Thoughtful estate and gift planning helps to preserve your wealth and pass it on to your designated beneficiaries in the manner that you choose. To that end, we suggest that you may want to discuss and consider the items addressed in this article with your tax and legal advisors.

For the wealthy family and sophisticated borrower, debt can be a useful tool in transferring wealth to future generations, while also providing the potential for tax advantages.

While interest rates are near historic lows, consider the benefits of a securities-based loan to execute on your family’s wealth transfer strategy.

Borrowing to Gift

One of the simplest ways to make a gift is for the donor to transfer property to the recipient, outright. For income tax purposes, a gift of appreciated property gives the recipient an inherent capital gain, while a gift of depreciated property does not provide an inherent loss. Also, by giving appreciated property, the donor loses the “step-up” in basis at death and the ability to erase that gain. Consider the difference in approaches below.

Example 1

Consider the parent who owns a portfolio of appreciated securities, desires to give $250,000 to a child, but lacks the cash to do so. The parent has a couple options: give appreciated stock to the child, or borrow $250,000 and give that cash to the child.

View our illustration of the difference in approaches

Example 2

Assume the same facts as above, except that when the child receives the gift of stock, the child retains the stock or when the child receives the gift of cash, the child invests the cash in a portfolio of marketable securities having a 6% annual rate of return. Assume all assets are liquidated on parent’s death. 

View our illustration of the difference in approaches

Borrowing to gift can – in some cases – be a tax efficient way to transfer wealth to designated beneficiaries like children or other loved ones without depleting or disrupting existing investment strategies and wealth plans.

Borrowing to Lend

Borrowing can provide liquidity for those who are fully invested but want to assist family members financially. Consider a parent who is fully invested in illiquid and appreciated assets, yet wants to assist a child with the purchase of a residence. Rather than liquidate appreciated or appreciating investment assets and incurring a capital gains tax, the parent could borrow cash and relend that cash to the child.

There are many ways to structure such a transaction, depending upon the family’s goals and desires.

If the parent desired to make gifts to the child, the parent could forgive the loan over time. (IRS heavily scrutinizes intra-family loans. If, when the loan is made, there is no intention that it be repaid, then IRS will consider the amount lent a gift at that time.) Alternatively, if the parent desired the child to “have a stake” in the residence, the parent could lend cash to the child – either to pay for the residence outright or fund a down payment – and require it to be repaid.

To avoid certain gift tax consequences, the parent’s loan to the child would bear interest at the appropriate applicable federal rate (“AFR”) set by the IRS. If the parent’s borrowing carries a higher interest rate than the AFR, the parent will receive less interest from the child than they are paying; however, potential income and growth on the retained assets may offset that interest rate differential.

Generally, the parent would recognize income on the interest received from the child, but the child may not be able to deduct the interest paid unless it is eligible for a deduction, such as investment interest or certain home mortgage interest. You should consult your tax advisor regarding the tax consequences of this transaction.

If the parent’s loan to the child bears adequate stated interest (generally, the appropriate AFR), the parent’s loan would usually not be a gift to the child, and there should be no gift tax consequences to the parent.  Upon the parent’s death, the investment assets remaining in the parent’s estate would, generally, receive a step-up in basis. This is another potential benefit of borrowing to fund the loan to the child.

Of course, if not forgiven, the loan, at some point, must be repaid. 

Many Opportunities – But Not Without Risk

There are many opportunities for the wealthy family and sophisticated borrower to use debt in a wealth transfer plan. However, using debt for these purposes is not without risk. For the borrower who secures debt with assets, should the value of the assets securing the debt fall below the amount required to secure the debt, additional security would be required, or cash used to reduce the debt to levels commensurate with the loan’s requirements. 

Liquidity When You Need It

Beyond its use as a tool for wealth and estate planning, a securities-based line of credit can offer liquidity for a variety of needs, including:

  • Taking advantage of investment opportunities, e.g., private equity or other business investments
  • Paying an unexpected tax bill
  • Buying a new home before selling your current home, i.e., bridge financing
  • New home construction/renovation
  • Financing the cost of continued care facilities for a loved one
  • Tuition and student expenses

Would you Like to Learn More?

If you would like to learn more about the use of debt in a strategic wealth transfer plan, speak with your PNC Advisor.