The Transfer on Death Deed – the most powerful tool in estate planning

 

By Daniel Harris, RIA, Wednesday April 27, 2016

 

The primary reason most people are convinced to get living trusts is to transfer their real estate to their kids while avoiding probate fees.  The statutory attorney’s fees for probate in California are:

 

4% of the first $100,000, plus

3% of the next $100,000, plus

2% of the next $800,000, plus

1% of the next $9,000,000

 

If you and your spouse both die without a transfer on death deed or a living trust you will absolutely pay these fees to transfer your property to your kids. 

 

According to Zillow, the median home price in San Diego currently is $536,000.  So if they have no estate plan and the second spouse dies, the median homeowner will pay a probate commission of $13,720 to the attorneys to transfer their home to their kids. 

 

The fee is based on the market value of your home at your date of death – it doesn’t matter how much equity you have in the home or how much you paid for the home.  So a $536k house where you just put 20% down on and then passed away, will be treated as $536k asset for probate fees even though you only actually own $107k of that house.

 

The good news is that $13,720 “tip” to the estate attorneys and the county probate court is completely optional – you don’t have to pay it so long as you are preemptive and set up a transfer on death deed in advance (a $35 1-2 page document filed with the county).

 

The best way to do this in my view is simply the transfer on death deed.  This document can be gotten from the county law library or online and all you do is you copy the description of your property on your current deed and list your beneficiaries by name, sign it and get it notarized and record it with the county. 

 

I recommend that you have your lawyer check your transfer on death deed for accuracy the first time just to be careful – but I doubt it will take a lawyer more than 15 minutes to check each transfer on death deed (each individual on your house’s deed needs to have their own transfer on death deed filed with the county).

 

A Transfer on Death Deed lacks the major downsides of a living trust: 1) the requirement to file trust tax forms each year and pay higher than normal taxes on trust assets after your spouse dies and 2) splitting your interest in your house with your kids during your lifetime (a bad idea).  The Transfer on Death Deed only takes effect when the second parent dies and so the kids get an immediate interest in the house upon the second parent’s death but not before it.  Like a living trust, it avoids probate fees and the house or any other piece of real estate transfers to your kids quickly outside of the probate process and without involving the courts.

 

Why haven’t I heard of a transfer on death deed before?

 

First of all, transfer on death deeds are standard in the majority of states and have been used with very little to no litigation since they were first adopted in Missouri in 1989.  They were such a good idea that 27 states copied Missouri, with California being the last one having made transfer on death deeds legal starting January 1st of this year.  The instrument is well tested in the law and is widely accepted across the country.

 

How the Transfer on Death Deed Works

 

When the first spouse dies nothing happens with their transfer on death deed.  The property automatically goes to the surviving spouse because the house is held either in joint tenancy with rights of survivorship or community property.  This ownership structure takes precedence over the transfer on death deed – so the transfer on death deed of the first spouse to die is pretty much ignored.

 

When the second spouse dies their transfer on death deed governs.  The asset transfers automatically in equal portions to all the listed beneficiaries on the deed.  This means that the real estate transfer happens outside of probate, and therefore is not subject to the $13,200 in probate fees most homeowners would otherwise pay. 

Although it depends on each case – the property should be transferred to the children within a few months after the second parent dies.

 

Is this a complicated legal document?  No.  What does it look like?

 

Here is a copy of the 1 page Transfer on Death Deed that you would file with Santa Barbara County that I found online.  The ones I’ve used for clients in other counties look basically the same. 

 

http://www.sbcounty.gov/arc/_pdf/Revocable_Transfer_on_Death_Deed.pdf

 

As you can see, it’s a simple one-page form.  On the form you:

1)  Copy your property description from your current deed

2)  List your beneficiaries and you relationship to them.  An example would be: “John Smith, my son, and Jane Smith, my daughter”.

3)  You sign it in front of a notary, you have them to notarize it, and then you file it with the county recorder within 60 days of having signed it.  That’s it – you just saved yourself $13k in probate commissions with probably 30 minutes of work.

4) (Optional) – You can give it to your attorney to review along with your current deed to get a second opinion on accuracy.  Plenty of estate attorneys will do this; don’t let your attorney talk you out of it unless they have a really good family planning reason to use a trust instead of a transfer on death deed.

