A Tax Deferred is a Tax Denied

Why would it make sense to delay paying taxes?

In tax law class in law school, our professor did a big calculation on the chalk board (yes, chalk, not a white erase board) on how a tax deferred is essentially a tax denied.  What does this mean and how does it work?  I noted in a recent posting that Elon Musk (among others) avoided taxes by taking out loans using his stocks as collateral.  At first this makes no sense, until you do the numbers.

There are a number of scenarios where you can delay taxes and thus reduce their effect, over time.  Life insurance loans, capital gains rollovers, the IRA and 401(k), or just borrowing against assets. These tricks usually make sense only for high earners, but then again, the IRA or 401(k) works for us "little people" in the middle class.

Let's crunch some numbers on these techniques and see how they work.

1. Borrowing against assets:  Say you are a Billionaire and want to cash in some equity in your big company and spend it on cocaine and hookers and a new Ferrari.  Problem is, you cash out a billion dollars worth of stock and three bad things happen.  First, you have to pay capital gains tax on that stock sale - both Federal and State - and that could be 20% or more!  Second, you lose control of your company each time you sell off stock - eventually you could become a minority shareholder.  Third, people get nervous when the founder sells shares - and your sale of large chunks depresses the share price as there are not enough suckers buyers for the stock - even if you sell it off in little dribbles at a time.

So you talk to your accountant and banker and they propose a solution - a loan!  You borrow a billion dollars at, say 5% interest, using your stock shares as collateral for the loan.  Since loans are not "income" (they have to be paid back!) you avoid paying, say, $200M in taxes to the State and Feds in capital gains tax (let's use that as a round number in these calculations).  That's a big savings right there.

Say the term of the loan is ten years, with a balloon payment due at that time.  In ten years, if your stock appreciates at 5% a year, your $1B in stock that you didn't sell is now worth $1.63 Billion dollars.  Of course, the loan balance is now about the same, so you break even - right?  But breaking even is still coming out ahead, as you had control over that $1B for a decade, without having to pay taxes on it, and also maintained ownership control of your company, since you didn't sell shares.   The "Future Value" (FV) of money is always worth less today, so paying $200M in taxes ten years from now is always a better deal than paying it today - and maybe you'll never have to pay it at all!

If your loan rate was, say, 3% and the stock appreciated by 7% a year (which isn't hard to do) then you come out ahead.  The loan balance would be about $1.34B and your stock worth $1.97B which means you could easily pay back the loan and the taxes and still have stock left over. It does entail risk, though - particularly if your stock is over-valued or volatile.

Worse yet, most banks have a "trigger" price that will force the sale of stock shares once the amount pledged is worth less than or equal to the loan balance.  This means you may be forced to sell your shares and give the balance to the bank if they "call the note" and you may end up with a hefty tax bill as well.

On the other hand, the bank may "rollover" the note into a new 10-year balloon note, and you can keep doing this until you die and then really cash in - death and taxes.  You see, once you die, those shares are transferred to your heirs at stepped-up basis and thus they owe no taxes on the capital gains.  As we shall see, this works also for Real Estate rollovers.  But even if your estate ends up paying taxes, who cares? You're dead and you cheated the tax man to the very end.

Like I said, most of these games are things only super-rich people can get away with (and that's fair - right?) because they have an "in" with banks, who are willing to loan them money at low rates as the loans are "secured" by the pledged stock.  Banks consider this a low-risk loan, as the worst that can happen is they force sale of the stock and get all their money back.  It isn't as risky as some unsecured credit card debt to some middle-class plebe and a helluva lot less costly to administer as well.

The next time you hear about some rich guy paying little or no taxes, chances are, they may have used this loan dodge to avoid paying taxes.  But even if they do pay taxes, often it is capital gains taxes, which have a far lower rate (particularly today) that ordinary income taxes.  As Warren Buffet noted, his tax rate is less than that of salaried secretary - and that just isn't right.  It isn't about to change, either, as rich people write the tax code.  Sad, ain't it?

2.  The IRA/401(k):  Congress threw us little people a bone back in 1978 by creating these tax programs that allow us to put aside money, tax-free, for retirement.  The net result was that it created a whole new class of investors - and investment houses and advisers - which has in turn, made markets more volatile.  In addition, most companies, when enacting 401(k) plans, phased-out their defined pension plans, which was a net loss for many working-class people who were unable or undisciplined enough to set aside money in a 401(k) plan.  Of course, the remaining few with pensions often found those gutted when the company they worked for went bankrupt.  It was a huge robbery of the working class, but it took so long to happen that it largely went unnoticed.  And of course, we were told that economic conditions were to blame, what with the price of oil, inflation, and layoffs.  We were told we were lucky to have jobs at all - and that politicians "created jobs" for us and we should be grateful for whatever crumbs were left on the table for us!

But I digress.  Enough soapbox for one day!

