US Tax question: investing on personal borrowed money

[jobyts]

I was wondering if the following tax strategy has anything illegal based on US and California tax laws.

 

Person X comes under high tax bracket. Person Y, who is an extremely trustworthy relative of person X, comes under very low tax bracket.

 

Step 1. Person X lends $100K to person Y as a personal loan. (just a bank to bank transfer)

 

Step 2. Person Y uses the $100K for investment and after, say 5 years, the amount grows to $150K. Person Y pays short term capital gain for the $50K he gained, but not much since his income bracket is low.

 

Step 3. After 5 years, person Y returns $100K immediately back to the person X. No tax for both the parties, since it is just repaying the borrowed money.

 

Step 4. Person Y gives back the ($50K - the tax he paid) to the person X as a gift over a period of multiple years, each year's gift within the tax-free gift limit.

 

 

This way, person X avoids paying higher short term capital gain tax and avoids hitting AMT due to the long term capital gain.

 

Does this strategy work? Are the tax assumptions I mentioned in each steps accurate?

 

 

 

[smreitz]

Your assumptions look fine to me. You are accomplishing income shifting.

 

The loan should be (1) documented with a loan agreement and payment schedule and (2) follow the IRS's AFR published rates to avoid IRS scrutiny.

[John Hjorth]

jobyts,

 

What are you going to to do, if the  USD 100 K actually turns into ,- say 50 K [over 5 year time frame, as posted by you]?.

 

Person Y would be  deleted from my list of clients immediately, assessed as an idiot, taking on risk without no return.

 

In short:

 

1. Make some money by investing - first

2. Think about taxation - after you have actually made some taxable money on investing.

[Jurgis]

Somewhat what John said, but also:

 

This works only in rather limited money range: might work with exactly $100K, but if sum goes to $200K or higher, then X will start paying pretty high tax. Also gift amount is limited and at higher amounts might take long years to transfer gains back, which hits value of money (although money can be invested while it's waiting to be returned).

 

Since this only works within $100-200K range, is it worth for person X to deal with all complexities to avoid paying some tax? BTW, even if it's legal, it might put person X under IRS audit flags, which might not be worth it.

 

Also why not buy BRK (ok SP500 ;)), never sell and never pay any tax? ;)

[jobyts]

When I say 50K profit, I just used an example to illustrate. Person Y does not have even a brokerage account now, I will be taking care of everything - risk, tax filing, online account management etc.

 

The amount will be in the range of couple of millions. This is from private company investment, so to move to SPY or BRKA, I will have to sell the equity. As mentioned by few from the board, this tax saving strategy is probably not  worth for this amount.

[Guest]

I believe there is also an interest rate one must charge when loaning money to relatives.