debits and credits
Enjoy the Ride
by Rick Hillsbery and Craig Schmitt
When the general economy is suffering, the real-estate market is down and the stock market is falling on a daily basis, it can try the patience of any investor. However, difficult market conditions sometimes provide smart investors with potentially rewarding investment opportunities. We will explore how to handle this difficult investment market and also explore a solution for a real-estate
owner with a large net worth composed of illiquid real estate.
When financial markets are sluggish, keep in mind these five basic investing tips.
1. Stay the Course
If falling prices are causing you to think about selling some of your investments, think twice. There are, of course, good reasons why you might want to sell certain investments—if, for example, you’ve identified better potential elsewhere or you want to realize capital losses to offset capital gains. This situation can be particularly difficult in today’s climate, when both the financial markets and real-estate markets are under such tremendous pricing pressures.
But if you’re selling only because you’re worried about prices falling even further, it’s usually a bad move. When you liquidate otherwise good assets in decline, you lock in losses with no hope of recovery. Assuming your investment time horizon is long enough to wait out a downturn, take comfort in the fact that, despite considerable short-term volatility, markets historically rise over the long term. If your time horizon is relatively short, however, make sure you work closely with your wealth manager or investment advisor to determine the best portfolio mix for your age and risk tolerance.
2. Use Panic to Identify Buying Opportunities
As the famous investor Warren Buffet recently wrote: “Be fearful when others are greedy, and be greedy when others are fearful.” When the overall market drops, it takes many different kinds of stocks with it. Sometimes the reasons behind an individual stock’s price drop are rational, such as weaker earnings, management troubles or a worsened outlook for the future. But at other times, a stock may fall even when its underlying business remains solid. This can be an opportunity for attentive investors to buy shares of quality companies at a significant discount. If you’re right about a firm’s long-term prospects, you have the opportunity to buy in at lower prices, thereby magnifying your potential
for future gains.
A similar perspective is advisable for real estate. Consider your investments in segments. Assets in those segments that have held up well could be sold to provide liquidity for taking advantage of opportunities in housing segments that have been hit harder, but which are still capable of rebounding.
3. Diversify, Diversify, Diversify
One way to reduce your portfolio’s vulnerability in a weak market is to make sure it’s diversified across a variety of asset classes. This means not only being diversified among stocks, bonds and money market funds, but also within each of these groups. This would also be a well-considered perspective for your real-estate holdings. For example, on the equity side, a combination of growth and value stocks, domestic and international companies, and large- and small-cap companies can reduce your risk. On the fixed-income side, a well-balanced portfolio should include both lower-risk/return and higher-risk/return securities and bonds spread over a variety of maturities. In real estate, look not only at the type of your holdings, but their locations, their conditions and their viability in the market place.
The goal of diversification is to own some investments that can be expected to outperform while others are underperforming. These diverse asset classes can reduce your portfolio’s overall volatility and minimize the negative impact of a market downturn on its value. However, in very difficult markets like we are experiencing now, there is often no place to hide as even noncorrelated assets can devalue in concert.
4. Provide Options for Liquidity
Consider the scenario where a person has worked hard for a lifetime to get to the point of owning and managing apartment buildings, which have grown into a sizeable portfolio to leave to the next generation. Assume in this scenario that the portfolio was worth $15 million dollars at the height of the market a couple years ago, and is worth only $11 million dollars now. If the investor is single and happens to pass away in 2009, when the estate tax exemption is $3.5 million, there would be an estate tax of $3,375,000 due.
Wouldn’t it be unfortunate if there weren’t sufficient liquid assets to pay the estate tax? Our investor’s heirs would be forced to sell the property in a buyer’s market for much less than could be negotiated if there was time on the heirs’ side and they were not forced into a sale. Life insurance can be used as a tool to prevent a fire sale from happening.
Life insurance provides peace of mind that your loved ones will be provided for, even if the unthinkable happens to you. The two main categories of life insurance, term and permanent, both have important uses.
With term insurance, you make regular premium payments in exchange for a set sum that will be paid to your designated beneficiaries if you die during the policy’s term. You select the term, which can range from 1 to 30 years, depending on when you buy the policy.
Permanent insurance, by contrast, doesn’t expire as long as you continue to pay premiums on time. In most cases, the premium remains constant. Accordingly, premiums are usually more expensive than term insurance for younger policyholders. On the other hand, older individuals who have owned permanent insurance policies for a long time will generally find permanent insurance to be more cost effective than equivalent term coverage. Therefore, permanent insurance is usually the right choice for estate planning.
Generally, permanent insurance policies include two parts. An insurance part provides a minimum death benefit to your loved ones. An investment part has a cash value, which grows at a predetermined fixed rate, tax-deferred. This cash can be withdrawn or borrowed in certain situations.
Permanent insurance might also benefit older individuals because they can tap into the policy’s cash value to pay the premiums. And it can be a good choice for those who want the comfort of insurance that remains with them for the rest of their lives; they won’t have to worry about losing their coverage due to health problems. (Payment is mostly dependent upon the claims-paying ability
of the issuer.)
There are other estate planning strategies with little risk and potentially high rewards, regardless of what ultimately happens with the estate tax. Perhaps foremost among them is an irrevocable life insurance trust (ILIT).
When an ILIT is the owner and beneficiary of your life insurance policy, the policy escapes tax in the estates of both you and your spouse. A spouse may have the right to income and principal distributions during his or her lifetime, or the insurance policy may be of the “second to die” variety, where policy proceeds are paid only on the surviving spouse’s death.
In either case, the trust assets—typically the policy proceeds plus income earned subsequently—will not be subject to estate tax in either estate without using up the estate tax exemption, leaving it available to be applied against other assets of your estate.
An ILIT’s risk is low because typically the amount of the gift to the trust, the annual insurance premiums, will fall within the annual gift tax exclusion of $12,000 (increasing to $13,000 in 2009) per year per beneficiary (double the exclusion if you and your spouse both make the gift). Meanwhile, the policy proceeds are removed from your estate regardless of when they’re paid.
It’s important not to let your estate planning become paralyzed by uncertainty in the estate tax law. Planning strategies such as the ILIT can result in substantial tax savings without much, if any, risk.
5. Establish or Revisit Your Overall Financial Plan
This final tip applies to all types of market environments: work closely with your wealth manager to assess your portfolio’s health and make any needed changes to your investment mix. Ask how you can best position your portfolio to perform steadily in both favorable and unfavorable market conditions. Have your wealth manager review your current estate plan and life insurance policies to identify opportunities to provide additional overall value to your estate. A good wealth manager should have experience and knowledge in financial planning, investment management, insurance planning, tax planning and estate planning, with the goal of working with you to meet your financial goals.
The opinions expressed in this article are those of the author, and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Rick Hillsbery is a CPA, CFP and a manager in the wealth management practice in the San Jose office of Burr, Pilger, & Mayer LLP. Craig Schmitt is a CPA and senior tax manager in the San Francisco office of Burr, Pilger, & Mayer, LLP. Both can be contacted at 415-421-5757. Copyright © 2009 by Black Point Press. All rights reserved.