The 401(k)/IRA concept is simple - a tax deferred is a tax denied.  In addition, a working-class person can take advantage of lower marginal rates when they retire - provided they make less money in retirement, which is possible if you are debt-free.  I have no debts, so that knocks tens of thousands of dollars off my required income.  No mortgage, no car payments, no credit card debt, no student loans - all paid off, over 30 years.  And since I am retired, I spend a lot less money.  I own a seven-year-old car with 32,000 miles on it - it will last a long time compared to when I was working and commuting.

Say you are paying 20% taxes as a working person and only 10% in retirement (I am actually paying less than that - my Federal Taxes last year were $300!).  You put $2000 a year into an IRA earning 5% rate of return.  After 30 years, it is worth $139,521.58.   Now, if you put away $2000 in after-tax money, you would pay 20% of that in taxes, so you would only be investing $1600 each year - for a total of $111,617.26.   In effect, the IRA allows you to make money from the money you would have paid in taxes and as a result, build a larger nest egg.

The icing on the cake is that when you take money out in retirement, you only pay 10% in taxes on it, as opposed to the 20% you would have paid while working.  The Roth IRA is sort of the reverse of the regular IRA and for the life of me, I fail to see the real purpose of it, other than you avoid paying taxes on the gain which admittedly does save you something.  But there are bigger savings in the traditional IRA or 401(k) so I would go after that low-hanging fruit first.

So in retirement you pay 10% in taxes on that $139,521,58 or about  $14,000 over time.  Note that if you subtract the $111,617.26 from the $139,521.58, you net nearly $28,000 - nearly double the tax bill at 10% and about equal to the bill even if you stayed at the 20% rate.  A tax deferred is a tax denied, indeed!

3. Life Insurance Loans:  I have written about whole life insurance and its kin - Variable and Adjustable Whole Life.  I don't really recommend them to folks, but some people in higher brackets use them as a means of tax avoidance.   They can be handy for folks who retire in the upper brackets, for example - but not really useful for ordinary folks like myself.

Say you have a whole life policy that has a $1M death benefit and has a cash value of about $500,000.  You reach retirement age and you could cash out that $500,000 but would have to pay capital gains tax on the gain (what the policy is worth, cash value, versus what you paid into it over the years).  I am sort of facing this right now, as two of my policies are "paid up" and issue a grand or so in dividend checks every year.  I have to pay taxes on a portion of these dividends, but it is not a huge amount as my overall income is low and the standard deduction wipes out most of even that.

But for a wealthier person, a half-mill in capital gains means a hefty tax bill - say a hundred grand at the 20% we posited above.  Most whole life policies have a loan provision however.  So instead of cashing out $500,000 you "borrow" $500,00 - tax free - for a loan of ten years at 5%.  The analysis runs along the same lines as above.  The policy's "cash value" continues to grow during that ten years and if you keep rolling over that loan until you die, the "death benefit" (which is not taxable) could be used to pay back the loan, and any surplus paid out to your heirs - again, tax-free.

The only catch, of course, is that you have to pay interest in the loan, and that could be more than your tax bill.  So you are avoiding paying taxes, but paying interest to your insurance company.  In effect, though, what you are doing is borrowing against your death benefit - which is ordinarily something you don't have access to, unless you fake your own death (NOT recommended!).  Maybe you are screwing your heirs, but you end up with access to that half-mil, tax-free in the interim.

My loan rate is at 8% which is very high, even today, as I took out these policies at a time when interest rates were high.  So even if I wanted to try such a gag, I doubt it would be worthwhile, as the loan interest would be staggering.  But the good news is, since I have these spread out over three policies, I could "cash out" one policy during one tax year, if I needed the money, and thus not face a staggering tax bill.   The other tactic is to assume that since I am older than Mr. See, that the death benefit would pass to him, which he would need since he would presumably live longer than I would. Cheerful thoughts!

But, as in my example, the death benefit is about double the cash value (but nearly as large as in my example above!), so it makes sense to hang on to the policies rather than cash them out.  Borrowing against them?  It wouldn't work for me.  But then again, I'm not mega-rich.

4. Capital Gains Rollovers (Real Estate):  I wrote about the Starker Deferred Exchange or 1031 exchange, which is an example of how rich people write our tax code.  In this case, it was some rich dude named Starker, I guess, who challenged the meaning of "realization event" and got the code changed to allow you to "roll over" your interest in one investment property in a "like exchange" with another property.  If you play this right, you can avoid paying taxes entirely.

Say you buy a condo and live in it.  You and the wife get tired of condo living and buy a townhouse.  You keep the condo and rent it out and make a small profit on it, and it appreciates in value as well.  You move out of the townhouse and buy a free-standing home - and rent out the townhouse as well.  You now have a nice little real estate empire, and if you have good tenants (not hard to do in the Washington DC area, where everyone has a government paycheck) you make a nice extra income and the properties appreciate over time.