 

 

What are the benefits of the transfer on deed trust and why is it so powerful?

 

1)  Unlike living trusts that get locked in before you know what the tax or estate laws will be at your death, there are no known potential adverse tax consequences of a transfer on death deed

2)  Unlike a living trust, a transfer on death deed maintains maximum flexibility as only the second spouse to die’s transfer on death deed is implemented.  These deeds are fully revocable if you go through the proper procedure and record the revocation.  In contrast, trusts are irrevocable after the first spouse dies even if the trust structure becomes massively tax and legally disadvantageous – you're stuck with it.

3)  They are much less expensive than a living trust in terms of setting them up and transferring property. Looking at the current fee structure I think it will cost you about $25 to file each deed with the county and $10 for the notary to notarize your document.  So for a married couple owning a house jointly – this procedure can be done for $70 total.  Living Trusts if done by a lawyer are $800 to $3,500 in a lot of cases.  

    Additionally, with living trusts, you should expect to have ongoing costs like $200 a year extra in trust tax return preparation fees each year after the first spouse dies but before the second spouse dies.  Unlike living trusts, there are no expected ongoing costs to a Transfer on Death Deed.

 

What are the situations where a Transfer on Death Deed is not the best way to transfer property?

 

The Transfer on Death Deed is a standard legal instrument and while it works for the vast majority of parental wishes it won’t work in the following three situations:

 

1)  You want to keep your beneficiaries names private and don’t want it to be known that they are the beneficiaries of your home

2)  You don’t want to give to your beneficiaries equal interests in your home (the transfer on death deed can have multiple beneficiaries but they must receive equal interests)

3)  Your beneficiaries couldn’t own the home together even for a short time.  For example, if your two kids John and Jane are your beneficiaries when you died John will own 50% of the house and Jane will own 50% of this house.  They’ll have to work together to either keep it or sell it.

 

If I don’t want to do the Transfer on Death Deed what alternatives do we have

 

The Living Trust is the main alternative to the Transfer on Death Deed.  The downside of living trusts is that they often become massively tax inefficient and legally inefficient because the laws change each year but the trust rules are locked in at the first spouse’s death.  So you can really be hurt by a living trust for this reason.

 

With that said, a living trust can do all kinds of complex things that a Transfer on Death Deed can’t do and in general its more private. 

 

We can talk about your options and help set you up with an attorney who can carry out the Transfer on Death Deed of the Living Trust on your behalf in order to save you that $13k in probate fees.

 

 

 

 

What not to do in your estate plan

 

By Daniel Harris, RIA, Sunday April 24, 2016

 

Right off the bat I’m going to lay out my views on estate planning after looking at these issues closely, evaluating the evidence and talking to practitioners in the field.  There is no way around it -- estate planning involves a lot of risk. 

 

The main risks are that the law will change or that people won’t behave as you hope or thought they would.  The one thing both of these risks have in common is that the longer the estate plan takes to distribute the assets, the more complex the maneuver, or the longer the trust stays in existence before liquidating, the greater your exposure to these risks.

 

What are the six things good estate plans have in common?

 

1)  The parents maintain majority control over the assets until the second spouse dies even when discounted interests in the assets are gifted to the children

2)  When they distribute assets they do so instantly at death or as quickly as possible

3)  When a trust is required to transfer assets out of the estate for estate tax purposes the assets are tied up in trust for only a short period of time (2-3 years is usually optimal for short lived trusts [the least risky and best kind of trust])

4)  When a longer dated trust is required, the assets are kept in the trust for the minimum amount of time necessary (10-30 years is typically optimal for longer dated charitable trusts but these are inferior to shorter dated grantor trusts)

5)  The parental assets or business should not be imperiled by making bad business decisions in order to reduce the estate tax – there are lots of ways to reduce the estate tax but very few ways to undo bad business decisions.

6)  Estate plans should always use the simplest maneuvers that get the job done.  Complexity in estate planning generally increases risk proportionally or even exponentially in our observation so never use a complex maneuver when a simple maneuver will do the same thing.

 

Why complex, long dates trusts can be similar to open heart surgery

 

Trust and Estate Planning has a lot in common with medicine.  If you talk to surgeons they will tell you that with the human body you never know what you’ll see until you open someone up.  Also it’s really hard to know how people will respond to surgery so we tend to hesitate to do it until we’ve given the less invasive methods a shot and they’ve failed. 

