Is Your Financial Security At Risk?

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Topics: Asset Protection, Market Trends

This was Jack Miller’s Commonwealth Newsletter in 2006… just before the housing crash.  The advise is relevant to what is happening in housing markets today with another housing bubble and potential housing crash on the horizon….

EVERYTHING WAS GOING GOOD UNTIL….

Today we’ve never had it so good, yet many readers seem worried about: (1) When the “housing bubble” will burst, (2) what will happen to retirement plans when employers file for bankruptcy, and (3)law suits.  In this month’s newsletter I’ll try to put these threats into perspective and suggest ways in which to deal with them.

The “housing bubble” question breaks down into two parts:  (1) Should long term investors with highly appreciated houses sell out now while there are still buyers who can and will pay today’s prices; and, (2) is it too late to speculate on appreciation after such a huge run up in prices?  Here’s what the pros say:  Builders and Developers magazine reports that over the past 10 years, demand has exceeded supply by two million houses.

Over the past year, the nations median price for existing homes has risen 12.5% to $203,800.  In 33 states spread across the country, the rate of appreciation has been below the national average.  Arizona, Oregon, Washington, Virginia, Maryland, Delaware, New Jersey, New York, Rhode Island, Hawaii, Massachusetts, New Hampshire, Vermont, and Maine have exceeded the national average.  California’s, Nevada’s, and Florida’s median prices have increased 25.42%, 31.22%, and 21.42% respectively.  These 17 markets could run out of steam; but even there, some housing segments will out-perform others.

Speculators who have “stockpiled” houses could create a price dip if they sense a downturn and flood the market with houses, but past real estate dips even in worst case situations have only lasted for a few years before markets have fully recovered. In the interim, opportunists would be able to scoop up bargains and rent them.

Bottom line: Should you keep on buying houses to hold long for income and long term appreciation?  Yes, so long as you can get financing that the house can afford.  Borrowing at low fixed interest rates with payments that leave room for net rental cash flow is the key to long-term safety.  Conventional loans pose higher risks to long term investors.  Landlords would incur much less risk and obtain higher yields by using creative financing and lease/Options when buying in this market.

What about flippers and fixers?  House prices depend upon supply and demand in a particular price range in local markets.  Recently, in neighborhoods above the median price, “For Sale” signs are popping up everywhere.  This phenomenon doesn’t seem to extend into houses priced below the median where there is still strong buying demand.  In upscale markets that are changing from “sellers’ markets” into “buyers’ markets”, selling time is lengthening and some price discounting is taking place.  When sales slow, you must shorten the time houses are in your pipeline.  To do this, you’ve got to reduce the time it takes to buy a house, turn it around, and market it.

Shortening the pipeline is only half the battle; when profit must be discounted, you need to sell more houses to make the same amount of money.  Last summer, this is exactly what General Motors did to increase sales revenues.  There’s an upside to a price dip:  When John Q. Public can’t sell his house, you can buy it at a lower price.  You sell for less, but you also buy for less and stockpile at the same time your competition is being driven out of the market.  To do this, you’re going to need more cash.  The banks won’t be much help.  Now is the time to start seeking out seasoned investors willing to finance larger house inventories for a share of the profit.

That’s easy to say, but harder to do.  How does one attract private investors when the market slows down?  By showing them what you have been able to achieve when the market was hot.  If you’re a “fixer”, show them before and after photos of houses you’ve fixed up and sold.  If you’re a “flipper”, show them how much money you’ve made over the past few years.  If you’re a “newbie”, find a house you can lease/Option, then offer a major share of the future profits with a seasoned entrepreneur if he or she will finance it and coach you through the process.  The key is to have already gotten the house under contract so that you have something to offer.

ARE YOU GAMBLING YOUR FUTURE ON BROKEN PROMISES?

Traditionally, Americans have gone to work under a variety of pension schemes which provide for their retirement.  Quite often, these pensions are not indexed for inflation; virtually guaranteeing that pensioners will end their lives in genteel poverty.  Both government and corporate America are beginning to fudge their retirement plans, leaving employees at risk.  Social Security is increasing the amount of earnings subject to withholding and the minimum age at which a taxpayer can start collecting benefits.

Current proposed legislation contains a new type of retirement plan that will wipe out IRAs and replace them with a new program.  You can bet that the benefits to the taxpayers will be watered down in the process.  Ultimately if you expect to have any financial security, YOU are going to have to take full responsibility for your financial future and long term medical care.  If you don’t think it can happen to you, ask any retired United Airlines pilot what happened to his income when UAL filed for bankruptcy and the government took over.  You don’t need to experience this with houses.