Eventually you want to retire, so you sell your house and buy a retirement home on the Outer Banks.  You sell the condo and townhouse and buy other properties there which you rent out to vacationers on VRBO.  This, by the way, is not speculation but what I have seen many friends and employers do over the years. Since you are converting the rental properties to like properties in your new location, you don't have to pay capital gains tax on the sale  - your basis in the properties is transferred to the new property in a 1031 exchange.  And you can do this an unlimited number of times.

Now, when you die, your heirs get these properties with a stepped-up basis.  They are assumed to be worth "market value" at the time of death and they get these, tax free.  So it is a keen way of creating dynastic wealth.   The poor person who rents?  Yea, fuck him, the dirty plebe!  He doesn't write the tax code - we do!

But suppose you have no heirs and want to cash out of these rental properties?  Well, a tax deferred is a tax denied, and you have deferred paying taxes on these rental properties for decades now.  But you can avoid paying even that!   You could sell your personal residence, and the first $500,000 in gain is tax-free (no doubt, that number will be raised in the coming years).  So you could live off that money, tax-free for many years.

In the meantime, you move into one of your former rental properties and declare it as your personal residence.  So long as you lived there for three years out of five, it now falls under the same tax provisions as your personal residence because it is.  So you could do this and "cash out" of your personal home and your rental properties, and not pay a dime in taxes.  Not only is the tax deferred, it evaporates entirely!

Oh, and you can depreciate a rental property and save even more by converting (effectively) your ordinary income into capital gains - and pay taxes at a lower rate (and defer those taxes as well!). 

Note that tax codes change yearly, so consult a tax advisor for details on the current year's code. Things do change over time and Congress is constantly tinkering with the code and some of these "loopholes" may end up being closed over time - but not if the rich can help it!

Personally, we presently are facing a capital gains "problem" with our condo.  In August of 2023, they will buy the place and tear it down and hand us a check for $160,000, all of which is taxable.  Not only will this create a Federal and State tax bill of $34,800 plus we would lose our "Obamacare" subsidy for that year, or another $18,000(!!).  Obviously, rolling this over into something would be ideal.  If not, well, Uncle Sugar gets quite a taste!

If we could roll that over into a condo in a retirement community, we could then "downsize" at a later date and declare that condo as our personal residence and sell our existing home, tax-free and live on that money for a decade or more.  Nice work if you can get it.  We'll see how that plays out. 

As you can see, the tax code is biased toward property owners.  And you wonder why so many people are going nuts over real estate!

There are a number of ways for people - usually the wealthy, but also the upper-middle-class - to avoid paying taxes simply by deferring the due date.  The longer you can delay paying a tax, the lower the effective tax is, due to inflation over time and the Future Value of money.  But in addition, if you delay paying a tax, that money, in your investment account, can continue to grow. And if you can delay paying taxes until the day you die, well, you've cheated the tax man, but perhaps not the undertaker.

"Cheated" is, of course, a loaded word, as the schemes I have detailed above are all perfectly legal, at least at the time of this writing, to the best of my knowledge.  Even the IRS admits that tax avoidance (using legal means to limit your tax bill) is perfectly legal - and some call it a patriotic duty!  Tax evasion - using illegal schemes to underpay or not pay taxes - is breaking the law. But what is avoidance one day, could be evasion the next.  However, avoidance schemes which are elucidated in the tax code (e.g., the 1031 exchange) are, by their very nature, legal, as they are the law.

You could argue that some of these provisions are unfair - and many do.  Some propose ways of fixing these "loopholes" (i.e., Laws) by enacting new laws to limit their effect. For example, when Musk famously didn't pay taxes because he borrowed against his shares, some politicians made big grandstanding noises that Billionaires should be taxed on capital gains even if a realization event didn't occur.  So for example, you make a million dollars because some stock you invest in goes up in value, then you have to pay taxes on that stock even if you never sold any of it.  This would, in turn, force you to sell some of that stock just to pay the taxes.

But if the next year, the stock tanked and you lost a million bucks, could you deduct that from your taxes as a capital loss? You see how it gets sticky and the accounting becomes a nightmare.  Taxing phantom gains gets messy in a real hurry.  Sadly, this sort of heads-I-win-tails-you-lose occurs with second homes.  You make a profit on the sale of your vacation home and that is taxable.  You make a loss on it, and it is not deductible!  Oh, the sad plight of vacation home owners!

I doubt these "loopholes" will be closed anytime soon, and not just because they would create accounting nightmares.  Besides, borrowing against assets might delay paying taxes, but in the case of someone like Elon Musk - where the share price of the shares he pledged is in free-fall - the whole thing can blow up in his face, if he is not careful.   He might end up paying even more taxes as a result.

Really too bad that Tesla doesn't pay dividends - he could live comfortably off of that.  Sadly, though, dividends are ordinarily taxed as ordinary income, which is why they are not so popular with the mega-rich anymore.  They want capital gains!

And so, we play these games, to avoid paying even that.