There's a limit on this. If you borrow against the capital appreciation, eventually your debt percentage will put you at risk of a margin call. If your assets drop in value such that the assets are less than the debt, you lose all your assets, and the portion of the debt not covered by your assets still sticks to you.
I know people this has happened to.
The trick relies on your assets always increasing in value, which is not what assets do in the real world.
In practice the best strategy is not to borrow the maximum against the capital appreciation. You use this system to fund your day to day expenses as one part of an overall wealth management strategy.
You can keep under the maximum, and still get caught with a plunging asset value, leaving you with a negative net worth.
I had a stock that dropped 90% in a period of a couple weeks. I didn't borrow against it, but I could have easily borrowed 40%, then when it dropped, I'd be holding the bag.
Are there actively managed ETFs with target dates? That way when you are still working you are purchasing shares of the ETF that are investing in a more risky strategy. However, by a certain date the ETF shifts to a much more conservative focus, allowing for you to borrow against said ETF without the risk of a margin call.
Not an investment professional or even an amateur investor, just an idea I had so wouldn't be surprised if there is an issue in this.
So you become rich but never use your money and then become the richest guy in the cemetery. That kind of rich is not rich at all, just "paper rich".
As entrepreneur myself, it is not that easy to become rich, it is not that easy to make consistently 3% over inflation(specially when official inflation is not real like has happened for the last 20 years) and it is not that easy not to pay taxes. On the contrary in places like most of Europe the tax system is Hell for entrepreneurs, the System taking from 50 to 70% of your income.
In my life as entrepreneur I have seen many friends starting a business and losing 20.000-300.000 euros on their ideas before quitting and returning to their original jobs. In year 2021 with COVID I have seen people losing millions of dollars, their entire life's savings and business. The Government is giving them peanuts.
If you want to be rich, become a banker or Politian and be close to the printing money machine. They are the main beneficiaries from inflation, they create it, and extract a 3-9% of the economy's absolute wealth every single year doing nothing.
It's always surprising that when the last 20 years have been accompanied by extremely low inflation that people come up with the idea that inflation is too high.
It's easy to make money off speculation and bubbles because of low inflation. Is it really that difficult to understand?
If inflation was really as high as people claim then being idle and rich would really suck, as you would have to run or invest into a business with actual revenue and profit, otherwise your stocks would tank like in the dot com bubble.
Yes, it is possible. Think of total assets as annuity, annual loan as payment from annuity, and interest as management fee charged by annuity administrator.
Back of the napkin calculations:
Total assets $100 million
Annual Expenses as Annual Income
Annual withdrawal = $4 million
Assuming 40% tax, tax due = $1 million
Asset liquidated = $5 million
Remaining asset = $95 million
End of Year asset @ 4% growth = 98.8 million
Annual Expenses as Loan
Annual withdrawal as loan = $4 million
1% interest on annual loan = $40,000
Asset liquidated to pay loan interest and taxes on liquidated assets = $60,000
Remaining assets = $99.940 million
EOY asset = $103.937 million - $4 million
People have been saying “I’ve never seen interest rates this low in my life” for the last few decades. Also, much of the debt could be tied to long-term loans in which case the overall interest rate would not move much.
Certainly. This is basically a line of credit secured by your asset portfolio. As long as you keep that line of credit under your asset value and pay the interest, you can do this.
Interest rates are almost zero right now (AFR is 0.12% for short term in July), so money is "free" if you're a low enough credit risk, and fully collateralized loans are easy to get at near-AFR rates if you're rich.
I'm not so sure people are doing this to avoid taxes, though, as opposed to truly wanting to remain in the market as much as possible. If I was Bezos and I had faith in Amazon, I wouldn't want to exit any of my position, especially since that can send a negative signal to the market, etc. If I could hold my position and still spend money without racking up nearly any meaningful interest, I'd happily do so, you'd kinda have to be crazy not to since there's no downside (the principal keeps on earning for you and there's very little cost to service the debt). Companies do stuff like this all the time, there are a million good reasons to maintain debt even when you have assets you could otherwise liquidate, especially when rates are low.
