Heard About Buy-Borrow-Die? Meet Buy-Hold for Decades-Sell

America’s ultra-rich today love to play tax-avoidance games. One of their favorites goes by the tag “buy-borrow-die,” a neat set of tricks that lets billionaire households avoid any taxes on the gains they make from their investments.

The simple rules of the buy-borrow-die game: buy an asset — with your millions or billions — and watch it grow. If you have a hankering to pocket some of that gain, don’t sell the asset. Any sale would trigger a capital gains tax. Just borrow against that asset instead, a simple move that lets you avoid capital gains levies so long as you live.

And what happens when you die? Nothing! Your asset’s untaxed gains vanish for income tax purposes under a tax code provision known as “stepped-up basis.”

This buy-borrow-die, progressive lawmakers like U.S. senator Ron Wyden from Oregon believe, amounts to a gameplan for creating dynastic fortunes. Wyden has proposed an antidote, dubbed the “Billionaires Income Tax,” which would require billionaires to pay tax annually on the gains they make from tradable assets like the corporate shares that list on stock exchanges.

Gains from non-tradable assets would go untaxed, under Wyden’s proposal, but only until the assets get sold, at which point the tax rate would be increased to account for the tax-free compounding of annual gains. And those who inherit millions and billions from billionaires would no longer, under Wyden’s bill, be able to benefit from our current tax code’s magical stepped-up basis.

Closing the buy-borrow-die loophole would, all by itself, be reason enough for passing Wyden’s Billionaires Income Tax bill. But buy-borrow-die may only be the second leakiest loophole Wyden’s proposal would close. His Billionaires Income Tax proposal would also shut down a far less well-known loophole I like to call “Buy-Hold for Decades-Sell.”

How does this loophole work? Consider two rich taxpayers, Jack and Jill. Each invests $10 million in a stock they hope will grow at a 10 percent annual long-term rate, a good but not great return for a rich investor. Investors in Berkshire Hathaway, for example, have seen average annual returns of about 20 percent.

Our Jack goes on to hold his stock for 30 years and realizes exactly the 10 percent annual return he hoped to achieve.

Jill opts for a more aggressive investment strategy. After holding her stock for just over one-year, long enough to qualify her profits for the preferential tax rate available to long-term capital gains, Jill then sells at an 11 percent gain, pays tax on the gain, and invests the remaining proceeds in a stock she believes has more potential going forward. She successfully repeats this strategy each year for 30 years.

You might guess that Jill’s eventual nest-egg at the end of 30 years, after paying federal income tax at the current long-term gains rate of 23.8 percent, would be larger than Jack’s. But, despite Jill’s superior investment acumen, Jack’s $135 million nest egg turns out to be 20 percent larger than Jill’s $112 million nest egg.

How could that be? Jack, to be sure, does pay the same 23.8 percent tax on his capital gain as Jill. But Jack’s money has had the benefit of 30 years of compounding before Jack has to pay that tax. That benefit far outweighs Jack’s lower annual investment return.

Jack’s whopping tax benefit from holding an appreciating asset for several decades should give us pause. After all, we want investors to seek the highest yielding investments, not the ones that get the best tax treatment. We don’t want developers of promising new technologies, for example, struggling to raise capital because our tax law confers higher returns on investors who just keep on holding old, under-performing investments.

In our example, Jill’s annual tax of 23.8 percent on her gains reduces Jill’s 11 percent pre-tax rate of return to an after-tax return of 8.38 percent. But Jack, because he gets to defer the tax on his 10 percent annual gains for 30 years, sees the after-tax return on his investment reduced by only 0.93 percentage points, to 9.07 percent.

As a result, Jack, a poorer investor than Jill, has millions more wealth on hand at the end of 30 years.

What tax rate would Jack have to pay annually on the growth in his stock value to place him in the same position at the end of 30 years as a one-time tax of 23.8 percent upon the sale of that stock? He’d only have to pay tax at a 9.3 percent annual rate. That 9.3 percent would actually run lower than the 10 percent income tax rate that our federal tax code currently expects Americans with incomes barely above the poverty level to pay.

In some extreme cases today, our super rich can enjoy an effective annual tax rate on their investments far lower than Jack’s.

Consider a lucky Berkshire Hathaway investor who bought 100 shares back in 1979 at $260 per share, a $26,000 investment. That investor’s shares would be worth about $70 million today. The annual pre-tax return on those shares would be 19.19 percent. If the investor sold the shares and paid tax at 23.8 percent on the long-term gain, the investor would be left with about $53.35 million.

The investor’s annual rate of return after-tax would be 18.47 percent, a trifling 0.72 percentage point reduction from this investor’s pre-tax rate of return. The effective annual rate of tax on the growth in the investor’s stock value would be 3.75 percent, less than one-sixth the 23.8 percent one-time rate on the investor’s compounded gains.

That about sums up perfectly the magic of buy-hold for decades-sell, the loophole that causes the effective annual tax rate on the growth in the value of investments to decline as the rate of return and length of holding period increase. Thanks to this buy-hold for decades-sell, the effective tax rate on the multi-billion dollar gains of America’s Bezoses, Gateses, and Buffetts, even when they do sell assets before they die, approaches zero.

We don’t need to just close the buy-borrow-die loophole. We desperately need to shut the buy-hold for decades-sell loophole just as firmly.