Borrowing against a portfolio can be a relevant financial and tax strategy, but it is not without risks
With the stock market soaring to record heights and interest rates at historic lows, some wealthy Americans are looking to their securities as a source of collateral for large purchases. Securities-based (also known as portfolio-based) lending has become the funding mechanism of choice in many cases.
The economic recovery has increased the popularity of the “buy, borrow, die” strategy for those who have accumulated appreciating assets generating passive income. Increased worries about changes to gift and estate tax regulations under the Biden administration are also driving creative approaches to avert the realization of capital gains.
Many major financial institutions have reported an uptick in securities-based lending (SBL): at Bank of America, SBL increased year-over-year by $5 billion—12.5% in its wealth management division, which includes Merrill Lynch Wealth Management, Bank of America Private Bank, and Merrill Edge consumer investments. At Wells Fargo, total loan balances were up 4% to $80.8 billion, which the company’s CFO said was “largely due to customer demand for securities-based lending offerings.”
There’s an undeniable allure of dipping into personal reserves to fund major purchases and expenses at low interest rates. And in the words of Merrill Lynch advisor Tom Anderson, “the tax benefits are stunning.”
But before cashing in and checking out, there are some important points to consider.
A brief refresher on SBL
Securities-based lending, not to be confused with securities lending (which refers specifically to loans between financial institutions), is the practice of taking out a loan using the value of an investment portfolio as collateral. Once considered a financing option available only to the ultra-wealthy, SBL is now being used by investors who have amassed a high net worth but still would not qualify for the Forbes 400 list of wealthy Americans.
Securities-backed loans give investors access to a line of credit that can be used for purchases and other investments. Common uses of securities-based borrowing are travel, luxury cars, and real estate. This financing is also attractive to founders of new businesses in the pre-IPO stage. Using accumulated wealth to buy a significant stake in the company can prevent them from losing voting control during and after the public offering process.
The returns and risks of SBL
This loan option allows borrowers to enjoy cash liquidity without having to sell their stocks or bonds. That is especially attractive when the stock market is on fire, as it has been for much of 2021.
Most securities-backed loans also feature low interest rates, flexible repayment terms, and less red tape and paperwork than conventional loans. For example, Goldman Sachs Group Inc. advertises its securities-based loans with “no personal financial statements, tax returns, or paper applications.” Debt incurred through a securities-backed loan often won’t show up on credit reports. And if they don’t choose to repay the loan quickly, borrowers can opt to indefinitely accrue interest without making monthly payments.
But perhaps the most appealing feature of SBL is its ability to help investors avoid a taxable event. By using securities as collateral for a loan, the funds are not subject to capital gains taxes.
Under current tax law, investors and their heirs will not have to pay income taxes unless their securities are sold. Even if the Biden administration successfully passes proposed legislation that changes the tax codes governing gift and estate taxes and capital gains, SBL would still be a tax-saving option. The stock can be used repeatedly as collateral for loans. And the more stock that is borrowed against, the longer individuals can hold appreciating assets to avoid taxable events.
Taking on securities-backed loans requires accepting above-average financial risk, however.
SBL is vulnerable to the volatility of the stock market. When the market dips, the value of the borrower’s loan could exceed the real-time value of the securities used to back it. If that value falls below a certain point, the lender can make a margin call, demanding that the borrower deposit enough funds into the securities account to make up the difference and regain good standing. If the borrower cannot, the broker is entitled to sell the account to recoup lost funds, often at a loss and triggering a taxable event.
Funds secured through a securities-backed loan cannot be used to make payments on an existing margin loan or to purchase additional shares.
An option with strings attached
Some advisors, including Anderson of Merrill Lynch, warn against taking on too much securities-backed debt in times of high market volatility. It’s common for banks to allow a borrower at least 50% of a diversified portfolio’s value, he notes, while cautioning individuals not to tap more than 25% of their portfolio value at one time.
Investors interested in borrowing against their portfolios would be wise to discuss the risks versus rewards and potential tax implications with a knowledgeable investment advisor and a CPA. Other possible market changes, such as an increase in interest rates, will affect the cost of borrowing and could impact the attractiveness of a securities-based loan.
Securities-based lending may also become the target of legislation challenging what some have described as “loopholes for the wealthy.” Senator Elizabeth Warren (D-MA) and Senator Sheldon Whitehouse (D-RI) are calling for an investigation of big banking’s lending practices to the wealthy. Nevertheless, The Wall Street Journal’s wealth reporters believe that borrowing “gets less policy attention than capital gains at death.” Thus, making loan proceeds taxable may represent too large a shift in income taxation to be a viable option for a divided Congress to consider.
Lindberg & Ripple features a team of experienced wealth advisors who can assist with managing the complexities of wealth planning and complying with changing regulations. We’ll help you develop and maintain a customized strategy designed to grow and preserve wealth for future generations. Contact us to learn more.