Alternative Investments Are Solution To Fiscal Cliff

Everyone, including me as of this writing, is talking about the fiscal cliff that we’re rapidly approaching as a nation and will leap off on January 1, 2013.  If you’re reading this, then you already know the fiscal cliff involves, in part, a substantial amount of tax increases.  These increases will make many transactions and events more painful when the individual has to sign the final check made out to Uncle Sam.

Examples of these transactions are IRA-to-Roth IRA conversions, IRA required minimum distributions (RMDs), gifting transactions subject to gift tax, and estate tax calculations.  The amount written on that check to Uncle Sam in all of these events depends directly on the fair market value (FMV) of the assets involved in the transaction.  For example, a one hundred thousand dollar Roth conversion in 2012 will cost a lot less in tax than the same event in 2013.

Interestingly, alternative investments (AIs) offer a major solution to the fiscal cliff problem, yet hardly any broker/dealers or asset sponsors are using this to their advantage.  These entities invariably report the value of such assets at their net asset value (NAV).  NAV is entirely different from FMV (although in some circumstances they may be equal by coincidence but not by definition).  Importantly, FMV is typically much lower than NAV because IRS rules on valuation of non-traded investments (i.e. almost every alternative investment out there including non-traded REITs, BDCs, hedge funds, etc.) require that certain features be taken into account when determining FMV.  These features do not apply when calculating NAV.  Such features include discounts to valuation for lack of marketability, lack of control, illiquidity, and many others.  If a non-traded REIT share has a NAV of $9, but can’t be sold anywhere to anyone on the planet for $9, then why would companies (and consequently taxpayers) report the value as such for taxable events?

The rules say it should be valued at what a neutral third party would pay for it in an arms-length transaction.  The fact that a shareholder can’t find a buyer at $9 should serve as a red flag that this isn’t the proper tax reporting valuation.  Perhaps there are secondary market transactions of this particular REIT in the $5 range.  If so, this is probably more indicative of the proper value to be used in taxable event reporting (actual FMV can only be determined by means of an appraisal).  Imagine the difference in tax owed between a Roth conversion with 10,000 shares at $9 ($90,000) versus a Roth conversion with 10,000 shares valued at $5 ($50,000).  Same asset, same number of shares, same taxable event, but a completely different outcome based solely on proper determination and reporting of FMV as required by the IRS.

Alternative assets have this unique built-in, pre-existing feature that provides this incredible tax benefit.  AI sponsors, selling broker/dealers and advisors to individual clients should all be reviewing these opportunities in order to help their clients turn the fiscal cliff into more of a gentle slope.

Benjamin Franklin Promoted Tax Alpha

Clients want more money.  They want growth or income or preferably both, thankyouverymuch.  In every case, they give their advisor a fistful of dollars and expect two fistfuls in return (hat tip to Clint Eastwood).  Rare is the client that asks only for the same number of dollars to be available several years after hiring an advisor.

Advisors typically design a portfolio of assets intended to produce more dollars at some point in the future than the client started with.  The ability to successfully generate excess return over a stated benchmark produces investment alpha.  A positive alpha of 3.0, for example, represents a return three percentage points higher than the benchmark over a specific timeframe.  This is quite a challenge even for the best advisors.  It requires them to be right…a lot.

However, there is a different type of alpha that can be planned for, calculated in advance and achieved consistently.  Such is the nature of tax alpha.  Tax alpha is created when a particular planning strategy results in a reduction of taxes owed.  It provides the same net result as investment alpha, namely, more money in the client’s pocket.

Did you know Benjamin Franklin was the first known proponent of tax alpha?  His quote “a penny saved is twopence dear,” later updated into modern English as “a penny saved is a penny earned,” is directly on point.  A penny saved in tax is just as good as a penny earned from investment performance.  One might contend that Mr. Franklin was speaking against frivolous consumer spending, but I suspect he would equally advise against overspending on taxes as well.

A good advisor will sharpen up on advanced tax planning strategies as much as they will on the latest investment information.  This is especially pertinent in 2012 to help clients limit the cost of pending tax increases slated for January 1, 2013.  Increased tax costs are akin to investment losses in a portfolio while tax savings are akin to investment gains.

One example of how to add tax alpha for clients contemplating wealth transfer strategies can be found in our report titled “Waiter, There’s a REIT in my GRAT!” posted in the Education & Resources section of this site.  And pick up a copy of our book, KEEP IT! Advanced Tax Strategies for IRAs, for many ideas on how to provide significant tax alpha to retirement accounts.  Stay tuned for many more updates and ideas from Jagen™ throughout the rest of the year.

Tax mitigation strategies can provide “guaranteed” returns that are only dependent on following the rules.  Geopolitical activities, investor emotions, market movements and corporate profits have no bearing on returns generated from tax alpha strategies.  Wise is the advisor that can generate investment results via tax savings even if a portfolio is flat.  Ben would be proud.