August 1996
Vol 19 No 12
If you recall, that question is associated with the fable of the three little pigs. They were jumping around singing it just before the wolf huffed, and puffed, and reduced the real estate portfolios of two of the little pigs to nil. As with all fables, there’s a lesson to be gleaned here for those interested in protecting their assets: (a) Don’t go around tempting fate and assorted predators when you’ve got something to lose. (b) Consider structuring your assets in such a way as to protect and preserve them prior to the wolf’s arrival.
Let’s try to put things into perspective. Threats to assets might be divided up for convenience into legal, tax, physical, political and economic. The costs of making assets absolutely bullet-proof against all of the potential threats out there would be too cumbersome and expensive for most people. That means we have to weigh the costs, inconvenience, and time required to establish and administer a full blown asset-protection program against needed flexibility required to operate these same assets to provide income and financial security to our families. This month, we’ll look at some basic ways to hold and protect property which, hopefully, will be practical and cost effective for most readers.
Let’s start with legal threats. Whether as the result of valid claims for compensatory damages or spurious nuisance suits, litigation has risen to the top as the tool of choice for redistributing the assets of others. Courts tend to go off the deep end where one party is seeking compensatory and punitive damages for real or imagined injury. This is where jurors, who consider $15 a day to be a career fast track, award millions of dollars to claimants without regard to the financial havoc it can cause to hard earned savings. How might we defense against tort litigation?
Let’s start by following the ‘Golden Rule’ in our business dealings. The best place to stop litigation is by practicing the old maxim, ‘THE CUSTOMER IS ALWAYS RIGHT’ when we offer products or services, including rentals, to the public. Combining that with a policy of a full refund whenever a customer isn’t happy stops lawsuits before they start. A case in point is the Nebraska Furniture Mart. This largest single outlet furniture store was started 60 years ago by 102 year old Rose Blumkin with a simple motto: ‘Sell for less, and tell the truth.’ L.L. Bean has prospered even longer with a money-back guarantee on all merchandise. Customers may rip them off from time to time, but the cost is far less than litigation.
Contrast these policies with the Porsche customer recently who won $2 million in punitive damages against a Porsche dealer. The dealer had repainted part of the underside of the body and sold the car as new. He compounded his deceit by not immediately refunding the money or replacing the car. He’s paying as much for dishonesty as for any impairment to the value of the car. Bear in mind that when you let your legal department handle complaints, the customer may do the same.
On any given day, anyone can sue anyone else with or without provocation. Filing a suit is one of the great lotteries in America. The plaintiff gambles very little cash against the prospect of a huge award or settlement. His contingent-fee attorney gambles time and effort. Conversely, the defendant must spend thousands of dollars in legal fees to protect what could amount to millions of dollars. To protect against a situation in which fair dealing hasn’t warded off an attack, you should buy adequate insurance. At least this will provide the funds for an active defense against legal abuses. Of course, you could also counter-sue and let the other side see how much fun it is to pay for a legal defense. A caveat: If awards are going to be in the millions of dollars, so should your insurance coverage.
RUNNING AFOUL OF GOVERNMENT HAS BECOME A MAJOR THREAT TO ASSETS
There’s a higher probability that ordinary citizens will be victimized by government than there is that they’ll be involved in a civil suit. Government threats would include federal fines for regulatory offenses levied by SEC, OSHA, RICO, EPA, and the IRS. Local government levies fines for code violations such as might occur under various building and zoning ordinances. Rent and profit controls, usury laws take away income before it’s taxed. So do costs of permits, impact fees, and licenses. We certainly would want to include pre-judgment seizures of all sorts of property which are authorized under Clinton’s Crime Control Act and which have recently been sanctified by the Supreme Court. Government threats could become more acute once all the lead-based paint regulations have come into full force this year (September 6th for more than 4 units, and December 6th for 4 units under).
The lowest cost defense for those in the path of destruction is to try to master the regulations that apply to what you’re doing. Keep current copies of them nearby, and keep your agents, employees, tenants, trustees, directors and officers informed of them. Treat bureaucrats like customers when you can. Taking swift action anytime that a violation is pointed out can head off trouble before it has a chance to fester in the fertile ground of the bureaucracy. When you want to negotiate, to avoid the appearance of ‘fighting city hall, it pays to haven an intermediary such as a property manager, accountant or lawyer contact the complaining department to see if a suitable solution can’t be negotiated.
