[marotta]

Build with Bricks, not Straw or Sticks (2005-09-05)

by David John Marotta

We usually recommend only putting money in investments where there is a public market for pricing and trading. Requiring public pricing and trading for your investments will help you avoid some of the financial mistakes that can leave your financial house in ruins. The exceptions to this rule are few.

We’ve seen many examples of the dangers of investing in the absence of a public market. Private placement can be used to meet specific estate and tax goals, but don’t buy privately traded shares unless they are part of a comprehensive financial plan. The dangers of investing in something that doesn’t have a public market can be easily illustrated with a few examples.

<b>Bricks</b>

Your own home and your own business are solid additions to your portfolio. Like the wise little pig who built with bricks, these investments pay the solid dividends of a place to live and a place to work. These investments are also under your control, and you have the ability and the markets to get a fair price for them.

Houses are best built out of bricks. Sticks and straw have their appropriate uses, but they should not be used to build the bulk of your financial house. If you do, and the winds of reality blow, you may find you bought something you didn’t expect.

<b>Sticks</b>

Some real estate ventures are sold as tax reduction investments. They may be good tax dodges, but they aren’t good investments. Suppose you put $100,000 into a limited partnership and take $200,000 worth of losses over the next decade. Then, after the tenth year the company begins to turn around and generates $50,000 in taxable profit – profit you must report, but in reality will never see. Thus it is called “phantom profit”.

Now, you must either pay tax on the company’s profit that you did not receive or get rid of your shares. Because of 10 years of depreciation, your shares now have a negative cost basis of $100,000. Even if you give your shares away, you must pay $15,000 (15%) in capital gains taxes. There is no public market in the company, but the general manager of the property will take your shares off your hands for $20,000. (Remember, this is the guy you entrusted with $100,000 ten years earlier.) But to avoid paying income tax on the phantom income of $50,000 you give up your $100,000 investment for $20,000. You invested $100,000 and ended up with just $5,000 for a $95,000 loss.

In this case, your original investment purchased a decade of income tax losses totaling $200,000 and just enough cash to pay a large capital gains tax at the end. You probably made money from the tax write offs, but it may not have ended up being the investment you thought it was.

Real estate deals are usually built with a legal and corporate structure that benefits the general partners, not the average shareholder. The general partners use the structure to build equity so that when they die their families will inherit the investment at a stepped up cost basis. In other words, the partners use it as their tax savvy means of passing an estate to their heirs. Moving forward to the next generation, when the heirs sell the investment they do not have to pay capital gains because they have received a stepped up cost basis. But if you sell your shares, you will have to pay significant capital gains.

This is not a good investment with which to build your financial house. You will not be able to use this type of investment to fund your retirement. This type of investments is illiquid. The general partners set the rules that determine if you can sell your shares, who you can sell them to, and how much you can sell them for. Since your interests may not be the same as those in control of the partnership, the risks can exceed the rewards.

<b>Straw</b>

Other real estate ventures look great later on, until you weight the opportunity costs. In our second case, imagine purchasing shares in a real estate investment for $60,000. During the early years of the company, you receive no dividends and sales are not allowed. Two decades later, the partners allow you to sell your investment at about the same price as it was purchased, but by now your investment is paying a $6,000 dividend each year. It looks like you have a great investment. It is finally paying a 10% dividend! You might think you got a good deal. You did not.

After two decades, your investment should have doubled, doubled again, and been on the way to doubling a third time. At an 8% rate of return for 20 years, your $60,000 investment should be worth $279,600. Therefore the $6,000 dividends aren’t really 10%, but 2%. By keeping the declared share price low for 20 years, you are lead to believe that your investment has been good.

<b>Publicly Traded Market</b>

Perhaps 90% of wealth management is avoiding the financial products and mistakes that surround us and compete for our attention. Diversification of your portfolio doesn't have to mean lots of very different types of investments (biotech research firms, private bank placements, oil exploration ventures, etc.). Focusing your investments on those with the best risk adjusted return is the safest way to meet your goals.

We try to encourage our clients to determine what their financial goals are, and then work to determine what investments would best ensure the success of that financial goal. The temptation to put a little money in everything that is offered is very alluring, but very unwise. It is the reason why most of the suddenly rich don't have half their assets liquid in ten years. There are many things riskier than volatility (i.e. the immediate loss of your principal by purchasing something you can't sell.)

It is critical to be able to get your money out when an investment no longer helps you meet your financial goals. Requiring that your investments be publicly priced and traded is an important way to ensure that.



from http://www.emarotta.com/article.php?ID=143