 

With that said, for all of its potential complications, surgery can do stuff that drugs and behavior can never do.  A drug cannot give you a new kidney, you need a surgery for that.  It’s a more effective tool for big problems but is more risky too – so we save it for big problems that make it worth the risk.

 

I’ve noticed a lot of people who don’t understand the law well think of trusts as a minor procedure but the truth is that trusts are a major legal procedure that can mess you up in a major way.  Of course, they can also do things that no minor legal procedure like a deed or a beneficiary designation can do and so they are absolutely necessary when the less risky procedures prove ineffective for your needs.  But its always important to check and make sure that simple procedures won’t really do what you want because they are generally far less risky than using trusts (especially trusts that go on for more than 2-3 years).

 

What does a high risk estate plan look like?

 

The other day, I read an article about the estate plan that a guy set up for a well off business owner named Tom.  Tom is married, is 79 years old and has two children.  He has a pretty good business that produces around $3.1 million per year in income and like many business owners most of his assets are tied up in his business.

 

Tom’s Assets

 

$6,750,000 in an S Corp Small Business that he runs

$2,239,000 in nonbusiness assets

______________________________________________________________

$8,989,000 total assets

 

The fact pattern doesn’t say anything about Tom’s liabilities so I’ll assume that neither he or his wife have any personal or business debt.

 

Tom’s Estate Tax Liability in a community property state = $0

 

The Federal Estate Tax only kicks in for couples in 2014 if you have more than $10,700,000.  Tom and his wife only own $8,989,000 in assets so they wouldn’t pay any estate tax.  So basically any tax based estate planning doesn’t make sense for Tom or his family.  Doing so can only make things go bad but they can’t get his estate tax liability beneath his current exposure of $0.

 

What did the accountant recommend?

 

Although this procedure will not save a $1 in taxes under the current rules, Tom’s accountant recommended the following transaction:

 

1)  Tom gift $700,000 of nonvoting stock in his S Corp to a trust owned by his wife, and his two kids.  The structure of the trust is the intentionally defective grantor trust – which isn’t actually important – because no trust will reduce his estate tax liability beneath his exposure without a trust.

2)  Tom sold about $6.8 million in nonvoting stock to the intentionally defective grantor trust.  It doesn’t count as a real transfer, because kept the voting stock and the control of the S corp so he didn’t really transfer it to the trust (hence the “intentionally defective” nature of the trust).

3)  Tom had the trust pay him 0.92% interest per year or about $627,000 and at the end of 15 years (when he is 94) the trust must pay him a $6,750,000 million balloon payment.

 

What’s wrong with this estate plan?

 

The glaring problem with the trust is that it accomplished nothing from a tax point of view.  Estate planning almost always had a downside in terms of loss of flexibility and what you sacrifice doesn’t make any sense because you don’t get anything in exchange for your sacrifice.  Here are the main problems.

 

1)  He added his wife as a beneficiary of the trust.  Husbands and wives can give unlimited gifts to each other in their lifetime or at death without owing any tax or using up any of their lifetime gift tax $5.35 million in 2014 or estate tax $5.35 million in 2014 exemptions.  So there is no benefit in using a complicated structure when a gift at death would accomplish the same thing.

 

2)  He didn’t owe estate tax in the first place.  So the trust runs up his costs of administering it but he could have simply elected “portability” (ask you estate attorney or accountant what that is) and file an estate tax return and accomplish a tax free transfer of assets to the wife and children more simply with less risk.

 

3)  The business generates $3.1 million in income today but everyone knows that businesses have up and down years.  I’m guessing that if the business was only valued at $6.8 million then it probably doesn’t generate $3.1 million in profits each year.  A business that could consistently generate $3.1 million in profits without Tom running it would be worth about $55.4 million at today’s valuations and not $6.8 million.  It looks the estate planner put $16.2 million of debt on a business with $3.1 in profits.  That can be very dangerous, especially if Tom isn’t around to run it.

 

4)  The estate plan runs for 15 years, by Tom’s age life expectancy is around 8 years.  The lump sum payment for the business won’t come until Tom is 94 and will probably go to his estate.  In theory I guess the note will pass down to the wife, the kids and the trust – but this is an exceedingly complex way to do this and really it accomplishes nothing from a tax point of view.  Lots of risk was taken on by the family and not a dollar of taxes were saved by any of these maneuvers.

