America’s rich never sell their assets. How should they be taxed?

What is income, really? If you ask an economist, he or she might describe “Haig-Simons” income—the value of a person’s consumption of goods and services, plus the change in his or her net worth over a given period. A lawyer might refer to IRS Code 26 Section 61(a), which defines “gross” income as “all income from whatever source derived,” including but not limited to commissions, interest, real estate transactions, and wages. An accountant might talk about how to reduce that gross income, through deductions or exemptions, to a smaller “taxable income base.”

The answer is important. Whether governments should tax unrealized capital gains, in addition to realized ones, is a matter of intense debate. In March, during the State of the Union address, Joe Biden reiterated his commitment to impose a “minimum income tax on billionaires” if he is re-elected. This would include a 25% tax on unrealized capital gains for Americans with more than $100 million in assets, which he expects to raise $500 billion (2% of GDP) over a decade. The Supreme Court is also considering the question. Its justices are about to issue an opinion in Moore v. United States, a case in which the plaintiffs argue that a one-time tax on profits from an overseas investment was unconstitutional because the 16th Amendment, which enshrines in the U.S. Constitution the federal government’s right to tax income, does not apply to unrealized income.

A large portion of the wealth of ultra-rich Americans is made up of unrealized gains. Since ProPublica, an investigative journalism group, published the “IRS Secret Files” in 2021, a strategy known as “buy, borrow, die” has come under particular scrutiny. It allows those who employ it to completely avoid income and capital gains taxes.

Let’s say you own a successful company—so successful that your stake in it is worth $1 billion. How should you fund your expenses? If you pay yourself a salary of $20 million a year, the federal government will take 37%, or about $7.4 million. So maybe you should take a $1 salary and sell $20 million worth of stock. If it was gifted to you when you founded the company, the entire sum represents capital gains and would be taxed at 20%, meaning a loss of $4 million. What if, instead, you called your estate manager and agreed to put up $100 million worth of stock as collateral for a $20 million loan? In 2021, the interest rate on the loan might have been just 2% per year, meaning the returns from holding the stock, rather than selling it, would have easily covered the cost of servicing the loan. Since loan proceeds, which must be repaid at some point, are not considered income, doing so would not have triggered any tax liability.

The strategy is even more compelling when you consider the “step-up basis.” When an asset owner dies, the value of capital gains assessments is “stepped up” from its purchase cost to its value at the time of death. In this way, “buy, borrow, die” doesn’t simply postpone capital gains taxes, it can eliminate them altogether. Nothing is paid on gains made between the original purchase of an asset and the value at the time of the original owner’s death.

The tax collector is confused

Low interest rates and booming stock markets make the “buy, borrow, and die” strategy especially attractive. At Morgan Stanley and Bank of America (BoA), which run large wealth management firms, the total value of securities-backed loans to clients rose from about $80 billion in 2018 to nearly $150 billion in 2022. Banks are more than willing to make such loans. Because the loans are typically secured by securities that can be easily seized and sold, regulators treat them as low risk.

But over the past few years of high interest rates, borrowing against assets has become a riskier proposition. At Morgan Stanley, these loans are structured as revolving credit lines; three-quarters of them appear to have floating interest rates. If the loans make up, say, 50% of a portfolio with a high valuation, a market crash can leave borrowers with nothing. In 2022, after Peloton’s stock price plummeted, John Foley, the founder of the exercise bike company, ended up scrambling to restructure his loans, selling a $55 million home in the Hamptons just months after buying it. At BoA and Morgan Stanley, the value of loans secured in this way had declined by the end of 2023.

Yet politics, rather than high interest rates, pose the biggest threat to the strategy. There are three arguments against Biden’s proposal: that it is unfair, that it is unconstitutional, and that it would be an administrative burden. The fairness argument is based on the idea that unrealized gains are, in many ways, unreal. After all, the value of assets could change the day after a tax is paid. This perhaps explains why a survey by New York University academics in 2021 found that 75% of Americans oppose such taxes.

A clue to whether the Supreme Court believes wealth taxes are constitutional will be revealed in the coming days when the justices rule on the Moore case. The plaintiffs were taxed under the Tax Cuts and Jobs Act, which passed in 2017 and imposed a mandatory repatriation tax on the profits, dating back to 1986, of foreign corporations in which U.S. shareholders own at least 50% of the stock. The tax applies regardless of whether the profits were distributed to shareholders.

If the justices side with the plaintiffs, they could immediately dampen the push for a tax on unrealized gains, but they seem unlikely to do so. Sonia Sotomayor, speaking for the court’s liberals, has noted that the concept of “realization” was “well-established” when the relevant constitutional amendment was ratified in 1913. Early 20th-century lawmakers could therefore have specified that unrealized assets should be left alone if that had been their intention. On top of this, at least two conservative justices have suggested they will not weigh in on the constitutional point.

As for the idea that private wealth taxes are unworkable, that’s too simplistic. Versions of them are already widely used in the United States, undermining arguments that they are impossible to administer domestically. Property levies at the local or state level effectively act as taxes on unrealized capital gains. All U.S. states have property taxes, which range from 0.3% to 2.3% of property value each year. In more than half of states, property values ​​are reassessed annually. Biden’s plan also seeks to minimize headaches. It includes measures to smooth out volatility so that losses incurred in one year can be offset by gains in another.

Still, the bureaucratic effort to impose a new national tax on a small group of people and on every type of asset they might own would be staggering. Valuing assets like bonds and stocks is relatively straightforward, but private assets — whether a Picasso or an investment in a start-up — would be something else entirely. Adam Michel of the Cato Institute, a libertarian think tank, notes that it took the IRS and Michael Jackson’s heirs 12 years to reach a court-brokered agreement on the value of the late pop star’s assets. “Going through such a process every year for every taxpayer with assets close to a certain threshold is unworkable,” he says. Several European countries that have tried to impose estate taxes and ultimately abandoned the effort have cited administrative costs as one reason for doing so.

Fortunately for Biden, there is a less radical alternative that would have a very similar effect to going after unrealized assets. Eliminating the stepped-up tax base, which Biden also hopes to do, would remove many of the incentives to buy, borrow and die. It would also likely avoid a serious legal challenge and would be easier to administer. Such a measure would raise a quarter of the sum the president hopes to raise with his grander plan. Taxing capital gains at death would raise another sizable chunk. And closing a few additional loopholes would cover virtually the rest.

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