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.

Fixing IRA Transactions with Alternative Assets

Do some of your clients hold alternative investments inside their IRAs?  Have they taken RMDs, completed Roth conversions or other taxable events?  If the answer is yes, then it is very likely that they have a problem.  Alternative assets commonly held in IRAs include non-traded REITs, hedge funds, non-traded BDCs, private investment funds and other illiquid investments.  Such assets can be difficult to value which directly impacts the tax consequences of IRA transactions.  All IRA assets must be reported at their fair market value (FMV) for reporting purposes which for most investments means their trading price.  Alternative assets typically do not trade on established exchanges, and thus can cause adverse consequences for IRA owners when reporting taxable events.

For example, take the case of hypothetical client Mr. Stone who is 71 and has a traditional IRA with a purported $500,000 portfolio of non-traded alternative assets.  This is the value used to calculate Mr. Stone’s taxable 2012 RMD of roughly $18,900.  We take it for granted that this is the correct RMD and the calculation was based on the proper asset valuation.  But what if the illiquid alternative asset was still being valued at Mr. Stone’s original purchase cost from five years earlier with no subsequent update since the asset does not have a readily ascertainable trading price?  It is highly unlikely that the fair market value (FMV) is still $500,000.  If it is worth more, then Mr. Stone could face penalties for not taking the proper amount of RMD.  If it is worth less, Mr. Stone took more money from the tax protected environment of his IRA and incurred more tax than necessary.

A similar scenario occurs where clients completed Roth conversions of IRAs holding alternative assets.  If the investments were overvalued, the client reported excess taxable income and paid more tax than required.  If the investments were undervalued, the client could face unpleasant penalties, interest and additional tax.

Alternative assets are generally subject to valuation discounts for factors such as lack of marketability, illiquidity, lack of control, etc.  So luckily, in the majority of cases we find alternative investments to be overvalued for IRA reporting because these applicable adjustments have not been taken into account.  This means clients often stand to benefit by correcting the errors and requesting a refund of the excess tax paid or reduction of RMD penalties and so on.

The process to correct these issues can be detailed and complex requiring specific actions in a specific order in many cases.   Jagen™ offers direct consulting on these types of cases and can work with you and your clients to complete this process and improve IRA results.  Contact our office to discuss particular client cases.

Author: Joe Luby, CFP®

©2012 All Rights Reserved.

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.

AI Sponsors Will Pay Client’s Advisory Fees

Most RIA firms charge advisory fees to clients in the general range of one percent of assets under management annually.  Thus, a $1 million account would incur fee expenses of $10,000 annually.  Is it really possible to get an alternative investment sponsor to cover this expense on behalf of your clients?  In a roundabout way, yes.

Shane has an IRA valued at $1 million and total investable assets of $10 million.  Your asset allocation model calls for ten percent of the portfolio to be allocated to alternative investments such as hedge funds, non-listed REITs, etc.  These assets are often inefficient vehicles for income tax purposes (K-1s, high taxable yields, high turnover, etc.) and are generally designed to be longer term holdings (illiquid, lock-ups, no trading market, etc.).  So you allocate this portion of the portfolio to the IRA which avoids the tax issues and is itself designed as a long term holding vessel.

Shane’s wealth management and transfer planning indicate that a Roth conversion will be very beneficial and ultimately maximize his estate for his beneficiaries.  As you know, the fair market value (FMV) of the assets converted to the Roth IRA is taxable as ordinary income in the year of the conversion.  Luckily (or wisely), you allocated all of the alternative investments in Shane’s portfolio to his IRA.  Why is this lucky or wise?  As described above, alternative investments are typically illiquid, non-traded, minority interests.  When these features exist, there is generally a discount between net asset value (NAV) and FMV.  The tax reporting rules require FMV be used when reporting the value of an asset involved in a taxable transaction.

For example, Shane’s $1 million NAV portfolio of alternative assets may have a FMV for tax reporting of only $650,000 when adjusted by taking into account the fact that the holdings are illiquid, non-traded and so on.  The actual adjustment, if applicable, is determined by an appraisal.  Now consider the net result of the Roth conversion:

Hypothetical adjustment of 35%. Actual adjustment, if applicable, will vary. Assumes hypothetical combined state & federal income tax of 40%.

 By virtue of holding the alternative asset portion of the overall portfolio in the IRA and properly valuing said assets for tax reporting purposes, Shane saved $140,000 in tax on his Roth conversion.  Interestingly, this also dropped the effective tax rate on the transaction to only twenty-six percent when you compare the actual tax owed with the account NAV.

Back to the original assertion that alternative investment sponsors will cover your client’s advisory fees.  We already determined that Shane’s annual fee for his IRA is $10,000, and we just learned that he saved $140,000 in tax by owning alternative investments in his account.  Assuming no change in NAV, Shane just saved fourteen years of advisory fees in the form of tax mitigation.  Put another way, you just earned fourteen years of advisory fees in one transaction by properly allocating and valuing your client’s portfolio prior to a taxable event.  Note that while this example used a Roth conversion as the applicable event, the same type of result occurs when using alternative assets in many other taxable transactions including estate and gift tax planning arrangements.

While the alternative investment sponsors didn’t actually write a check to the RIA firm to cover the client’s advisory fees, it was the design of their products that provided the ultimate tax benefit.  Most firms use an asset allocation model that includes some alternative investments already.  Now you know how to use them to provide even more benefit and help pay your advisory fees…in a roundabout way.

Author: Joe Luby, CFP®

©2012 All Rights Reserved.

Waiter, There’s a REIT in my GRAT!

The next line in the old joke about a fly in the soup has the offended patron asking the waiter: “what is he doing in there?!”  To which the clever waiter replies: “it looks like the backstroke, sir.”  Please excuse my bad take off on the joke, however, some estate planners might react similarly upon the suggestion of a REIT in a GRAT.  That is, until they discover how much “flavor” this combination really has.

Non-traded REITs are popular and widely held alternative investments with billions of dollars flowing into them annually.  It’s an oxymoron to call a widely held asset “alternative,” but so it goes in the industry.  They are typically sold on the basis of portfolio diversification into commercial real estate and relatively high yields in the form of dividends.  It’s not uncommon to find non-traded REITs yielding between 5% – 7% even in the early stages.  But what do they have to do with GRATs?