Borrowing as Realization: Taxing Billionaires' Unlocked Gains

Should billionaires be able to live large by borrowing against appreciated assets? By holding and not selling the appreciated assets, billionaires pay no taxes on the wealth unlocked through the borrowing. This feat is accomplished by relying on the interplay of two fundamental principles of the U.S. federal income tax system. First is the principle of “realization.” Whether or not this principle has a constitutional foundation, which is hotly debated, the current tax system requires that, except in very limited circumstances, a gain is taxed only if it is “realized” through a sale, exchange, or other disposition of the asset. As long as the taxpayer retains the asset, any appreciation in the asset’s value is known as “unrealized” gain. The second principle is that borrowed funds are not considered to be income and therefore cannot be subject to income taxation. The foundation of this principle is even more fundamental: in order to have income, a taxpayer must enjoy dominion over an “accession to wealth.” Because the “accession” to borrowed funds is fully offset by an obligation to repay those funds, the conventional wisdom is that there is no “wealth” to which the taxpayer can accede When appreciated property is given as collateral for borrowing, the foundations underlying both of these principles are radically undermined. By pulling out cash that can be used for any purpose, the taxpayer has taken full advantage of the asset’s appreciation. This should clearly be considered a realization event, regardless whether the concept has constitutional underpinnings. And there can be no question that holding property that has increased in value is an accession to wealth, regardless whether it is sheltered from taxation by the realization requirement. Even though the taxpayer (or the taxpayer’s heir) has an obligation to eventually pay back the loan, taking cash out against appreciation in asset value is clearly a real and immediate monetization of that wealth. This Article advocates that Congress amend the Internal Revenue Code to make borrowing against substantial asset appreciation a taxable event.