If you think the US tax system is complicated, you’re not alone.

Scott Galloway, a professor of marketing at the NYU Stern School of Business, believes the complications stem from several loopholes in the law designed to help wealthy people.

“The tax code went from 400 pages to 4,000 pages, and those extra 3,600 pages are designed to make rich people super rich,” he told Steven Bartlett on a recent episode of his podcast “The Diary Of A CEO.” “Tax avoidance is a key skill for building wealth.”

One of the many tax loopholes, according to Galloway, is the use of securities-based lines of credit (SBLOCs). He said that when wealthy people want to buy something, they borrow against their capital assets, such as stocks and bonds, instead of selling them. This allows them to avoid paying capital gains taxes on the increased value of their assets.

In effect, this loophole could allow some individuals to avoid paying taxes forever. “Basically, it’s investing, borrowing money on it, dying, putting it in a trust, and then passing it on to your kids,” he said.

This tool can be used by anyone who owns the minimum required stocks, bonds, and mutual funds in a fully paid-up cash account with a brokerage firm. FINRA says it is not uncommon for a firm to require that your assets have a market value of $100,000 or more to qualify. The first withdrawal on an SBLOC would also have to meet certain minimum requirements. Your interest rate on the loan is based on the amount of assets you have with the firm.

The average investor may want to consider the pros and cons of this maneuver before deploying it to make a large purchase. Here are a few:

Advantages

The biggest advantage of an SBLOC is that it gives you liquidity without creating a taxable event. It is also a revolving line of credit, meaning you can repay the loan and borrow again against your assets. FINRA says you can typically borrow 50% to 95% of the value of the assets in your investment account.

In other words, you can access your wealth without paying capital gains taxes. You may also be able to continue to enjoy the benefits of your assets — such as dividends or interest — while using the cash value of the asset for other purposes.

For example, Elon Musk has pledged about 238 million Tesla shares of the 411 million he owns to fund his various ventures, according to The New York Times. If he were to sell millions of shares, he would owe billions of dollars in capital gains taxes.

According to FINRA, interest rates on SBLOCs are often lower than those on other forms of debt, such as personal loans and credit cards. Depending on your tax bracket, the interest rate may also be lower than the capital gains you would have paid upon selling the asset. Depending on the lender and your personal net worth, you may also have favorable flexible repayment terms.

The story continues

However, this financial instrument also has disadvantages.

Disadvantages

In many ways, an SBLOC is similar to a home equity line of credit (HELOC). Both forms of revolving debt are relatively less expensive because they are backed by the value of an underlying asset.

This means that the lender can seize your assets, whether it’s a home in a HELOC or stock in an SBLOC, if you don’t make interest payments on time. There are also limits on how much of the market value of your collateral you can borrow.

Another factor to consider is market risk. The stock market is volatile, and if a sudden crash pushes the value of your assets below a certain threshold, the lender may demand cash to cover the difference immediately or more collateral. FINRA says that if you are unable to repay the required portion of the loan or provide the additional collateral, the firm may sell some or all of your securities.

Borrowers are also subject to interest rate risk. SBLOCs are floating-rate debt, meaning that the interest rate changes over time and you may have to pay higher rates than expected.

Conclusion

Borrowing against your stocks is an attractive strategy for minimizing taxes. In many ways, however, this instrument is better suited to wealthy individuals who have excess cash and a well-diversified portfolio of different assets to weather the downside risks.

For individuals in lower tax brackets who have less money and assets in a brokerage, the risks of this strategy may outweigh the benefits.

This article provides information only and should not be taken as advice. It is provided without warranty of any kind.