Using Derivatives to Have Your Cake and Eat It, Too
| Publication year | 1995 |
| Pages | 2213 |
| Citation | Vol. 24 No. 9 Pg. 2213 |
1995, September, Pg. 2213. Using Derivatives to Have Your Cake and Eat It, Too
This article explores the tax advantages of using financial derivatives or their equivalents to reduce the risk of holding appreciated securities or other property.(fn3) Specifically, it focuses on four ways in which investors may utilize risk-reducing strategies to realize, in an economic sense, their gains without triggering a tax liability.
To appreciate the potential for deferring taxation through the use of financial derivatives, one must understand the distinction between "economic income" and "taxable income." A taxpayer's economic income includes "the change in the value of the store of property rights between the beginning and end of the period in question."(fn4) Notwithstanding this increase in wealth, the taxpayer may not have any taxable income, because the U.S. tax system historically has accounted for gains and losses only on the occurrence of discrete transactions.(fn5) That is, gains and losses generally are subject to taxation only when the taxpayer "realizes" them.(fn6)
In general, a taxpayer will realize gain or loss only if he or she sells or otherwise transfers "tax ownership" in the property to another party.(fn7) The attributes of tax ownership include: legal title; possession (including the right to use the property or to derive current income); and the right to subsequent appreciation, as well as the risk of loss (the "benefits and burdens of ownership").
Whether tax ownership has been transferred is especially difficult to determine (and thus is subject to taxpayer manipulation) where the property rights in question are fungible (such as a publicly traded security). For example, a taxpayer holding publicly traded securities can effectively transfer economic ownership by purchasing or selling a financial derivative that shifts the benefit of appreciation or the risk of depreciation to another party, while retaining tax ownership of the property. Only if the security and the derivative were integrated, which is not the case at present,(fn8) would a transfer of tax ownership be considered to occur.
Although the term "financial derivative" is of recent vintage, derivative contracts (risk-transferring contracts relating to the future purchase and sale of assets) have been utilized for many years to defer income recognition. Three of the most common historical techniques are: nonrecourse borrowing,(fn9) selling "in-the-money" call options and "short sales-against-the-box." Along with these older techniques, taxpayers recently have employed newfangled "equity swaps" to reduce their market risk, thereby "having their cake and eating it too."
An owner of appreciated property who borrows on a nonrecourse basis against the property is able to: (1) greatly reduce the downside risks of owning such property (while retaining the upside potential), and (2) temporarily convert a substantial portion of the value of such property into cash, all without triggering a taxable realization event.
Consider, for example, an investor who owns appreciated real estate that was purchased a number of years ago. The investor would like to "tap" into this value to support a new business venture, but does not wish to incur present taxation of the built-in real estate gain to do so. In these circumstances, rather than sell the property, the investor might obtain a nonrecourse loan secured by the real estate. Because loans (including nonrecourse loans) do not constitute taxable realization events, the investor will have obtained the money needed for the new business venture on a tax-free basis.(fn10)
Of course, the investor will have an obligation to repay the loan (plus interest) in the future. If the mortgaged property substantially holds its value or continues to appreciate, the investor will make the required mortgage payments to avoid losing the property to foreclosure.
However, if the real estate were to decline in value, the investor might abandon the property to the lender without incurring personal liability, and for tax purposes would be treated as having sold the property for the amount of the nonrecourse obligation.(fn11) Thus, aside from the remaining equity in the property, the investor is insulated from subsequent declines in value.
Owners of appreciated property who desire to convert...
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