Utilizing both sides of the balance sheet could help parents gift assets to children in a tax-efficient manner.
The strategic use of debt may carry tax benefits in certain situations.
Here is one scenario: You decide to help your daughter with the purchase of a house, so you plan to gift her investments that have appreciated over the years for the down payment. But is this the right move?
A good first step is to speak with a tax professional to understand the potential tax implications for your daughter as the recipient of those securities and whether there are other options that might achieve the same outcome in a more tax-efficient manner.
For example, if you gift your daughter securities and she then sells them to buy a house, she will likely need to pay capital gains tax on the difference between the original purchase price and the stock's selling price. For highly appreciated securities, the tax bill could amount to a large portion of the intended gift.
Capital gains taxes for the recipient aren’t the only consideration when gifting securities. If you liquidate a stock that has reliably paid dividends that help support your lifestyle, you’ll lose those dividends as a source of income.
Liquidating other assets in order to make a gift, for example, selling a rental property, can trigger the same problem. Once the asset has been sold, it will no longer generate income for you.
One way to address this situation is to consider borrowing against your assets for gift giving purposes instead of transferring them or liquidating them. While it might seem counter-intuitive to take out a loan to give a gift when you have other assets, there may be advantages to this approach: it offers the potential to keep the original investment intact, and no capital gains taxes are triggered for either the giver or the recipient. This approach would have expenses, such as lender fees to initiate the loan and interest on the loan. But it may be worth consideration.
Since interest rates are still relatively low, it might make sense to obtain a residential mortgage loan cash-out refinance of your first or second home in order to gift the loan proceeds. A cash-out refinance replaces your existing mortgage with a new, larger one. Of course, the interest rate may be different from your original rate, and the monthly payments on your new loan may be larger.
Your home is not the only asset that can be a source of capital. Another type of secured loan is a securities based loan (SBL). An SBL allows individuals to borrow money using eligible securities in a brokerage account as collateral. In the home buying scenario, an SBL could be an option in place of transferring the stock to your daughter for her to sell. Instead, you could take a loan against those securities and gift the loan proceeds made against that stock. In doing so, you may be able to defer any capital gains taxes until you’re ready to sell, while continuing to enjoy any dividends or potential appreciation the equity generates.
Of course, borrowing comes with risks. When borrowing against a home, you should be aware that failing to make regular payments could risk foreclosure and the loss of the property. With SBLs, it's important to know that if the value of the stock securing the loan dramatically declined, a maintenance call could require you to either add capital to the collateral account quickly or to liquidate the stock under unfavorable market conditions.
Gifting is one of many situations where you can strategically use debt to save on potential tax payments and keep assets working for you. For more ideas, Morgan Stanley clients should contact their Financial Advisor.
Borrowing against securities may not be suitable for everyone. You should be aware that there are risks associated with a securities based loan, including possible maintenance calls on short notice, and that market conditions can magnify any potential for loss.