What's stopping the average citizen from exploiting this tax avoidance strategy?
For example, every time I try to submit an order to sell stock that results in short-term capital gains, my broker should be asking me whether I want to take out a collateralized loan instead.
If there are loopholes in the tax system, they should be made readily accessible to all.
At ~2% interest the billionaire can borrow against their assets and keep borrowing to pay off interest. The assets gain in value at 4-6% per year so they are actually coming out ahead and paying 0% tax.
Even a middle class retiree typically needs to draw down their savings to pay expenses. Giving up 2% to avoid taxes wouldn't be viable. The bank would also observe that there is a higher risk that the retiree goes bust than a billionaire and not lend enough money for the scheme to be worthwhile.
The loans they can get are insanely (i think disgustingly) predatory.
payday loans with fees can ed up being like 664% APR!!!!! Your 500 loan becomes 2000 you have to pay back in a couple months, which you obviously can't..
https://www.cnbc.com/2021/02/16/map-shows-typical-payday-loa...
Boring commercial banking should be utility, and any private sector offering will have to compete with a new non-grifter baseline.
Selling the stock locks in the gain. Now, if you only need say 1/2 the value as cash and can absorb the risk of the stock going down, then it makes sense. Or if you want to "buy insurance" by taking out an opposite short position, that would also make sense. But that short position will cost you money too.
So it's not as straightforward as "just take out a loan". You need a very good (and expensive) tax accountant to run the numbers and figure out the best strategy for your situation. Most people can't afford that.
I.e. I don't get why the risky part of this loan can't be mitigated by the bank taking on the risk and managing it separately. Surely, there would be investors willing to back these types of collateralized loans?
Loans against other assets are much less risky, because they are backed by actual things. If the bank screws up in predicting the future value of a house, they can still own the actual house and land if you default. With stocks it would be far more risky because stocks are far more volatile than houses.
Because the risk of holding the stock is more than the difference in short vs long term capital gains.
If the stock is worth $1000 in gains, I know I can sell it and lock in the gains today and pay my normal income rate. If I have to hold it for another 6 months, there is a huge risk that it drops more than the 5-10% difference in the tax rate for the average person.
Other positions have a defined thesis and, if that thesis gets invalidated, I close out the position sometimes at a gain. I do try to make most of my gains be LTCG, but trying too hard to optimize capital gains rates can lead to poorer investment decision-making/asset allocation.
Banks don't take on risk. Seriously.
That's another conversation to have, but the simple answer is do you want the value of your checking account impacted by someone else's purchase of Gamestop, or Enron?
And that's why banks don't take risk.
Now why don't you plug in this scenario into any Black–Scholes calculator and see how much of a net credit at entry you get (if you even have one). That would be the maximum loan amount you'd be able to get under this scheme. If you could get one at all, the loan amount is tiny compared to the value of the asset.
Probably that the average citizen doesn't have capital gains.
It depends on which kind of retirement account. Might be in Roths and Roths-401Ks which are taxed when the money goes in (treated as regular income), or IRAs and regular 401Ks which are taxed as regular income when the money comes out.
Collateralized loans on stock we usually call "margin loans" and are easy to get.
Also, anyone in real estate will recognize the term "HELOC", where you can get a loan against the value of your home, presumably after its value has appreciated.
I think both of those are fairly accessible, at least in the US.
You can do the same thing with a HELOC. Otherwise you'd have to sell your house and pay cap gains then spend the net profit. I don't think a HELOC is tax dodge.
But there is something to be said about being able to defer taxes effectively forever. Only the ultra-wealthy are able to do this.
https://www.schwab.com/pledged-asset-line https://www.wealthfront.com/portfolio-line-of-credit
And HELOCs are essentially the same for people who own a house but not stocks.
The debtor avoids the elevated short-term capital gains tax.
The bank gets interest payments on a loan that has an almost 0 default rate due to the loan being fully collateralized.
It's not a win-win, there's significant risk.
> fully collateralized
This is not true! The underlying asset fluctuates in value and is open to lowering significantly in value, leaving the bank holding the bag.
You probably underestimate the ability of banks to evaluate risk. Yes, they absolutely could end up underwater on an asset backed loan, but you also shouldn't assume that you can take out $1 in loans on every $1 of stock.
On Schwab's page, they say: "Schwab Bank, in its sole discretion, will determine what collateral is eligible collateral and the loan value of collateral". So, if you have some recently highly-appreciated shares of AMC for example, they might decide they are not eligible collateral, or only offer to lend you $1 for every $5 of stock.
They do.
Wealthfront (as just one example) features and advertises this prominently in their app.
It's also very easy to do with Robinhood, simply withdraw cash using your margin. Interest rates are quite low. 2.5% with Robinhood, 3.65% with Wealthfront.
There's a big "Borrow cash" button right when you open the Wealthfront app.
The problem is that this is not nearly the same as selling stock and withdrawing the sales money, because you keep the risk that the stock will go down thus force liquidating your portfolio. You're conflating selling and borrowing, they're not identical except in these very vague tales about the ultra-rich.
1) pump up asset prices.
2) lower the rate at which you can borrow against unrealized gains to make avoiding taxes more attractive.
3) people use this savings to buy more assets. Repeat step 1. Virtuous cycle.
I can't go to a bank and get a loan against $1M in my 401k at 2% interest. But I know people with $50M+ that are doing this. It's absurd.
If you’re gonna say “they benefit in the extra capital gains between now and when the loan is repaid” - no, that can’t be it, that’s exactly equivalent to taking a $100 loan and investing in stocks instead (i.e. leverage).
2) You're buying a house, and you need $100 today.
3) You sell $100 of SPY, and pay short-term capital gains (up to 37%)
OR...
1) You purchased $100 of SPY on June 15th, 2020
2) You're buying a house, and you need $100 today.
3) You take a loan for $100
4) You wait until June 15th, 2021 and then sell $100 of your SPY holdings, paying long-term capital gains (15-20%)
5) You repay the $100 loan
...it doesn't really avoid tax. It's just an alternative way of accessing capital by taking out a loan instead of liquidating assets.
I might be misunderstanding your question though.
Finally, it's also possible to roll the gains into a trust and the cost basis is adjusted to zero on death. [0] So yes, it's tax avoidance.
[0]: E.g. this is how it's possible to do that: https://wellergroupllc.com/taxes-resources/tax140-guide-dete...
If your stocks go down, you still owe the full amount of the loan. If your stocks go to zero, you still owe the full amount of the loan.