Never underestimate the power of a minor functionary who decides you need to be taught a lesson. Vital paperwork can turn up ‘missing’. Notices of hearings can be mailed to the wrong address. False reports can ‘erroneously’ be entered into computer databases where they’ll infect credit records. Valuable property holdings can be rendered worthless simply because a permit isn’t renewed in time or a notice of a hearing is sent to the wrong address. Recently, 390 apartments in 35 buildings were razed to the ground under the authority of one such bureaucrat. Although a suit for damages might be filed against her department, it won’t hold her personally liable to account or restore the buildings which had been ‘grand-fathered’ in under a prior zoning code. At best, it will take years in court before this wrong is redressed.
The way to deal with omnipotence is to avoid being noticed. Try not to attract the attention of those who can do great damage to you. You should make a reasonable effort to keep your financial affairs as private as possible. If you must own high profile properties, you may find it worth the effort to have them bought by, and titled to an entity which holds no other assets. For real estate holdings, you might use a corporation to hold title as a nominee. You could complicate things further by having it sell the property to a neutral Trustee of an Irrevocable Trust. He’d be carrying back a purchase money, ‘shared-appreciation’ note. This might lose some tax benefits, but would enable the nominee to capture any gain on your behalf. Or you could personally be named as the Beneficiary of the Trust. Either way, you’d personally be well out of the line of fire if trouble were to come.
The combination of legitimate recorded liens which remove much of the equity in a property and the use of a legal title-holding entity rather than a person will go far toward insulating a property from your personal mishaps, and vice versa. Holding each property interest, whether a recorded lien or title itself, in a legal entity will also segregate one property so that it can’t infect another. To do this corporately could be pretty expensive, but properties can be segregated into separate trusts with little cost or trouble, so long as net income is distributed.
Taxes can steal away your assets as easily as litigation. You cannot afford to remain ignorant in this area. Know how and why your property taxes are assessed, and be willing to contest them when they’re too high. We’ve been able to have taxes reduced to mere fractions of their original amount by hiring specialists to file well authenticated protests with the property authorities. Once you demonstrate that you’re willing to do this, it becomes easier to have taxes reduced.
EVERY UNSPENT DIME YOU EARN WILL BE SPENT BY SOMEBODY ELSE
The Internal Revenue Code encourages spending and discourages thrift. It also encourages people who would normally never concern themselves with taxes to start buying tax preparation software such as TurboTax. People everywhere are starting to personally forecast their own tax liabilities and trying to decrease them. The key to reducing income taxes is to understand the grand scheme under the tax code which permits losses to be netted against gains, taxes to be deferred all your life, the tax advantages of various legal entities, and the timing of when taxes must be reported and paid.
Formulating a comprehensive strategy with the aid of a qualified tax specialist can save many thousands of dollars over the years. In almost every instance, you’ll save more than it costs the first year. Subsequent years will produce a harvest in saved taxes at very low cost thereafter. There are few fields of study that can yield as much after-tax-income as comprehension of the tax code.
Beware! Much of the income and taxes you avoid at rates between 15% and 39.6% during your life could be taxed at an estate tax rate of 50% when you die. The only choice you have is whether your designated heirs spend your estate or whether it’s spent by the government. In the next 10 years, almost one trillion dollars each year will pass on to the next generation. The Estate Taxes paid on this will be enough to completely retire the government debt. Don’t think Congress isn’t giving this a lot of thought. If you’re going to implement a plan, now’s the time to start. Strategic estate planning can pay off big, but not if you wait too long.
Everyone has a different estate planning concept. Some feel that giving their heirs a good solid education is enough of a start in life. Others want to see businesses they’ve started continue to grow in another generation. In some cases, disabled or retarded children will require lifetime care, so money must be set aside to grow for this purpose. Some people just plain don’t want their lifetime earnings wasted by faceless bureaucrats in another pointless government program.
Then there are those who truly like to use their accumulated assets to make a real difference in improving the world they live in. A charitable trust or foundation might serve the multiple purposes of avoiding estate and income taxation, passing on control of assets to heirs, providing for those with lifetime dependencies, continuing a business, and at the same time funding a charitable purpose. In all probability, charitable gifting combined with trusts and insurance will provide the foundation for the biggest income and estate tax savings while allowing the maximum estate to be passed on to the next generation.
