GTH Estate Planning Blog

To refine his study of the wealthy a bit, Lars finds a sub-group within his 32, of the 11 with net worth in excess of $20 million. This still falls short of the league of the Carnegies and Rockefellers, but in Lars's town it's a bunch. Eight of the 11 are in real estate, an even higher ratio than in the larger group. The eight are evenly divided between commercial and residential success, and the four residential are equally split between single-family and multi-family. So maybe real estate is the thing, but there are different ways to do it.

How does leverage enter in? There are six of the 11 who made it in real estate without inheritance (more on the heirship thing in a minute). Lars eyes these six. All of them have borrowed a lot of money. It looks like leverage is critical. This might be a bit self-evident to some, but Lars wants to numbers-test a little. He figures: let's go back to our example of Cervantes and Panza. Panza has $1 million in cash and stocks and Cervantes the same value of equity in real estate.

Cervantes' $1 million consists of a $2 million property with a 5% mortgage for $1 million. Let's also assume each has an investment return of 7.5% per year (a little optimistic during these hard times, but not unreasonable for good investors over decades). Panza will gain $75,000 a year. Cervantes will have $150,000 of gain less $50,000 of interest expense, for an advance of $100,000.

Lars has stumbled upon a shortcut method for studying how the rich get rich. With 2012 being such a good year for making tax-saving gifts, he has early in the year made a list of 32 clients he'll follow up with specially. They are candidates for making large gifts and therefore rich people. It might not be a perfect sample for his new study, but it's a sample. He is Lars-type excited to test his real estate hypothesis, and learn other things. His initial tally is supportive: 17 of the 32 have mostly real estate.

Of the 17, he finds four especially interesting: a lawyer, a physician, and a two CPAs each of whom started out in those fields, began buying real estate, and used their professional incomes to feed it and keep buying more. Three of the four actually kept their hourly jobs for decades. Lars wonders: how do people have the energy to do this? He feels pretty consumed by his CPA practice and family life.

He sees that another 11 of the 32 have made their money on what he calls "business": things like banking, wholesaling, insurance, and employee stock options. A few of the 32 are just plain hard to characterize.

Nils is a rich guy, with a net worth of something like $20 million. Our CPA friend and Nils's nephew Lars is considerably less wealthy, but he has much more than the average person. Lars has many very wealthy clients. He's happy himself being less wealthy but quite comfortable, but he does find it interesting to think about how rich people get and stay rich. It's sort of part of his job to help people do this.

So he's started looking at his list of clients for clues. This is not done out of envy but of (mostly professional) curiosity. He realizes he has at least one preconception upon taking on this unscientific study. OK, let's make it sound a little more scholarly and say Lars has a hypothesis.

We have seen how rich Uncle Nils is likely to save estate taxes by taking advantage of the increased Federal gift tax exemption, and his State's (Washington's) failure to tax gifts at all. Those savings are projected at $200,000 on his $500,000 gift of cash and securities to a trust for relatives. He might have saved another $50,000 for his heirs by using a family investment partnership or LLC to make his gift.

Nils can create even more savings by qualifying his gift to the trust for the annual gift tax exclusion. Here's how that works. Under the law in effect in 2012, Nils has a $5 million lifetime exemption from gift tax. This means (assuming the law isn't changed before he uses it) that he may give up to $5 million to relatives before paying any Federal gift tax. In addition to the lifetime exemption there is an annual exclusion that allows him to give $13,000 per year per recipient before even using any of the lifetime exemption. The idea is that givers shouldn't have to report small gifts. But a bunch of relatively small gifts can amount to something significant, especially if repeated year after year. Particularly if the gifts accrue gain and income after they are made, there is a fairly miraculous effect similar to the miracle of compounding in the investment world.

Last week we saw that Nils's gift of $500,000 to a trust for relatives in 2012 was likely to yield about $200,000 in tax savings, by getting future gain and income out of his estate, and by avoiding State estate tax altogether. There is another potential benefit of current law that Nils did not take advantage of this time, having to do with the valuation of certain kinds of assets.

Let's say that instead of giving cash and securities, Nils had given a 25% interest in a $2 million investment partnership (or limited liability company) to the trust. Wouldn't this still be a $500,000 gift? The answer is pretty clearly no. Why? It has mostly to do with marketability and control.

If someone gives you $500,000 in cash and securities, you can sell them and go out and buy a half million dollar yacht. Great, huh? However, if you got a 25% interest in a $2 million investment partnership instead, it would be evidenced by a piece of paper certifying your ownership, that you could not use to buy that yacht. You'd have to sell the partnership interest, or persuade the other owners to liquidate the entity. However, most partnership agreements restrict the ability to sell to any but existing partners, who might not be buying. And your 25% wouldn't give you enough of a vote to force a liquidation. For these reasons your interest would likely remain illiquid, and worth something less than $500,000 in sale value. How much less? An expert would probably say about 30% less. So instead of a $500,000 yacht you'd have a piece of paper worth $350,000.