FINANCIAL PLANNING FOR THE THIRD MILLENNIUM
VOLUME I
LAWYER AT LARGE, LLC.
MICHAEL LYNN GABRIEL
ATTORNEY AT LAW
B.S., J.D, M.S.M., DIP.(TAX), LLM (TAX)
FINANCIAL PLANNING
VOLUME I
TABLE OF CONTENTS
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . 1
PART ONE: INDIVIDUAL TAX PLANNING . . . . . . . . . . . . . . . . . . . . . . . . 5
1. Tax Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2. Investment in a Home . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41
3. Real Property Rental . . . . . .. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
4. Collecting Debts in Small Claims Court . . . . . . . . . . . . . . . . . . .. . . . . . . . . 105
PART TWO: INVESTMENTS . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . 128
5. Limited Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .130
6. Stocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .150
7. Bonds and Government Securities . . . . . . . . . . . . . . . . . . . . . . . . . … . . . . 163
8. Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
9. Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
10. Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . .200
11. Money Market Vehicles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
12. Real Estate Investment Trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . .232
PART THREE: DEBT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
13. Living with Debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
14. Filing Chapter 7 Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .299
FINANCIAL PLANNING
VOLUME II
TABLE OF CONTENTS
PART ONE: INDIVIDUALS ENGAGED IN BUSINESS …………………………………. 1
1. Partnerships ……………………………………………………………………………………………….2
2. Doing Business as a Corporation ………………………………………………………………….35
3. Limited Liability Companies …………………………………………………………………………62
4. North American Free Trade Agreement …………………………………………………………86
5. Guarding Against Employment Problems ………………………………………………………104
PART TWO: AFTER RETIREMENT …………………………………………………………….132
6. Social Security …………………………………………………………………………………………133
7. Supplemental Security Income …………………………………………………………………….170
8. Disability Benefits ……………………………………………………………………………………..189
9. Medicare …………………………………………………………………………………………………211
10. Nursing Home Care …………………………………………………………………………………235
PART THREE: ESTATE PLANNING …………………………………………………………….246
11. Revocable Trusts ……………………………………………………………………………………. 250
12. Probate ………………………………………………………………………………………………….270
13. Joint Tenancies and Gifts ……………………………………………………………………………305
14 Durable Powers of Attorney ………………………………………………………………………..318
INDEX ………………………………………………………………………………………………………. 358
INTRODUCTION
Earning money is one thing; keeping it is quite another. Some 15 years ago, a Democrat Congressman stated on the floor of the House of Representatives that all money belonged to the government and the people could only keep the amount the government said they could. That actually is correct since the government can take all money by simply taxing it. The Congressman received polite applause from his fellow congressmen. Unfortunately that belief seems to pervade Washington and most state capitols.
We, Americans must work over half the year to pay all of our federal, state and local taxes, and that still isn’t enough to pay the government bills. The federal deficit is still increasing; so are most state deficits. In 1993 the California deficit increased by $1 billion per month. What is frustrating is that the government simply raises taxes. It could cut government spending simply by implementing the same financial practices used by businesses. Farmers harvest crops; politicians harvest taxpayers. Most people do not believe that we get full value for our tax dollar, whether it be for the $1,000 toilet seat used in the military or the $250,000 grant to determine why rats get drunk when they drink alcohol.
Most Americans believe they can handle their money and spur the economy better than the government. If a reader of this book does not share this philosophy, this book is not for them. Through this book we are trying to help people make more money and keep it legally. If a person does not care about making and keeping money, there is nothing to be gained from reading this book.
Besides the government taxing our assets, we also have to contend with all of the vagaries of the financial world: inflation, a poor economy, job loss, retirement, disabilities and nursing care. These are the normal concerns of life. They should be recognized, and there should be a plan developed for facing and dealing with them. To do so requires money, usually a lot of it. Such money is not obtained by paying it in taxes nor is it amassed by putting it in a jar and burying it in the ground.
As a lowly citizen and even a lowlier taxpayer, there are only a few things that we can do legally to fend against government seizure of our money and to help it grow.
This book is designed for the average middle class person. Rich people have their own advisors. There are no advanced financial planning techniques in this book designed to be used by wealthy individuals only. On the opposite end of the spectrum extremely poor people have no estate to manage. Only the social security and debt chapters of this book will be of use to them. The average person however with family income of $100,000 or less per year and assets of less than $600,000 will find the information in this book practical, informative, instructive and easy to use.