Besides, unless it's given away to charity the bulk of the wealth will be taxed at death anyways via estate tax, so I'm not entirely following the nefarious implications here. I guess people are mad that the borrowed and spent money effectively escapes taxes since it's paid by the estate pre-estate-tax, I guess? I'm reasonably sure that no bank would loan someone in this situation anywhere near their entire net worth, so I can't help but feel like this is a very edge-casey small issue that is only a problem in the rare years where interest rates are so low that it makes sense to do this...
Scroll further down on the IBKR table. 1.6% is the rate everyone gets. If you manage 200 million for example, you pay 0.75%. Some other currencies have 0.5% interest.
Don't forget that you get to keep your money invested, which means it keeps appreciating. As long as your investments outperform the interest rate, you come out ahead no matter how long you hold the loan. If you borrow at 3% and have the same amount of money invested and earning 10% nominal returns as the S&P 500 tends to do, you're still ahead 7% a year and can hold the loan forever without losing money.
The biggest issue is if you keep taking loans every year, you might become over leveraged. Then if the market crashes you'll get margin called and lose everything. So this only works if your net worth is much higher than your annual spend, so your loans never reach more than around 30% of your net worth within your lifetime.
The other issue of course is that there's no guarantee your investments will be able to outperform the interest rate, especially as it will almost certainly be a variable rate. But ignoring short term fluctuations, I think it's pretty unlikely that this would be a big problem over the long term.
Mathematically, the logic works for anyone obtaining their income from capital gains. So it’s not so much about how much you make annually, but about how much of that is capital gains on assets you own.
Realistically, it doesn’t make sense for smaller figures. Banks are unlikely to lend (at the required rates) for small figures, transaction cost and management fees will reduce the gains too much, fixed costs to setup the scheme will be too high, etc.
I'm still confused about the mechanics of this as well. I suck at finance (Damnit Jim, I'm a coder, not a mortgage broker!) Like, if I were to get a reverse mortgage on my home equity let's say while rates are low. Take that and put it in the stock market, something that pays a high dividend. Makes sense that would be a win as long as the market doesn't crash[0]. But where's the tax advantage? If I ever want to spend that money I have to take it out and pay capital gains. The fact that the basis is adjusted when I die doesn't really help me. I guess if I had enough gains from stock to service the debt and declare a loss... is that the ticket?
I really hate how I can write a genetic algo from scratch and then feel like a freakin 11 year old who just missed an easy layup every time I call my accountant. Reading a tax form makes my eyes gloss over faster than trying to look at someone's wordpress plugin.
> If I ever want to spend that money I have to take it out and pay capital gains.
No. This is the trick. You can take money out of the asset tax free by borrowing against it.
Say that you wanted to invest your home equity. You have two choices. You can sell the house and rent or borrow against the house.
Imagine that you paid $0 for the house and can now sell it for $500,000. You have to pay tax on that, bringing it down to $425,000 in your pocket. You lose 15%.
You put that 425K in the stock market and it gains 10% per year. After 10 years you have 1.1 million.
Alternatively, you can just borrow 500,000 and put your house up as collateral to the bank you are borrowing from. You pay no tax on that 500K. Put that 500K in the market at the same 10%. You end up with 1.3 million in 10 years.
The tax benefit is in avoiding the destruction of your initial capital by 15%. You effectively spent the money in our home, but one method makes you pay capital gains while another does not.
You could spend your house equity on a boat in the same way.
This example is very contrived and ignores things like the capital gains exemption on housing (and the fact that no house costs 0) and that you generally can't borrow 100% of house value (but you can with stocks as long as they are liquid).
I think the point is that people who make 35,000/year are unlikely to have a huge net worth to be able to take advantage of these tax strategies. So, the advice would be to invest as early and often as possible to hopefully be able to take advantage of this strategy later in life... or just be born into intergenerational wealth, where this is going to be most relevant.
> The appreciated assets are now at a stepped-up basis, washing away the unrealized gains. They are then sold, without any built-in taxes
I don't understand how this part works. Your estate has to pay off the accumulated debt before distributing the rest to your heirs. To do this, the estate must sell the underlying assets, which will realize gains. Those gains are subject to CG tax. What is this "stepped-up basis" wizardry? Does the cost basis of your assets reset to their market value the day you die?
All assets within estate tax exemption limit $11.5M ($23M for married) receive a step-up basis on death. This means that cost basis resets to market value on the day you die, and your heirs can sell at market price the amount of money required to pay off the accumulated debt and start the cycle anew.
