Rick Kahler's Financial Awakenings

Listen to Rick’s column here: Download setting_the_record_straight.mp3

When I read Bill Napoli’s editorial in the October 26 Rapid City Weekly News, I felt compelled to respond. My concern is not with the merits or problems of Amendment D, but with correcting his egregious factual errors regarding the use of LLCs and corporations as they pertain to the ownership of residential property under the current property tax system.

Mr. Napoli listed seven negative consequences of putting your personal residence in an LLC. None of them has anything to do with Amendment D. Additionally, none of them is true. He contends:

1. You would not qualify for the federal home mortgage interest deduction.

2. You would lose your 30% “owner occupied” property tax reduction.

3. You would lose your residential mil levy rate and end up with the higher commercial rate.

4. Your property would be rezoned from residential to commercial.

5. Properties currently owned by LLCs and corporations represent an extreme method of tax evasion by circumventing the current property tax system and are not paying their fair share.

6. Putting your property in an LLC would almost double your taxes.

7. The average commercial property sells only twice every 80 years (“in a lifetime”).

Let’s take a look at the facts:

1. According to Paul Thorstenson, an accountant with Ketel Thorstenson, a single-member LLC is able to fully deduct mortgage interest. In addition, there is nothing in the tax code that would indicate a personal residence placed in a two-member LLC will lose its mortgage interest deduction.

2. According to Rob Miller, Pennington County Director of Equalization, an owner-occupied house placed in an LLC will not lose its “owner occupied” property tax reduction.

3. Also according to Mr. Miller, a house owned by an LLC will not be taxed at the commercial or non-ag mil levy rate.

4. According to Dan Jennissen, Planning Director for Pennington County, “Ownership has no bearing on what the property is zoned.” Putting a residential property in an LLC will have no effect on its zoning.

5. According to Mr. Miller, properties currently owned by LLCs and corporations are taxed based on zoning, value, and use. The ownership of a property has absolutely nothing to do with the property taxes paid. In fact, commercial property, whether owned by an individual, LLC, or corporation, is taxed at the highest property tax rates.

6. Obviously, since all the above are false, putting your property in an LLC will not change your property tax bill one iota.

7. I don’t know where Mr. Napoli got his information that commercial properties are sold only "twice in a lifetime." Having sold commercial real estate in Rapid City for over 30 years, I can assure you that very few commercial properties sell that infrequently. As an example, the old First Federal Building, now Turnac Towers, has sold four times in 40 years.

There is one caveat to keep in mind if you decide to put your personal residence in a LLC. Make sure it is a single-member LLC so you will retain your Section 121 capital gains exclusion when you sell the house. “If the LLC is owned by one individual, the LLC entity is ignored by the IRS. If there are two or more members in the LLC, the exclusion will be lost,” says Thorstenson.

I also want to emphasize again the importance of consulting attorneys and accountants before you put either residential or commercial properties in LLCs. Decisions such as these need to be based on what is best in your particular situation. They also need to be based on accurate information. That is why I felt the need to set the record straight.

I can’t help but wonder why the new highs reached by the Dow Jones have been buried on the financial pages of my local newspaper. Granted, the Rapid City Journal is not the New York Times, but I clearly remember the late 1990′s when every hiccup of the Dow was reported on the front page.

The inattention given by the press to the resurgence of the bull market gives me confidence that this market probably has staying power. In my experience, when a financial story hits the front pages of newspapers or covers of magazines, its opposite is about to happen.

One case in point was the proclamation three years ago that the real estate bubble was about to explode in an ugly crash. What did we see? Three more years of significant price increases. And even now, real estate markets are flattening, rather than crashing.

My best guess is that the market is set to go higher, until the popular press takes notice.  Then, the majority of investors, who have a nasty tendency to buy high and sell low, will climb on board….once again, exactly at the wrong time.

Here is some information I received today from Forefield, Inc. on changes in taxation to private annuities.