 

I don’t mean to be harsh on estate planners or pick on this one accountant (which is why I left his name out of the article) but you’ll see this kind of stuff all the time in estate planning.  I think most people don’t really fully understand their estate plan or fully grasp the simple yet equally effective alternatives available to them.  My view is that you should always use the least complex measures first and then escalate to more dangerous and risky measures if the simple measures don’t reduce or eliminate your estate taxes.

 

To me, this plan feels like stopping the beating heart of someone who doesn’t have heart disease just because you wanted to practice open heart surgery.  While the estate planner is really proud of the intellectual gymnastics he went through our job is not to create the most complex way to do things – it’s actually to create the simplest way to do things.

 

In estate planning, complexity creates the opportunity for things to go wrong and I think its best to do the least complex thing that accomplishes your goal, as that is the lowest risk estate planning strategy in our view.

 

In case you are interested, here is the original article:

https://www.nerdwallet.com/blog/advisorvoices/intentionally-defective-grantor-trusts/

 

 

 

The Accuracy and Effectiveness of Modern Portfolio Theory, the Efficient Markets Hypothesis and the Capital Asset Pricing Model

 

By Daniel Harris, RIA, Saturday April 23, 2016

 

If you’ve ever spent any time in the academic world, as I have, you’ll understand how important theories are to professors.  Most academic papers have an exhaustive analysis right at the beginning tracing through how an idea was developed.

 

Usually in academic articles the empirical evidence is tucked in the middle somewhere and is deemphasized to some degree.  The hypothesis and the conclusion are what really gets emphasized.

 

So you won’t be surprised the popular academic theories about investing including efficient market hypothesis, modern portfolio theory, the capital asset pricing model all tend to make big assumptions that we know are not true, and consistently fail badly at the margins when they are empirically tested, in order to present clean theoretical thinking.   In economics as well as other fields in social science, the theory usually trumps the facts in terms of how much attention it gets.

 

Economic academics say “if the world was this way then my theory would predict x, or y, or z.”  But we know from the evidence that the world isn’t that way.  It’s sort of like saying if I were king, ice cream would be free – but I’m not king so I guess I’m just going to have to pay for my ice cream :)

 

I’m not a big fan of operating in the world of theory because it is hard to enough to understand our world, our people, and our markets with all of its natural complexity without draining our time and effort on what would happen in a world that only exists hypothetically.  As a result, I prefer the newer fields of social science as opposed to the older ones (like economics) because they are more closely tied to the real world and how it operates.  Its sort of akin to the fact that new science subjects like computer science tend to be much more practical in their teaching than older science disciplines.

 

Coming back to the popular theories, each one has their own set of assumptions but if you were to combine them, I think the assumptions would look something like this:

 

1) everyone knows the exact same things about investments at all times

2) everyone wants the exact same investments at all times

3) there is such a thing as a risk free asset no matter what the supply/demand situation looks like in that asset

 

Now I’m going to quickly give the one sentence to rebut each of these things because the theory is really preposterous if you think about it:

 

1)  If everyone knows the same things about business and investments we all could turn $100,000 into $60 billion in our lifetimes and every company anyone starts will get as big as Microsoft

2)  If we all want the exact same investments at the same time this means in our lifetime we will own as many bonds at 22 as we will at 82 and our tolerance for risk after we finish working will be the same as our tolerance for risk while we are working

3)  If an asset can be risk free even if you grossly inflate the supply of that asset, hyperinflation could have never existed and German’s wouldn’t have had to carry around a wheelbarrow worth of money to buy a newspaper.

 

The research shows that these assumptions do not meaningfully describe our world and its simple to point out the flaws in the assumptions – so why accept the conclusion if the assumptions are wrong?  As they often say in data analysis if you have bad inputs you get bad conclusions, or less nicely, garbage in…garbage out.

 

I just want to be clear in investing there are two camps.  There are successful investors who mostly reject the most preposterous parts of academic theories but accept parts of their theories that are reasonable.  These investors have had success in a way that the academic theories have not personally had and therefore say is not possible and the success is common enough that its unlikely to be due purely to chance (but is almost certainly due somewhat to chance). 

