This is the ultimate tax loophole that the rich use to avoid taxes. Technically, anyone can do it. But the more assets you have, the more you can take advantage of it. Here’s how it roughly works:
Step 1: you buy appreciating assets, like stocks and real estate.
Step 2: you borrow cash, using your assets as collateral. This means if you can’t pay back the loan, the bank can take your assets.
Unlike wage income (an employee’s earnings), borrowed money isn’t taxed. So while the employee is cash-rich and asset-poor, most of their money is taxed. For a founder who might be cash-poor and asset-rich (tons of equity but not much cash), if they follow steps 1 & 2, most of their money isn’t taxed.
They will have to pay interest, but interest rates are only a fraction of tax rates. Current personal loan rates are sitting under 3% while tax rates can go as high as 37%.
Step 3: you die. This is the ultimate exit strategy.
If you own assets, you don’t get taxed until you sell. Selling is one form of exit. When you sell, you pay taxes on the capital gains. So if I buy 1 share of Apple at $100 today and in 2 years it grows to $150, if I sell at that time, I get taxed for the $50 of capital gains I’ve made.
However, if I hold forever and die, my family will inherit my shares. Let’s say I survive for another 50 years, and the share price is now at $1,000. If I sold while alive, that would be a capital gains of $900.
But due to a tax loophole known as “step-up”, when my assets transfer to my inheritors, the new cost basis is adjusted to the time of my death. That means from the tax perspective, it looks like my inheritors bought this Apple share at $1,000, even though they paid nothing and it was actually I who paid $100 way back.
And the cycle can actually infinitely continue.
Because thanks to my hard work, my offspring have an incredulous amount of wealth via these assets, and they can simply borrow and not really pay any taxes.