"A private annuity is an unsecured promise to make periodic payments for a specified length of time in return for cash or property. Individuals who exchange appreciated property (such as a business, a piece of real estate, or an investment portfolio) for a private annuity have been allowed to defer the recognition of capital gains. Effectively, rather than recognizing capital gain and paying the resulting capital gains tax at the time of the exchange, individuals have been able to spread out the capital gain and resulting tax over the life of the annuity. The IRS has suggested that private annuities have been used inappropriately to avoid federal income tax, pointing out that mechanisms have been put in place to secure the payment of amounts due under the annuity contract.

The Treasury Department and the IRS have issued proposed regulations that would significantly change the way the exchange of appreciated property for a private annuity is taxed. The proposed regulations are not restricted to those perceived to have used private annuities inappropriately; they will affect any client considering a private annuity.

The proposed regulations would put the transferor in the same position that he or she would have been in if the property transferred was sold for cash and the cash was used to purchase the annuity. The entire amount of any gain or loss must be recognized at the time of the exchange. This makes the tax rules consistent with those that currently apply to commercial annuities. The proposed regulations do not apply to exchanges of annuity contracts under Section 1035, or to charitable gift annuities.

Effective date: The proposed regulations will generally be effective for exchanges made after October 18, 2006. The regulations would not be effective for annuity payments received after October 18, 2006 under an exchange made prior to that date. The effective date is April 18, 2007 for exchanges that meet certain conditions (in general, where the exchange involves an unsecured annuity contract issued by an individual, and the property that is exchanged is not sold or disposed of for a two year period)."

This article came from:

Forefield Inc.
33 Boston Post Road W
Suite 190
Marlboro, MA 01752
tel: 508-630-1100
fax: 508-630-1164

Rick and co-author Ted Klontz were guests today of Olivia Mellon on her radio talk show that airs weekly on WWDB-AM 860 in Philedelphia.   Olivia is a therapist who may be considered the grandmother of financial therapy, having written six or more books on the topic of emotions and money, which include Overcoming Overspending, Money Harmony, and Money Psychology.  I first heard Olivia speak at the 1995 ICFP retreat in San Diego along with Jacob Needleman.  That was the start of my journey to integrated financial planning.  However, let me stress, that Olivia doesn’t look old enough to be a grandmother of anything! 

This interview gives a look into the work that Rick and Ted have pioneered around uncovering hidden beliefs about money and how their book, The Financial Wisdom of Ebeneezer Scrooge, came into being.  Click here to listen to the interview: Download 0610interview_with_olivia_mellon.mp3

LIsten to Rick’s column here: Download asset_protection.mp3

Among the responses to my recent columns about creating LLCs to own real estate was one from an elected official who was critical of the strategy. The accusation was that LLCs and corporations are not even "paying their fair share" under the present property tax system; he implied that making use of them was somehow not ethical.

None of the lawmakers, attorneys, and government officials I’ve talked with could come up with any scenario to fit this assertion of unfairness. In fact, the evidence would suggest the opposite. Corporations and LLCs typically own commercially classified property and pay the highest possible property taxes.

Such an unsupported assumption is tied to the broader issue of asset protection, which some people regard with suspicion. They seem to believe asset protection is sleazy at best and outright fraud at worst. They assume it means hiding assets in the Cayman Islands or in secret Swiss bank accounts.

Certainly, there are people who do exactly that, despite the fact that it is illegal and immoral as well as unethical. There are people who rob banks, too. Most of them end up in the same place—jail.

Anyone who suggests such strategies as fraudulently transferring assets or failing to pay taxes you owe is asking you to compromise your own integrity. Avoiding financial responsibility, including responsibility for your mistakes, is a clear misuse of asset protection. It is also, in many cases, illegal.