It's a bit similar to tax gain harvesting, which is when if you live in a no state income tax state and anticipate making very little income this year, but have some appreciated stocks, what you can do is harvest the tax gains by selling the stocks in order to reset to the higher cost basis and immediately buying them back. Since you have little income, you can get away paying $0 tax until $38.6k ($77.2k if married).
That's called a wash sale and the IRS is going to have a word with you about it. If you're going to do these things, I recommend getting some advice from a tax accountant.
To my knowledge, there's no wash sale rule on gains. Only losses.
One can sell a stock, pay the gains, and buy it back immediately at current market value making the holdings cost basis today's market value.
Why would you do such a thing? Exactly as the GP said, to take advantage of better capital gains rates during a low income year.
Another fun one is deliberately realizing small gains in a kid's UTMA account then paying a modest sum to file taxes for the kid. Only works for a specific amount of gains/income each year so read up first.
Like ac29 pointed out, wash sales only apply to losses. The motivation for the wash sale rule in the first place is IRS doesn't want you to be able to use a paper loss for tax deduction and let you maintain the same stock position.
Tax gain harvesting is similar, but the opposite of tax loss harvesting in some sense, because instead of a loss, you are taking a gain in a low income year. IRS doesn't care if you are generating capital gains, because for most people with stocks (read: not making low income) it increases your taxes owed.
Wash sale rule applies to identical or "Substantially Identical" securities [1]. IRS is a bit vague in its definition, and you may have to argue that the new security is not Substantially Identical. Your example are two different indexes and two different companies, so it might be fine.
A large amount of tax loss harvesting automation services work on the principle I just described, I even used one for a while. You have to tell them which funds you already own elsewhere so they wont trigger that wash sale rule inadvertently, or move all your stock funds to them.
For something like VTI, you have about 4 other companies that have a similar product you can execute it with. Schwab, Fidelity, iShares, SPDR. Other major banks probably also have them, but they're usually not as popular.
So, viewing such a thing being possible as a problem, what kind of "fix" to the tax rules is best?
Prioritize taxes on spending instead of income? Sales taxes are usually regressive (people with less wealth/income spend a larger proportion of their wealth/income each year, AND they tend to spend it less on things that aren't sales-taxed like real estate, services, financial instruments, travel abroad, political lobbying). Spending also tends to be more sensitive to economic downturns than income, tightening government revenue when it often is needed the most. Maybe a separate expenditure tax that only applies to spending significantly more than you earn (and so is only collected from the wealthy)?
Maybe something like... treating unrealized gains as realized when taking out debt? The problem is that if you have a $1 million trust that appreciates $40,000/yr, you "have" that money, but to actually _have_ that money costs you a taxation event, yet lenders don't really care about the difference between "having" and _having_ when there's so much extra collateral.
They could... charge the cap gains tax to the estate, getting rid of a big point of the strategy? The estate not having to pay cap gains on their gains is the big kicker and essentially arbitrary. If the person 1 month before they died sold a bunch of wealth to settle all of their debts, they would pay cap gains tax. But after their death, you do the same thing with their estate and they dont pay cap gains tax from gains before their death? It's a bit absurd.
They should not charge cap gains on the estate, since that'll force sales of illiquid assets which is not good. They just have to not allow the resetting of the cost basis of the assets. It's a very simple fix.
I was more implying when the estate sells something, you charge the original basis of cap gains tax when they try to pay off its debts by liquidating, but illiquid forced asset sale issue is also a good point.
What about taxing lenders when they take loans against non physical collateral? i.e. something that's not a house, car or otherwise utilitarian infrastructure. Let them pass the tax on in rate hikes until it equals the capital gains tax. Just a spitball idea.
It's true. Maybe 50 years ago more wealth in america was inherited, now, not nearly as much. In "bastion of equality" western europe, the percentage of inherited wealthy is far higher!!
The article you're quoting mentions first generation millionaires, however, the commenter you replied to was talking about the 10MM to 1B range. 10MM is very different from 1MM. Almost every professional working as a doctor, lawyer, or programmer can make it to 1MM and in reality, 1MM is considered a very average amount to retire on these days so it's nothing special to be a millionaire.