 

The academics have sometimes or often sound theories in certain contexts, but they’ve been proven to not make very good predictions at the time you need them the most (in periods of asset price distress) because in those times, prices don’t seem to correlate closely with a risk of loss but more so reflect times of panic or euphoria with the academic theories largely can’t explain why that happens.

 

This evening, I was having dinner with a friend who is big into real estate and we were talking about risk and reward in real estate.  While we both agree that at any one point in time an lower priced assets may be more risky than higher priced assets – the theory doesn’t explain why the same asset is cheap in one period and expensive in another.  The fact is when the asset is cheap you have a lower risk of losing money than when it is expensive – exactly opposite of what economic theory says, but something we inherently know to be true.

 

By the way, here are the three theories you hear the most:

 

Capital Asset Pricing Model: US Treasury bonds are a risk free asset and anything that returns higher than U.S. treasury bonds does so because the investor takes on “nondiversifiable risk.”  Importantly the theory does not clearly define what risk is.  If it said risk was the odds of long term loss, the theory wouldn’t hold up since bond holders have a higher probability of long term loss than diversified stock holders.  If it said risk was short term movements in pricing – it would hold up – since high growth assets are usually more volatile than low growth assets in the short term.

 

Modern Portfolio Theory: This says that you should capture as much return as possible per unit of “risk” or movement in prices that you are taking.  Once again “risk” is generally undefined by this theory.  But if it were defined it would be useful in guiding how to invest in the short term because low growth assets tend to have less movement in prices (both up and down).  It would not be useful for long term investing because reduction of volatility often dramatically shrinks returns over a lifetime.  It’s a very serious decision to reduce the growth of your assets for money you don’t need in the short term and absent a need to reduce volatility for spending needs it isn’t clear why you’d want to reduce the growth or productivity of your assets.

 

Efficient Markets Theory:  This one is my favorite, because its very structure is a tautology or based on circular reasoning.  The theory says that markets reflect all known information, are inherently perfect, and therefore whatever the price that an asset is, that is what it should be.  The glaring weakness in this argument is that the same asset goes for dramatically different prices in different environments.  If markets were truly efficient then assets would go up at a steady rate with an even slope they wouldn’t have the up and down gyrations that they do. 

 

So are these theories useful anymore and if so, how can I use them?

 

The reality is that the Capital Asset Pricing Model and Modern Portfolio Theory are highly useful for short time horizon (10 years or less) investing.  When you invest with a short term horizon, if something goes wrong you don’t have the time for it to recover before you need to sell the asset and spend the money.  So the concepts about volatility reduction are really helpful for short term investing. 

 

Efficient Market Theory was sort of dead on arrival because the logic of the theory was so obviously flawed.  It shouldn’t be confused with the idea of investing efficiently, which is a different concept that doesn’t really come out of this theory but exists independently of the efficient markets theory.

 

So in short, Modern Portfolio Theory and the Capital Asset Pricing Model because say that you need to look at past returns to reduce your volatility in money you’ll need in the long term.  None of theories say anything really useful about long term investing, simply because over time the inaccurate assumptions if relied on should dramatically reduce your investment results over your lifetime.

 

 

 

 

 

What I’m Reading

By Daniel Harris, RIA, Friday April 15, 2016

 

I read all the time – usually several hours each day.  When I was a kid my parents used to offer to pay me to read books (it didn’t work I never read back then).  As an adult, if I were paid each time I read something I’d be rolling in the dough.  

 

Probably like you, I read different sources for different things.  The news aggregators are best for breaking news, the investment sites are best for the technical features of financial products, the general news sites provide in depth stories that are fun to talk about with clients and the trade journals provide industry specific knowledge about how to do (and how not to do) things as well as the latest practices in the field.  I feel drawing from lots of sources and sometimes keeping it light (with news sites) and getting very deep (with technical sites) is the very best way to stay informed. 

 

Here are some of my go to sources for news, facts, and information:

 

Keeping it Light and Getting Real Time Breaking News: New Aggregators

 

Business Insider: http://www.businessinsider.com 

 

Business Insider is by far the best financial news aggregator on the internet.  I like them because news usually breaks here before anywhere else on the internet.

 

Bloomberg: http://www.bloomberg.com

 

Bloomberg is much better than the Wall Street Journal for timely and useful financial information, in my opinion.  They will tell you exactly what is happening in the markets and they write for a professional audience instead of a general one.  For in depth real time financial reporting, they are the best news site on the internet.