For legitimate financial advisors, asset protection is defensive, not offensive. In today’s world, with the increasing mindset that “somebody must be to blame,” anyone who owns a business or has significant net worth is vulnerable to a frivolous lawsuit. In addition, there are attorneys so lacking in integrity that they make a living filing lawsuits with little or no merit just because the defendant has “deep pockets.” They know someone is likely to write them a check rather than go through the expense and hassle of defending against the suit. Asset protection is intended to protect you from such lawsuits by making your “deep pockets” less obvious to the general public.

Another legitimate use for asset protection strategies is to reduce taxes or to mitigate the impact of ill-conceived laws. To some, this may seem unfair. In a way, perhaps, it is. A wealthier person with easy access to accountants and attorneys can take advantage of complicated strategies much more readily than a poorer person can.

A wealthier person can also travel in first class instead of coach, pay the tuition to send the kids to Harvard, and take advantage of many other benefits that go along with having money. This is "unfair" in the same way it is unfair that a young man who is six foot eleven is more likely to get a basketball scholarship than one who is five foot seven. There are vast differences in people’s circumstances, abilities, and luck of the draw. It is absurd to suggest that those who can use circumstances in their favor shouldn’t do so, just because others aren’t able to do the same.

As a financial planner, one of the things I get excited about is asset protection. It is a way to use my training and skills to save my clients money or help make their futures more secure.

I also enjoy teaching about asset protection. That includes educating those who aren’t wealthy about basic strategies such as buying appropriate insurance, setting up a small business wisely, or keeping savings in a more protected financial institution. Whether you are wealthy or are just starting out, knowing how to protect what you have is part of building prosperity and security.

Listen to Rick’s column by clicking here: Download amendment_d_part_2.mp3

In last week’s column I talked about using LLCs to mitigate the impact of Amendment D if it should pass. Now it’s time to get more specific about that strategy.

Since Amendment D would provide that property is reassessed when it is sold, the basis of this strategy is never to sell the property. Instead, you form a limited liability company and deed the property to that LLC. Then, instead of selling the property, you sell the LLC, which remains the owner of record of the property.

As I said last week, this doesn’t give you a direct tax advantage. What it does is position your property to potentially have added value when you sell it, because the buyer would have a significant tax advantage.

If you choose to use this approach, I do recommend consulting an attorney and an accountant to make sure you don’t affect your estate plan or create adverse tax consequences. Also, it probably is important to set up the LLC before the election, which doesn’t allow much time to get everything taken care of. If that’s a problem, you could go to the website of the South Dakota Secretary of State (www.sdsos.gov). There you can find forms to set up an LLC. Once you have the basic setup, you can consult an attorney and accountant and make any necessary changes to the company.

Don’t forget to execute and record a deed transferring the property to the LLC. It’s also important to have a separate LLC for each piece of property. Otherwise you can’t transfer an individual piece of property, but the LLC would have to sell it.

I’ve discussed this approach with several attorneys and lawmakers, who agreed that it would be workable. It is certainly possible, even probable, that the Legislature will attempt to eliminate this strategy in the future. It isn’t clear just how they might do so.

It’s also possible that Amendment D, if it passes, won’t be around forever. The current "150%" provision has been in effect for several years, and problems with it are just now starting to become evident. The same is likely to happen with Amendment D. It also might be challenged on Constitutional grounds, as my reading of the South Dakota Constitution is that it requires property tax to be "fair and equal."

Even if the amendment is questioned, however, it would be in force for at least a few years. A Constitutional challenge would take time. Also, since this is a Constitutional amendment, if it caused problems it could not simply be repealed by the Legislature. It would have to be changed by a vote of the people of South Dakota.

For those reasons, it makes sense to think now about strategies to manage your property should Amendment D become law.

One or two supporters of Amendment D have criticized using LLCs in this way, even implying that such an approach is somehow unfair or abusing the system. Yet, ironically, the goal of this strategy and the goal of Amendment D are essentially the same: paying less in property taxes. It’s hard to see how this can be considered "unfair," since corporations and LLCs that own real property are taxed at the same rates as individuals.