There’s a growing following for a fun concept of avoiding the expense of estate taxes. Spend the money! Educate your kids, buy some life insurance, and live well on what’s left over. This isn’t as facetious as it may seem. Suppose you had accumulated $1 million in appreciated zero basis real estate. Selling the assets, and paying $280,000 in capital gains taxes would still leave $720,000. You could form an irrevocable trust and gift it enough to buy a $1,000,000 insurance policy naming you kids as beneficiaries of the trust. This way, they’d get their inheritance completely tax free. You’d still have enough to live well for many years, paying income tax only on the earnings of your investments. If you ran a little short, maybe the trust would lend you a few dollars that it might borrow against the cash values in the insurance.
If you’d like to formulate an estate plan that is extremely rewarding, there’s absolutely no substitute for going into business with your heirs. Let them use their initiative and energy to dream up projects. You can use your mature wisdom and experience to evaluate them, your contacts to get them launched and your cash to keep them going. Dividing up the profits with your kids is a low profile way to distribute your estate while they build their own financial security. Besides, it’s lots of fun for everyone concerned in both generations.
PREVENTION IS THE KEY TO WARDING OFF FINANCIAL RISKS . . .
Every time you apply for a full recourse loan to buy more property, you make all of your assets more vulnerable to a slumping economy. Every time you pay off a full recourse loan, you increase the financial safety of all your assets. When a person has never seen a real economic downturn, it’s hard to really believe it can happen. All one would have had to do would have been to travel to Texas in 1987 to see it at first hand. Decent new tract homes selling for less than $15 per foot, including the manicured building lot. Fully rented brick apartments selling for less than $8000 each. Palatial 4000 square foot waterfront homes on 5 acre lots selling for under $100,000. Billions of dollars in equity were lost because people couldn’t sell their properties to satisfy their debts.
The best defense against economic assaults on assets begins with avoiding hazardous loans. If you feel you absolutely must agree to full recourse debt, at least try to limit it. You might agree to personally guarantee the top 10% – 20% of the principal payments, or the first 5 years of payments, or to pledge other collateral for a limited period of time until the loan has amortized below a certain percentage of the original value. All these steps would protect your other assets from a general judgment lien in the event of a default.
You’ve also got to keep a weather eye cocked for fundamental changes in the economy that would affect your investments. Rising interest rates tend to reduce the market value of almost everything, while falling interest rates have the opposite effect. Locally, changes in neighborhood trends caused by new roads and real estate development can make an area suddenly unpalatable. The reputation of local schools has more to do with the value of housing than virtually any other factor. Deterioration in a school’s desirability could cause values to drop. Before this happens, try to exchange your equity into another area, tax free.
Loss of private property rights looms as the biggest political threat just as manipulation of interest rates is the greatest economic threat to most people’s assets. Anytime that private property can be seized without due process, everyone is placed in jeopardy. However, before you spirit all your cash out of the country into foreign bank accounts, remember, under the law, these must be reported. There’s an easier and cheaper way. Make a special effort to maintain a low financial lifestyle profile. You can avoid being rich and famous by using Trusts to hold your assets. If you own nothing, there’s nothing to lose.
Trusts represent an impenetrable landscape to most people. Very few people really know much about them. By establishing a contract between yourself as Grantor and another party as Trustee, assets can be held privately under a separately assigned tax ID number in an account segregated from other assets. These are easily administered, and you can have as many of them as you choose. Because assets are held for the benefit of anyone you name, you, they, or anyone else you select, can direct the Trustee’s actions.
Even though real estate might be contributed to a Trust, the interests of the beneficiary are personal property. This enables you to hold beneficial shares privately, in almost any legal jurisdiction you choose under the terms of the Trust. Can you imagine the frustration of a predator, who, after having spent a lot of money to win a suit, discovers that he’s filed suit in a jurisdiction over which the court has no legal authority over the Trustee, Beneficiary, or Trust? While, any particular property can be successfully attacked and/or seized if the political winds are against you, separate trusts for each asset, make it much more difficult for all of your property to be lost. Thus, assets can be diversified, held for gain, for use in business or for personal use privately and inexpensively.
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