I'd like to see an analysis that shows the breakdown in different buckets. I suspect it's much easier today to be a first-gen millionaire in the 1 million dollar range but the higher you go, the more we'll see inherited wealth.
hopefully someone else can find this- but it was only recently that business people started dethroning the inherited wealthy off of the top Forbes spots. Recently as in 1980 or so. So second and third generation children of tycoons were still dominating.
I have a friend who worked in the past five years for two tech companies that IPOd and has lots of vested stock.
She wants to buy a house in San Francisco but doesn’t want to sell her stock to make the downpayment. She plans to use a collateral-loan offered by ETrade (who manages her employee stock plans).
Would mortgage lenders allow this? I was under the impression that they trace the origin of the down payment for this reason (to prevent it from originating from another riskier loan), but I have no expertise here.
1. Transfer $500k in stock to TD Ameritrade (a stock transfer is not a sale/buy so it's not taxed)
2. Withdrawal $100k without selling anything (now you're $100k into margin.
3. Wait about 6 months.
4. Now you can use that as a down payment, and they'll just consider your margin balance as part of your overall debt picture.
> into the extraordinary by withdrawing $300,000 in debt
And gets to pay 8% interest on it (can't borrow money for free), which is $24,000/yr and compounds. Keep doing that every year, and this can get overwhelming.
Someone rich borrowing against their own assets would never come close to 8%. Prime is 3.25% and AFR is even lower if they're able to borrow from "themselves" in some way (from an LLC, etc).
But with the example numbers in the post, your fund increases by $300,000 a year even after your "withdrawals".
So, you're still netting $260,000 after the interest on your loans. And that growth compounds, too. (I'm not a multimillionaire, but I'm guessing you can get a bit better than 8% rate for a fully collateralized loan in exchange for your business)
This strategy only works when your account grows by significant more than you need to spend, but that can happen with a relatively small fortune of a few million dollars.
you get paid for the work. Capital gets anything above the cost, but could be negative. Capital trade certainty of reward (wages paid for work) with uncertainty of reward, and correspondingly higher return.
So unless you're saying that workers are not paid (aka, slave labour), both gets their appropriate reward.
Time is the most important thing we have. That’s a major reason why prison is a deterrent. Practically everyone with significant capital trades it to gain more time. To deny this aspect of capitalism is straight up absurd.
That's a bit disingenuous considering the scalability and concentration of capital compared to labour. Regardless your point doesn't refute mine. Supplying capital reqires zero personal effort.
It's not disingenuous, it's simply a description of the market reality of both capital and labor and why they both have prices.
Supplying capital is compensated by the market because it's a scarce factor of production. It is a scarce factor of production because (i) there are risks associated with its provision, (ii) there's an opportunity cost. Nobody would invest in a startup if there wasn't an expectation of an ROI. Because it's risky, that ROI is high. The ROI is high because the cost base is deflated by the market. This is a risk premium, and it's built into the cost base by supply and demand. This basic mechanism underpins all capital markets and is the reason capital markets function at all.
Your statement about the scalability of capital is of course true. Capital offers the owner intense amounts of leverage and scale. The same can in general not be said about labor except in domains where that labor is scaled by technology (e.g. dev), media (e.g. instagram influencer), or being in a managerial position (e.g. decisions impact 1000-person org), which probably covers about 2% of the workforce.
I think we’re generally in agreement. Another consideration is that capital creation is controlled by the federal reserve or equivalent so supply is only as scarce as they say it is.
They are low effort, but I'm not sure why that's relevant. Effort isn't what's valued. Scarce and useful resources and inputs are what is rewarded. A talented dev who works 3 hrs/day can earn more than a less competent dev who works 12 hrs/day, despite expending less effort. Effort is only relevant insofar as it pertains to valuable output.
On index funds, the reason they are profitable to hold is because of the risk premium embedded in its current price, and this risk premium comes about because of the risk aversion of the average investor. As time passes and the world hasn't blown up yet, the price goes up, as it should. It has nothing to do with effort, it is about risk and opportunity cost. It's the same mechanism underlying the yield spread between corporate bonds and government bonds.
I know people this has happened to.
The trick relies on your assets always increasing in value, which is not what assets do in the real world.