Recently I was discussing the declining purchase power problem with a vigorous 77 year-old.  He was caught in the cross-fire between shrinking Social Security payments, a fixed-rate teacher’s pension, and rising costs of medical insurance.  He had two choices; either sacrifice lifestyle necessities to insure against future medical expenses, or find a way to supplement his income.  He figured if he could Lease/Option and sell just one house each year, it would double his retirement income.  He called me to find out where he could buy a book or go to a seminar on the subject. If he had made that choice a few years earlier, it might have made him a millionaire as it did for so many people who were already holding houses for long term appreciation.

One subscriber took a practical approach to building a retirement income.  He’d buy 10 houses each year, then fix and flip five of them to provide current cash flow, and keep five to hold for long term appreciation and income.  Over the years, he used the income that he didn’t need to maintain his rentals and to pay down his mortgages.  When he decided to retire, he began the process of methodically liquidating his rentals.  He’d sell one and pay off the remaining loan balance on another.  This gave him an immediate boost in his retirement pay while reducing his debt.

Once all his houses were free and clear, he continued to sell them one at a time, but this time he paid his taxes and put the sale proceed into 90-day T-Bills until he consumed it.  At that point he’d sell another one and repeat the process.  With each house sold, his management chores are reduced and he has more time to travel and enjoy life.  He’ll never use up all his houses in this lifetime.

A few months ago, one subscriber in one of the hotter markets who owned 11 houses had them appraised in preparation for selling some of them.  He discovered to his astonishment that their value had increased by over $90,000 per house with very little help from him.  He had paid the mortgages way down, but even if they had been mortgaged to the hilt, he would have found himself to be about $1 million richer simply because of fairly recent appreciation.  When he raises rents up to fair market value, his income will increase by over $1,500 per month.  Surely, buying just a few long term rentals priced near the market median and holding them for retirement would provide more security that betting your financial life on the judgment and well wishes of your employer.

Today, Roth IRAs are all the rage because payouts are tax-free upon withdrawal; but they have a few negative factors.  Roth IRAs are funded with earned income on which payroll and income taxes must be paid.  In the 15% tax bracket, this boils down to 30.3% plus State taxes; so to contribute $4000 to a Roth IRA, you’ve got to earn $5212 plus State taxes.  What else could you do?

If your 1-employee corporation established a defined benefit plan and you contributed appreciated houses to the corporation, it could sell them and put the proceeds into your retirement plan.  It could deduct up to $205,000 in plan contributions each year, but for three years you’d have to pay income tax on a high salary to establish the funding level.  After that, your plan could continue to be funded at that level even if you received only minimum wages.

REAL ESTATE CREATES LIABILITY FOR ITS OWNERS

Litigation continues to pose a significant threat to landlords, fixers, and flippers.  This shouldn’t be surprising when you consider that real estate wealth is highly visible.  Tenants are prone to blame the landlord for any mishap to themselves or their guests occurring on rented property.  A recent California decision held the owner of a building responsible for a slip and fall accident caused by an uneven surface on an adjacent city-owned sidewalk.  Upon appeal, the court ruled that the tenant could sue the landlord, and the landlord had to sue the city to recover his costs.  Count up on your fingers and toes how many lawyers got in on the fees generated by both sides of these multiple damage claims.  What did all this do to the new worth of the hapless landlord?

“Fixers” typically hire “independent contractors” to rehab properties.  These pose a double-edged threat; one from personal injury lawyers when anybody is injured, and one from the IRS when, on audit, they rule that those working on a house were de facto employees.  Not only were they supposed to have been covered by workers comp insurance, but payroll taxes should have been withheld and submitted to the IRS from the point of employment.  To show you how insidious this can be, one cooperative entrepreneur had his labor costs audited for 10 years.  He was assessed over $130,000 in penalties and interest.  One solution might be to employ and pay corporations rather than people, or to contract with a corporation to rent worker-bees on demand.  You’d pay the corporation, and it would pay the workers and take a small profit on their wages.  This way, you’ll steer clear of trouble, and have a ready source of people to work on houses.

“Flippers” who flip contracts to investors, landlords, fixers, and users may run afoul of State regulations that deem them to be attempting to get around State real estate licensing laws, but this is a rare happening.  Their major threat is in failing to disclose repairs not done according to code, the presence of toxic mold and lead based paint, and implied warranties they occur by virtue of State consumer laws when someone is unhappy with their new home.  A simple remedy to restrictive licensing laws is to form a corporation and to hire a licensed broker for a flat fee per deal — or per month — to represent it in all dealings.  Next, disclose and disclaim all facts about the property being sold.  Of course, fair, ethical dealing with all parties, and quick resolution of complaints, is the cheapest and most effective way to ward off legal problems.

Ruinous lawsuits aren’t limited to real estate.  One owner of a successful business plus several parcels of valuable real estate asked me how he might protect his assets from a lawsuit.  He’d had a skidding accident on a slippery road where several people were injured and where he was deemed to be at fault.  The suit had already been filed.  His business was uninsured.  His personal automobile liability insurance was for only $50,000.  He owned all personal assets, including his corporate stock, in his own name.  He had no estate plan or Living Trust.  Fortunately, he held the real estate in the name of an unrelated Land Trust Trustee.  He was the sole beneficiary and as such held neither equitable nor legal title to the real estate.  Unfortunately, his personal possessions could all be levied to pay judgment creditors.  If they had always been held in a Personal Property Trust, they too would have been safe from levy.

