Question: My mother is 85 years old and owns a portfolio of blue-chip stocks worth over $2 million. They were purchased a long time ago and have very low cost basis. The stocks are paying dividends that yield a cash flow that is only about two-thirds of the cash flow she needs. What is the best way to increase the cash flow with the minimum amount of tax? I have come up with the idea of borrowing against the principal to avoid selling and paying capital gains taxes. The interest rate would be around 8%. Is this a sound answer? Would the interest be tax-deductible?
Answer: That’s a great question and it’s a common one for older folks who bought dividend paying stocks long ago and held on to them. So how do you get money from highly appreciated securities without paying tax? I’ll discuss three ways. These are: (1) sell some of them, (2) borrow against them, and (3) use a bona fide charitable gifting technique.
There are a several reasons you may not want to sell any of the highly appreciated stocks. By not selling, you keep the dividends and voting rights, defer capital gains, and continue to enjoy the benefits of future appreciation. The tax deferral is probably the most important reason because you can defer the tax until you die and pass the stock to your beneficiaries who will enjoy a new, stepped-up basis, eliminating that tax. (Only the capital gains tax goes away, not the estate tax).
You should consider selling some of the stocks if you can keep the capital gains tax low. Remember that if you are in the 15% or less ordinary income tax bracket, your Federal capital gains tax rate is 0%. But if you are in the 25% or higher bracket, the tax rate can go as high as 20% plus a 3.8% net investment income tax.
Your solution of borrowing against the stocks is the easiest way to provide income without selling. You can simply put the stocks into a margin account with checking features at a brokerage firm and begin writing checks. The brokerage will charge you margin interest on the outstanding loan balance. Some banks and credit unions offer loans that use your stock holdings as collateral, and these loans may offer lower interest rates than your brokerage firm’s margin rate. The IRS will only let you deduct the interest on these loans if you use the loan proceeds to purchase stock, securities, or other investment assets. You can’t deduct the interest if you use the money for personal living expenses.
The third way to provide income from the stocks and avoid capital gains tax is to set up a Charitable Remainder Trust (CRT). A CRT is an irrevocable trust. You give your stock to the CRT. The CRT sells the stock and pays no tax and pays an annual income to one or more individuals. When the last income beneficiary dies, the remaining assets in the CRT goes to charity. Advantages of the CRT include: (1) a higher annual income then you can get now, (2) an immediate tax deduction for the gift, and (3) the removal of the stock from your estate for estate tax purposes.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to firstname.lastname@example.org.