The Most Gaping Loophole in Our Tax Law: Tax-Free Compounding of Gains on Investments

The tax-free compounding of gains on investments is one of the most glaring loopholes in our tax law, allowing wealthy Americans to avoid paying income tax on billions in investment gains. This loophole enables two main strategies for income tax avoidance: buy-borrow-die and buy-hold for decades-sell.

Under the buy-borrow-die strategy, wealthy individuals can hold onto their appreciated assets until death, avoiding income tax entirely. If they need cash before then, they can simply borrow against the appreciated assets at low interest rates. The buy-hold for decades-sell strategy allows investors to pay a super low effective annual tax rate on investments that appreciate over long periods of time, resulting in decades of compounding gains without taxation.

While the effective tax rates under the buy-hold for decades-sell strategy may not reach zero like the buy-borrow-die strategy, they can still be as low as 4 percent. This means that an investment with a pre-tax growth rate of 20 percent per year could enjoy an after-tax growth rate of 19.2 percent per year.

Congressional apologists for the ultra-rich often argue that wealthy individuals should be entitled to tax-free compounding of investment gains, claiming that they may not have the “wherewithal to pay” taxes on their gains before selling their assets. However, this argument is met with skepticism, especially when compared to the tax burdens faced by average wage earners who have taxes deducted from each paycheck.

The ease with which wealthy individuals can avoid paying taxes on their investment gains is exemplified by a hypothetical scenario involving a wealthy investor named Rich who buys shares of Nvidia. Even if Rich’s shares increase in value by $20 million in a year, he could easily sell off a portion of his shares or borrow against them to pay the tax liability.

Overall, the tax-free compounding of gains on investments highlights the stark inequality in our tax system and raises questions about the fairness of allowing wealthy individuals to avoid paying their fair share of taxes.