By Jeffrey Richman
A lot has been said recently about the tax-free wealth building strategy of ‘Buy, Borrow, Die.’ The concept is simple enough.
First you buy an asset that will appreciate, and you hold onto it as it appreciates. As you need money to live, you refinance instead of selling the asset. Taking out a loan is a tax-free event, unlike selling the asset. Now comes my least favorite step in this process: If you pass away while holding an asset with appreciated value, the owner and their estate will never pay income tax on the appreciation of that asset. The owner’s estate and/or beneficiaries get a step-up in basis to the market value at the date of death or the six-month alternative valuation date, and the estate can sell the asset with no or minimal income tax gains at that time. While it may be tax efficient, we do not recommend death as a planning technique.
The strategy works well, but there are some tax complications that can result from the strategy, especially when the assets you own are held in pass-through entities for federal income tax purposes.
This article does not consider any additional complexity related to IRC Sec. 163(j) interest limitations that can complicate these rules even further. Please consult your tax advisor if you are subject to those limitations. The distribution of financing proceeds can also have implications for the gain that is realized on a sale or exchange of the property including in a deed in lieu of foreclosure or foreclosure scenario.
Interest Tracing Rules
Taking out a loan would not result in paying taxes, but it would result in paying interest expense on the principal balance of the loan. Section 1.163-8T of the Income Tax Regulations provides that the deductibility of debt interest is determined by tracing the debt proceeds to specific expenditures made, and the nature of those expenditures determines the deductibility of the interest. The deductibility is not based on what the loan is secured by.
For example, if you have an investment account with stocks and bonds and you take out a margin loan on that account to pay for personal expenditures, then the deductibility of the interest on that loan would be traced to the personal expenditures and would not be deductible.
Debt-Financed Distribution Interest
Assuming you have a pass-through entity that owns an asset that appreciated in value: If the pass-through entity refinances or initiates a loan inside the pass-through entity secured by the appreciated asset, and then distributes the additional cash proceeds to the owners of the entity, you might have what the IRS would call a debt-financed distribution.
Based on the interest tracing rules mentioned above, the deductibility of any interest related to the debt proceeds distributed must be traced to what the proceeds were used to purchase. In the case of a pass-through entity, the entity would not be able to determine what the proceeds were used for after they were distributed to the owners, so the pass-through entity would report any interest expense related to distributed proceeds separately under other deductions, and the owner would have to determine the deductibility of that interest expense.
For example, Partnership P refinances a loan for $10,000,000, and $7,000,000 was used to pay off the original loan to purchase the appreciated asset. $250,000 was used to pay loan costs for the refinancing and the remaining $2,750,000 was distributed to the entities’ owners. In this example by the general interest allocation rules 72.5% of the loan proceeds would be allocated to rental or ordinary income based on being traced to the old loan and loan costs. The remaining 27.5% would be separately stated as debt-financed distribution proceeds; the interest on which would be separately stated on the owners’ K-1s. The deductibility of that additional interest (or lack thereof) would be based on how that money was spent by the owners. If the owners took the distribution and contributed the proceeds to equity in another business or rental property, that interest would potentially be deductible as ordinary or rental expense. If the owner invested the distributed proceeds in stocks or bonds the interest could be considered investment interest expense on Schedule A of their personal returns, and if the owners used the proceeds for personal expenses the interest expense could be non-deductible interest.
Optional Allocation Rule
There is an Optional Allocation Rule where the pass-through entity may allocate debt proceeds to all the cash expenditures other than distributions that are made during the same taxable year as the distribution. This means for our example, if P has a $10,000,000 loan and $7,000,000 of those proceeds went to pay off the original loan, $250,000 went to loan costs, and P had an additional $750,000 of cash expenditures during the tax year for fixed assets or expenses, then the amount allocated as debt-financed distributions would be only $2,000,000. If you distributed the same $2,750,000 of the proceeds after the loan costs, then only $2,000,000 or 20% of the interest is originally allocated to debt-financed distribution interest and 80% would be able to be allocated to business or rental expenses.
30-Day Rule
There is a rule that if expenditures occur 30 days before or after the debt proceeds are received, you can consider those proceeds as being traced to those expenditures and you would potentially not need to allocate them to debt-financed distribution proceeds. This could be helpful if you have a refinancing of a loan at the beginning or the end of the year, and you deployed capital within 30 days but in a different tax year.
Repayment Rule
Whether you use the general interest tracing or elect the Optional Allocation Rule or 30-Day Rule, under Paragraph (d) of section 1.163-8T the pass-through entity is able to reduce the principal allocated to distributions first as the loan is repaid. For example, if the loan allocation was originally $8,000,000 to rental and $2,000,000 to debt-financed distributions at the end of the prior year, and $1,000,000 of principal is repaid equally throughout the current tax year, the average balances of the two allocated portions of the loans would be $8,000,000 and $1,500,000 for the current tax year. Therefore, only 15.8% of the interest would be allocated to debt-financed distributions (1,500,000/9,500,000 = 15.8%), and that percentage would decrease every year as the debt-financed distribution allocation of the loan is paid off first.
Conclusion
Borrowing money against appreciated assets and taking the money for personal expenses or other business investments is a very useful tax planning tool and can lead to significant growth of assets. There are some tax complexities and potentially non-deductible interest expenses of which you should be aware. Always consult with knowledgeable tax professionals to remain in compliance with these rules while still maximizing your deductions.