The first reaction so people in this situation is to try hide assets by selling them at a low price to friends and family.  This is a no no.  This can be deemed a “fraudulent conveyance”.  Depending upon how egregious the transfer is, what starts out as a civil matter could swiftly become a criminal offense.  His best course of action was going to be to negotiate an out of court settlement and hope for the best.

What might he have done to have prevented this situation?  His first line of defense should have been a large liability insurance policy in the amount of several million dollars to protect himself and his company against this situation.  It’s not uncommon for the employer to be named along with the employee when an accident occurs while on the way to and from work, or on a business errand.  Next, to protect his assets and family against any future mishap, he should form a Living Trust and have it be the beneficiary of separate land and personal property trusts which in turn would hold all his assets.  That would not only have protected them, but would have provided a legal and simple way to pass them on to his heirs if he had been killed in this accident.

HOW DO TRUSTS, CORPORATIONS, AND LLCS PROTECT ASSETS?

Many people form Corporations, Trusts, and LLCs, then try to figure out what to do with them and how to do it.  Somewhere along the way the Law of Unintended Consequences comes into play, and they find themselves wound around their own axle in a Gordeon’s knot of title exceptions, tax issues, and financing problems that even Alexander the Great couldn’t cut through.  This certainly provides a full measure of asset protection against predator creditors, but often exposes assets to extra taxes and legal costs when their creator dies or is mentally incapacitated.  Any time a third party — or court — has to step in and sort things out, the costs can explode.

Each kind of legal entity serves a different purpose, although they overlap to a certain degree.  Trusts can be created without the permission of the State, but the creator may elect to form them under the asset protection laws for Trusts in Alaska, Nevada, and Delaware.  Trusts can be used to form Limited Liability Companies, other Trusts, Corporations, Foundations, Partnerships, and Joint Ventures.  They can be used to hold assets for pension plans, IRAs, individuals and estates.  Trusts can be taxable or tax neutral.  Grantor trusts can pass all profits through to their beneficiary and leave the tax liability with their Grantor.  Combinations of revocable, grantor, simple, irrevocable, complex, charitable, and non-grantor trusts can confuse the enemy, but it can also confuse you.  The main point to keep in mind is that Trusts are great for HOLDING assets rather than for use in a business context or to mask illegal transactions.

What about corporations:  You can have multiple S-Corporations that can pass earnings through to its owners without being taxed at the corporate level.  If you use multiple C corporations they’ll be taxed as a single entity for income tax purposes.  An exception is IRC Section 1536(e)(5) which allows one C corporation to each spouse.  A C-corporation can initiate a full range of employee benefits capped off with a pension plan.  Because all employees must share in most fringe benefits, a one-person corporation who is the sole employee works best.  Fringe benefits provided by S-corporations aren’t deductible when the employee owns more than 2% of it.

C-corporations can deduct unlimited passive losses, but they don’t have a separate capital gains tax rate.  Up to $50,000 in net earnings, corporations pay the same tax rate as capital gains and dividends.  They can retain up to $250,000 in earnings and use a fiscal rather than a calendar year.  In most cases, net earnings and appreciated assets that are sold are taxed twice; once to the corporation and once to the owner.  One more little item; corporate assets can be levied to pay corporate judgment liens, and they don’t get a step up in basis when a shareholder dies.

Bottom line:  Use one-person corporations for the fringe benefits they afford, but keep them lean and mean with as few assets as possible.  They make excellent Trustees and LLC Managers.

Where do Limited Liability Companies fit in?  Because the assets of managers and owners of Limited Liability Companies can’t be attached for company judgments, LLCs are excellent entities for doing business in any potentially hazardous situation.  They can master lease property, operate companies that have lots of employees, do hazardous work, etc. while continuing to protect the assets of their owners.  LLCs do not protect their own assets.  For this reason, it’s a good idea to hold assets in one LLC – or in a Trust — but to lease them to a second LLC which will actually engage in hazardous work.  LLCs are very flexible:  One-person LLC’s have all earnings and gain taxed either as sole proprietors or corporations.  Multiple-owner LLCs can be taxed either as partnerships or corporations.  I prefer a two-party LLC formed by a C-corporation that holds just enough percentage of ownership to fund all its fringe benefits, with the other portion of profits going to a passive Trust to be passed down to its beneficiaries.

The ownership of all single-person entities should be held in a Living Trust so they can be passed along to heirs easily if an owner’s death or disability occurs.  If you don’t already have a Power of Attorney, Living Trust and Will, set them up now.

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