When Can Borrowing Save You Taxes?

When Can Borrowing Save You Taxes?

A client we’ll call “Joe,” owns several family-style restaurants in Southern California. Joe was recently contacted by a friendly competitor. The competitor was ready to retire and wanted to quickly exit the business. A very attractive, discounted price was offered to Joe, but he had to act quickly to get the discount and avoid having other potential buyers compete with him. Joe was considering selling a significant amount of securities to fund the purchase price.

Joe’s annual income puts him in the 20% Federal long-term capital gains tax bracket (> $425,800 for a single individual in 2018). So, not only would he pay the capital gains tax of 20% if he sold the securities, he would also have to pay an additional 3.8% tax on any gain above $200,000 ($250,000 if married). And, by the way, California treats the taxable gain as income with a tax bracket of 14.63% on any gain of $1 million or greater. Understandably, Joe was leery of selling the securities because he did not want to pay the combined ~36% tax. There were several alternatives we proposed, but today we’ll talk about one that is missed by most advisors, including sharp tax advisors. Joe used this method to obtain the funds and purchase the restaurant within three days, all without paying the collective 36% tax. 

So – What Did He Do? 

Joe ended up using a strategy called a “securities-backed line of credit” to obtain the funds to purchase the restaurant.  It is an option to consider in lieu of selling appreciated stocks, bonds or mutual funds.  The borrower deposits securities into an account in which the lender has a lien.  Various lenders will typically give loans ranging from 30% to 95% of the market value of the securities, depending on the specific securities in the account as well as the level of diversification in the portfolio.  Whether through a bank or other financial institution, securities-backed loans and lines of credit can be particularly useful for people who engage in large purchases from time to time, such as buying real estate, acquiring a business (as Joe did), business expansion, other time-sensitive business opportunities, or debt or loan consolidation.

What Are The Advantages Of A Securities-Backed Line of Credit?

There are many advantages to using a securities-backed line of credit, some of which include:

  • Easier to obtain.  The amount of credit offered to Joe was solely based on the securities that were pledged.  Joe did not have to fill out a lengthy loan application.  His credit rating and debt level were not reviewed.  Joe did not have to obtain an appraisal of the value of the restaurant or its equipment.  There was no review of the financial condition or anything else about the new business.
  • Faster to obtain.  Joe was literally able to obtain the funds in 72 hours.
  • Tax savings benefits.  By taking a loan on the securities, instead of selling them, Joe avoided paying the combined taxes of 36%.
  • Lower interest rates.  Typical rates for a securities-backed loan range from 2-5% above the 30-day London Interbank Offered Rate (often abbreviated “LIBOR”), or roughly 3.56% to 6.56%.  These interest rates are lower than what Joe would have paid if he had taken out a home equity line of credit or a second mortgage on his home.
  • Greater flexibility in repayment.  The loans are often tailored to the borrower.  They can be short or intermediate, with five years being common.  Interest-only loans are also available in certain cases.
  • Greater flexibility in “cure periods” to meet demands for additional collateral.  Often the lender will provide a certain number of days or weeks to remedy or “cure” the shortfall before the lender will sell some of your securities—the promissory note will provide the specifics.  Compare this with a margin loan, where you would not be provided with such a cure period—the lender would immediately sell your securities to meet the minimum threshold.
  • The borrowing won’t disrupt your investment strategy.  You can keep “legacy assets” rather than be forced to sell them.  Legacy assets are often those in which there is an emotional attachment—a personal tie to the company or asset.

Nothing’s Perfect!

This strategy is not without its share of risks.  The greatest risk is if the pledged securities drop in value below the minimum threshold set by the lender.  The U.S. stock market is at an all-time high, and while the market may go even higher, it is bound to make a correction sometime in the future.  If there is a large downward correction, the securities you pledged as collateral could dramatically decrease in value, leaving you forced to sell the securities or asked to put additional capital into the pledged account.  Unless you have surplus equity outside the pledged account, this can result in a collateral call, followed by forced liquidation.  Forced liquidations seldom bring an attractive price.

Another risk is based upon which specific securities were pledged for the loan.  The lender can determine it no longer feels comfortable with a certain security serving as collateral.  For example, if all your pledged securities were invested in Sears stock, the recent news of Sears intending to close another 100 stores by April of this year may make the lender concerned about Sears going out of business or filing bankruptcy.  The lender could determine that Sears stock is no longer acceptable collateral.  You would then have to sell the Sears stock and replace it with acceptable securities, or you would need to contribute additional capital into the pledged account.

Although not a risk per se, securities-backed loans also come with a restriction: the borrower cannot use the money to pay down margin debt or invest in securities.  This is, rather, the role of a “margin loan.”

Have A Knowledgeable Investment Adviser Review Any Securities-Backed Loans

Because of the risks involved in a securities-backed loan, you should have a knowledgeable investment adviser review the situation to ensure you are not sacrificing your future goals, or overlooking other strategies.  A qualified adviser can assess your investment goals and financial situation, and then determine whether the proposed debt is consistent with your risk tolerance and time horizon.  Prudent planning will help determine whether the additional debt fits into your long-term financial goals.

While a securities-backed-loan is no panacea, it was the best answer overall for Joe.  He received his cash quickly, paid no taxes, kept his investment portfolio chugging along and added a restaurant at a bargain price.  Every situation is different.  Would you like to learn more about the benefits of securities-backed loans?  Let’s have a conversation about whether this idea could help you accomplish your long-term planning goals.

Imagine That™!

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