may finally pay their fair share.