In late 2008, the Federal Reserve took the unprecedented step of lowering interest rates to near zero. But when will this near-zero environment end? Your guess is as good as mine, but one thought is certain: rates remain at historically low levels. Some are calling for the Fed to raise interest rates this year, but even that estimate keeps changing. As we compare today’s rates to those of the past, it’s easy to see that rates today are way lower than they have been in the past. Some may see this as a problem. However, some may take advantage of this environment by locking in these low interest rates.
Look at the Bright Side
Over the past few years, we’ve heard a lot of bad news regarding the housing market. Bad news, however, breeds opportunity. Anyone able to get a home loan or refinance their existing loan would have been able to lock in rates at record levels (in some cases less than 3% for a 30-year mortgage). Those fortunate enough to have kept their job and to have also refinanced a loan have benefited from an increase in cash flow…in some cases saving a substantial amount of money. For example, lets look at a $220k loan initiated in 2004. At the time rates were around 6.5%. This year, one could have refinanced to a rate of 3.5%. Given some of the principal would have been payed down in those 9 years, one could have saved almost $500 per month. In some industries this is like the equivalent to a substantial pay raise. So look at the bright side, even though all this news seems to be negative.
Home Sweet Home
A key part of the financial planning process involves being cognizant of the estate tax. A large portion of the estate at death could be your home, and although you may be far from the time your estate goes through probate, removing this asset from your estate could save you and your family millions of dollars in estate tax expenses.
Let’s suppose we owned a two million dollar home and we did not plan correctly. In 20 years, this home may be worth around four million dollars, assuming the value of the home grows at 3.5% (which is near the annual inflation rate the US has experienced since 1914). If we were to pass away in 20 years, our heirs would inherit a four million dollar estate comprised of the home. After deducting the applicable estate tax exclusion amount, we would be left with a taxable estate of $500,000 (four million minus 3.5 million). The top estate tax rate is 45%, so this means our beneficiaries just inherited a home with a $225,000 tax bill. Since our beneficiaries will inherit our assets after the estate tax is settled, selling the home in order to pay the estate tax remains possible.
Suppose, on the other hand, we engaged in some good planning. We heard from our financial planner that the home can be a great asset to gift. A Qualified Personal Residence Trust (QPRT) can be set up to pass on a personal residence to future generations, without facing our previous estate tax issue. The way this works is that a title to a home can be placed in a trust for a specified term. This type of trust will freeze the home’s value and allow it to appreciate outside of the estate. Furthermore, the IRS allows a discount to be assessed on the home’s actuarial value. This means the value of the home when it is transferred to our heirs may be a lot higher than the calculated future value going into the trust, yet the gift tax will be assessed at the time the QPRT is set up, using the calculated future value.
At the end of the QPRT term, ownership of the home will be passed on to our heirs. We would then have to pay rent to our heirs, or put the transaction at risk. If we take the previous example, the actuarial value may be three million dollars (lower than our estimated future value). This value would fall below the 3.5 million dollar estate tax exclusion amount, saving our heirs $225,000 in estate tax and allowing us to shield an additional $500,000 from the estate tax.
There are some catches to the QPRT, however. If the home depreciates in value, we would be obligated to take the deduction as outlined in the QPRT. Furthermore, we need to outlive the life of the QPRT to see any of the benefits. For this reason, we may want to structure the QPRT with a shorter tenor. Last but not least, we are entering into an irrevocable agreement and are relinquishing control of our property when starting the trust.
The QPRT is just one of the many available financial planning tools that can help us pass more of our assets to our younger generations. Given the current financial storm, which has devalued real estate properties around the country, a little planning can go a long way.
In the Face of Uncertainty
The media is doing a great job of pointing out what is wrong with the financial industry. However, the present may represent a great financial planning opportunity.
Removing assets from the estate is one strategy of financial planning. The goal is to download the estate and allow family members to enjoy your property, leaving less of your possessions subject to the estate tax. Recent market conditions can provide the opportunity to download a larger portion of the estate without triggering a taxable event.
Cash flow is another consideration when looking at your financial plan. As mortgage rates fall, loans can be refinanced, freeing up cash or shortening the tenor of a loan. The average rate of a 30-year mortgage is currently below 6%, meaning payments on a $200,000 loan would be less than $1,200 per month.
Long-term stock performance represents a retirement planning opportunity. Even with the recent performance of stocks, an investor contributing to an investment plan regularly is able to buy more shares of a given company with the same contribution. Look at the bright side of investing in stocks for the long term (Franklin Templeton wrote a great article earlier this year supporting this claim). Using historical S&P 500 data, they calculated the return for 1-year, 5-year, 10-year and 20-year periods. The 1-year periods had a positive return 70.9% of the time, while the 5-year periods were positive 88% of the time. Do you see a pattern developing? Ten-year returns were up 95.7% of the time. For the 20-year holding periods, every one between 1929 and 2007 was positive. Even with the abysmal returns in the early 1930s, investors holding on to stock investments for 20 years were rewarded with a positive return.
It’s not all doom and gloom. Sometimes we need to shut off the television and exercise some financial planning. A few years from now, we’ll look back and realize there is a lot to be thankful for this holiday season.
Another Semester Down, One More To Go
The beginning of August marked the end my penultimate semester at Fordham Business School. Over the summer semester, I took three classes: Personal Branding, Financial Planning Case Studies and Marketing of Financial Services. Personal Branding was an exceptional class, taught by a Senior Partner at Ogilvy & Mather. It provided me with valuable perspective on succeeding in today’s workforce. In the Financial Planning Case Studies course, we examined real-life examples of people in need of financial advice. Our assignments consisted of preparing tailored recommendations. This course is meant to be taken toward the end of the Financial Planning curriculum and touches upon all the topics studied in the course work at Fordham. The Marketing of Financial Services was different from any class I’ve taken at Fordham. This class was administered online by the professor. This provides students with flexibility, even the lectures were posted online.
Next semester I look forward to learning about Real Estate Finance, Estate Planning and Leadership. The semester kicks off the first week of September.