Using strategies like these to reduce taxes is really no different from claiming all the exemptions and credits to which you are entitled when you file your income tax returns. Taking advantage of a legitimate opportunity to minimize taxes is certainly an appropriate and valid approach, especially when that opportunity is available to almost any property owner.

Today’s Rapid City Journal ran a front page story, by Dan Daly, on my last tele-class where I suggested that SD property owners put their real estate into LLC’s as a way to combat proposed Amendment D.  In the article, Sen. Bill Napoli, a strong proponent of the Amendment, discloses that he was aware of the LLC "loophole" and vows to plug it with legislation, whether or not Amendment D passes.

I am having a hard time understanding exactly what the existing "loophole" is. Right now, property owned by an LLC is reassessed just as frequently as any other property, so I am a bit in the dark regarding what he was referring to.

My guess is that if–and that is a big "if"–Amendment D passes and legislators can agree on a "fix," it won’t be a simple one. As with almost every piece of legislation, there will be more unintended consequences that lawmakers will have to deal with.

Whether you are for or against Amendment D isn’t the issue, although I do believe it will increase inequality in the property tax system. If you own property, putting it in an LLC may be a very prudent move if Amendment D passes.

A copy of the teleclass is available to KFG clients at www.kahlerfinancial.com.

Listen to Rick’s article here: Download amendment_d_part_1.mp3

One of the issues South Dakota voters will be asked to decide this November is Constitutional Amendment D, the latest attempt to reform our property tax system. It would base the assessed value on the purchase price of a piece of property rather than the comparative values of similar properties.

If county officials had the resources to keep up with the market by assessing all property every year, assessed values would increase gradually. Instead, many properties are reassessed every few years. If neighboring properties have sold for significantly higher prices during that time, the assessed value of a property might increase dramatically. This is especially true for commercial property in an area of new development. Attempting to avoid such unpleasant surprises is the driving force behind Amendment D.

Amendment D would roll back current assessed valuations to the 2003 valuation, then cap the annual increase in those values at three percent. It’s important to note that this is a cap on your property’s assessed value, not a cap on property taxes.

Then, beginning January 1, 2007, the assessed value would be set according to the purchase price whenever a piece of property is sold. The assessed value also "may be further adjusted if there is a change in use or classification or to account for any addition, improvement, or destruction to the property."

To illustrate, let’s take two virtually identical houses in a fast-growing area. In 2003, they were each assessed at $100,000, which we will assume to be 80% of their market value. Under Amendment D, that assessment can only increase by three percent each year. By 2017, each of them would be assessed at just over $152,000.

Now, let’s assume that property values increase at 7.5% annually, which is the historical average for Rapid City. The 2017 market value of each house would be $350,000. If one property sells, its new owner would pay taxes over twice as high as those paid by the owner of the property that had not been sold.

The bottom line is this: Amendment D will reward owners who don’t sell their property. You would enhance the value of your property to a future buyer, then, if you could transfer it without selling it.

There is a way you can do exactly that. If the property is owned, not by you, but by a separate legal entity owned by you, what you sell is your ownership of that entity. The legal ownership of the property does not change.

The best vehicle for this would be an LLC, or limited liability company. An LLC has many of the same features and protection as a corporation, as well as the pass-through features of a partnership. If each piece of real estate is owned by a separate LLC, you could sell your shares in that LLC to someone who wanted that property.

The disadvantages of this plan would be the costs to set up LLCs, plus the need to file separate tax returns for each one. The advantage would not be lower property taxes for you, but lower property taxes for a future buyer. There is a real possibility that this would enhance the value of your property whenever you decided to sell it.

In the example above, let’s assume the taxes on the home that was sold increased by $3000 a year. If that property had been in an LLC so the taxes stayed the same, how much of a premium would a buyer pay to save $3,000 a year? My guess is somewhere between $3,000 and $30,000. That’s a significant gain for the seller.

In next week’s column, I’ll discuss this strategy in more detail.