 

Going Deep on the Product Offerings: Investment Sites

 

Morningstar: http://www.morningstar.com

 

Morningstar is my go to place for expense ratios, portfolio holdings and distributions.  They also have some interesting news and interviews from time to time.  I don’t agree with everything that is said there but it is a good source for investment related information.

 

Yahoo Finance: http://finance.yahoo.com

Yahoo is an old site, but they have the best information about company financials spelled out in a really easy to follow way.  I use them to quickly look up profitability, revenues, return on equity on other pertinent facts.

 

Google Finance: https://www.google.com/finance

 

Google Finance doesn’t have very deep information but their quotes load very quickly.  If I need to look up a company or a dividend, this is where I go.

 

Big Charts and Dividata: http://bigcharts.marketwatch.com  https://www.dividata.com

 

I use big charts and Dividata all the time to look up current and past dividends and interest payments for investments.  They have pretty comprehensive historical information.

 

Investment company sites like Vanguard https://investor.vanguard.com/corporate-portal/ , State Street: https://www.ssga.com/home.html , and iShares: https://www.ishares.com/us/ and PowerShares https://www.invesco.com/portal/site/us/psgateway are all great places to go for real time product information from these four leading index fund providers.  These sites will break apart the investment holdings in real time so you can see exactly what you are buying.  Their information is usually more timely than what you’ll get from general investment sites.

 

Keeping it Light: General News Sites

 

Client’s love to talk about what is happening in the economy and I like talking to them about these things.  Most people find finances kind of interesting – maybe not the really technical product related stuff – but the general “here is what is happening” type of stuff.  If it’s newsworthy, it often eventually ends up in some of my favorite general news sites: the Wall Street Journal: http://www.wsj.com ,The Economist: http://www.economist.com the New York Times http://www.nytimes.com and the San Francisco Chronicle http://www.sfgate.com.

 

Going Super Deep: Technical Sites and Trade Journals

 

This is where the real work is done and where I spend a ton of my time.  This is the information that almost no one else looks at because it isn’t easy reading and you have to learn the language and the way information is presented in each field.  I routinely read company and fund financial filings from the SEC: https://www.sec.gov/edgar/searchedgar/companysearch.html , but I also read cases from the U.S. Tax Courts https://www.ustaxcourt.gov as well as legal analysis and studies published by the American Bar Association http://www.americanbar.org/aba.html, and the American Institute of CPA’s http://www.aicpa.org/Pages/default.aspx

 

I’ll give you an example of how this works.  The other day I was in a meeting with an estate attorney and asked her about California’s new Transfer on Death Deed and what she thought about it.  She said it was a bad idea because she was certain that it would be litigated heavily and wouldn’t work for its intended purposes.  Most people would take her at her word because she’s an estate attorney – but I never do that – I always try to verify the technical information people give me.  It turns out the American Bar Association had extensively studied the issue and published their findings.  Based off their exhaustive analysis it was clear that Transfer on Death Deeds are almost never litigated in any of the 27 states that have adopted them since the first time they were used in Missouri in 1989.  I’m kind of in the Ronald Reagan camp on this one – I trust you, but I’m still going to try to verify before I pass the information onto a client.

 

I extensively keep up on tax cases from the tax courts simply to see what works and what goes wrong.  Reading these cases shows you what went wrong when things went bad and I feel that is really good knowledge to have. 

 

I sometimes read insurance journals on insurance products, financial journals on financial products, industry trade journals on industries our clients invest in, legal cases on insurance claims and estate disputes and I even read those financial and insurance product prospectuses and disclosures that few people ever read. 

 

I don’t always like doing that reading, because it is really hard, but I think it is very important to do.  We don’t like to think of it this way, but investing is really a competition and the more knowledgeable competitors definitely have an advantage, in my view.  It’s better to be prepared and know as much as possible before you make financial decisions and if doing this technical reading isn’t your cup of tea, you can always just get in touch with us and we’ll share with you what we know and save you the time and hassle of having to become an expert on this stuff.

 

The famed economist, David Ricardo argued that if you focus on what you do best in life and outsource your other functions to others you’ll be highly productive.  I wholeheartedly believe that is true.