Money is an esoteric object. Most people are content holding it, clinging to dollars as if they will inevitably be lost like a toddler outside of its playpen.
Some more daring individuals cautiously let those dollars wander just down the block into an investment account, going to work but still quickly within reach. Then there is a select group of wealthy people who seem to despise holding cash.
Real estate is the third largest creator of wealth among the ultrarich, responsible for 163 billionaires (like our president).
Such investors obsess over getting multiple uses of the dollar, using the same funds over and over into project after project. They don’t see a dollar being worth a dollar, but rather a dollar that can hypertrophy into a fortune with repeated exercise. Investing in real estate can be a prosperous endeavor, but not one without risks.
The bulk of these financial perils stem from the double-edged sword of leverage and illiquidity.
There are a multitude of threats which can seize property investors favorite asset. Creditors are quick to identify real estate because of its tangibility and value, making it an easy target for creditor claims. Healthcare costs are at the forefront of everyone’s mind these days, and real estate investors must be ready for costs of care like anyone else. The unfortunate loss of a breadwinner can send an investor’s family into a downward spiral even with well laid plans. An investment partners’ death or disability can suddenly force the surviving members to handle multiple responsibilities, financial and otherwise. Then there is the unexpected downturn in the economy.
Last, but not least, Uncle Sam impatiently waits for his stake. The Tax Policy Center estimates that in 2017 there will be 5,500 Federal Estate Tax Returns subject to tax. Considering that an estate does not get taxed until it exceeds the $5.49 million exemption, that means there’s a lot of super rich Americans transferring wealth each year. Tax Payer Relief Act of 2012 allows for “Portability”- the use of a deceased spouse’s estate tax exclusion, making the effective combined exemption for married couples nearly $11 million. Even though this tax will only hit 1 out of every 487 American decedents this year, it should generate $19.9 billion of tax revenue to the U.S. Treasury. Almost all of these returns will possess real estate.
The panacea to any financial problem is typically cash. But the Donald Trumps of the world don’t just horde dollars waiting for a rainy day. So, how does one eat their cake and not get poisoned by it too?
For ages one of the most popular methods of replenishing lost wealth has been life insurance, particularly Whole Life Insurance. Whole Life typically allows an individual to buy a guaranteed and growing death benefit. The leverage is exaggerated even further via the unique income tax-free treatment afforded to life insurance by our tax code, which can also be estate tax-free if set up correctly.
Real estate investors have many needs for permanent life insurance. It can serve as the vehicle to cover estate taxes and probate costs for a wealthy family. It’s often the funding mechanism for a buy-sell agreement amongst multiple investment partners; should one pass away his/her surviving spouse’s shares can swiftly be bought out by the life insurance proceeds. The cash values can become a side fund for business operations. Life insurance creates an influx of capital when needed most by a family or business, and creates a multiplying effect of current day assets for legacy purposes.
Real estate investors know they need it, but these masters of leverage often hit a liquidity obstacle in affording big premiums. For instance, a $10 million Whole Life policy for a healthy 55 year-old male can easily cost $400k annually. So what’s the answer? Premium financing has become a prevalent strategy for real estate investors to purchase very large amounts of life insurance in situations which cash flow is limited or restricted.
As we’ll see, real estate Investors make ideal candidates for premium financing. The target market typically includes business owners who can’t touch working capital without disrupting operations, investors who may have assets that have experienced a down market who can’t bear the thought of selling at a loss, individuals with established gifting programs that large premiums could interfere with, clients with assets whose liquidation could trigger large capital gains or people with appreciating assets who would rather maintain ownership until death to utilize step up in basis rules under section 1014 of the tax code.
So how does one go about securing a legacy for generations using premium financing to purchase their Whole Life Insurance policy? Here’s a quick overview…
- Have an attorney draft an ILIT (Irrevocable Life Insurance Trust). This will ensure the policy is held out of your estate, eliminating potential estate taxes, and providing detailed instruction for disposition of assets after your demise.
- Identify a lender. Usually the lender will be fronting 100% of the annual premium for a term of 1-10 years. On high six-figure premiums, lenders like to see creditworthy customers with net worth well over $3-5 million.
- Have the trustee of the ILIT obtain Whole Life Insurance policy, policies with a focus on high early cash values can be extremely helpful. The importance of having a good credit history and dividend track record of the insurance company cannot be overstated enough. Close the loan with the lender.
- Lender pays the carrier the premium directly. A collateral assignment is placed on the policy to help secure the loan.
- The client can gift cash to the ILIT to pay loan interest (the interest rate is tied to LIBOR and can be variable and sometimes locked), fund additional premiums, or add more required collateral capital.
- Client creates an exit/rollout strategy through GRAT (Grantor Retained Annuity Trust), sinking fund or similar strategy that coincides with the with expected loan termination date. Other exit strategies include a “planned event” such as the sale of business, sale of a property, inheritance, or even the use of some of the Whole Life policy’s cash surrender value.
- The exit strategy pays off the loan.
- Upon the insured’s death, the net proceeds are received by the ILIT and paid out accordingly.
The result of this plan is the acquisition of a significant permanent life insurance policy with the out-of-pocket costs (loan interest payments) of a similar face amount term policy.
Clients are often advised to use Whole Life Insurance because the dividends from mutual carriers are closely correlated to prevailing interest rates. The rising cash value helps to mitigate the interest-rate risk associated with a variable premium finance loan.
Once interest-rate risk is planned for, the main hazard left with this strategy is the loan termination/exit strategy. Just as a business owner with no succession plan leaves his/her retirement in jeopardy, so does the recipient of premium financing without an exit strategy.
Purchasing life insurance using premium financing is not for everyone; frankly it’s not for most. But for the high net worth individual shying away from large annual premiums, this may be an option worth further exploration.
(As originially published in NJBiz)
Bryan Kuderna is a Certified Financial Planner™, Life Underwriter Training Council Fellow, and Investment Adviser Representative with Kuderna Financial Team.
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