A true financial planning book deals not only with life but death as well. Government taxes a person both in life and death. As Napoleon’s sister said on her death bed, “Nothing is forever except death and taxes.” Unless a person plans for the disposition of his estate after death, an expensive probate is required and unnecessary estate taxes have to be paid. All of which will come out of the estate, reducing the amount the heirs will receive. In other words, part of a decedent’s estate will go to the government rather than loved ones. This result is avoided with good estate planning, which should be part of every person’s total financial plan. Consequently, there are two companion estate planning volumes to complete the package started by Financial Planning Volumes I & II.
Since financial independence is the goal of everyone, a good financial plan helps to guide the growth of a person’s money. This book discusses the major types of investment that are available to the average person. This book does not talk about every type of investment, but it does speak on those available to a person with a small to medium amount of disposable income.
This book deals with the possibility of facing bad times. Discussions on social security, supplemental security income, disability, Medicare, nursing homes and even debt are discussed in detail. These are all possibilities that face everyone. No matter how wealthy or in good health a person is now, things can change quickly. Money can be lost or stolen, and good health can disappear in a wink of an eye. The practical person is aware of those possibilities. He builds a plan to shield against those possibilities by incorporating potential government benefits into a financial plan.
This is a practical book. It could be expanded into an entire treatise with every chapter becoming a book in itself, but that is not necessary. The basic information is distilled to the point that the average person can read any chapter and find the basic information needed to make an informed decision. These are recommendations concerning common tactics and investment strategies that should be employed by the average middle class person as part of his investment plan.
We live in a great country with a great deal of opportunity. No one ever takes advantage of every opportunity that is presented to them. What is important is that a person take advantage of enough opportunities so as to be protected from adversity in the future.
PART ONE
INDIVIDUAL FINANCIAL PLANNING
Part One of this book addresses those areas that are most often considered by an individual in creating and implementing a financial plan. Fundamental tax law is presented at the very beginning of this book to create a basic understanding on which to build.
Part One covers the following areas of financial planning which affect most persons with assets in some fashion:
1. Tax Planning.
2. Investment in a Home.
3. Real Property Rental.
4. Collecting Debts in Small Claims Court.
The purpose of financial planning is to keep as much money and assets from the government as possible. Once the government gets its hands on a person’s property, it’s gone. This is not hyperbole. It’s an absolute fact.
A person should not rely on social security to provide for support in old age. The social security system is tottering on insolvency. It is estimated that in 2010 a person retiring will only receive eighty one cents ($.81) for every dollar contributed. The reason for this is that the number of people receiving benefits will dramatically increase while the number paying into the system drops.
In 1945 it was estimated that 16 people paid into the system for every person receiving benefits. In 2010, it is estimated that 1.6 persons will be paying for every person receiving benefits.
The reason behind this increase in people receiving benefits is that the life span for people has increased. In 1940 life expectancy was 65 years of age. When social security was created it was believed that people would die within a year or so after they started receiving benefits. The plan was designed around that assumption.
Modern medicine and a change in life style have changed that scenario significantly. As a result, people who have not planned for their retirement may find themselves destitute in their golden years even though they are receiving social security.
This book is written for people attempting to create an estate. In the movie The Barefoot Countessa, a wealthy man tells Humphrey Bogart, “Taking one hundred thousand dollars and raising it to a million dollars is work. Taking a hundred million dollars and raising it to one hundred and ten million dollars is inevitable.” It is hard to get started, but once a person is successful, it gets increasingly easier to make and keep money. It is toward that goal of helping people become successful and secure that this book is directed.
CHAPTER 1
TAX PLANNING
I. INTRODUCTION
Tax planning is the process of reviewing tax alternatives available to determine how to reduce the obligation to pay taxes. Tax planning requires that the person know the tax code and be familiar with his tax situation. The best tax planning takes advantages of the tax breaks and opportunities authorized by the Internal Revenue Code to reduce taxes legally.
Tax planning is totally legal and the right of every American. Justice Learned Hand of the United States Supreme Court once ruled,
“Over and over again courts have said that there is nothing sinister in so arranging one’s affairs so as to make taxes as low as possible. Everybody does so, rich or poor, and do right, for nobody owes any public duty to pay more taxes than the law demands. Taxes are enforced exactions, not voluntary contributions.”
Income taxes are an important consideration in the financial lives of most people. They usually play the determinative role in financial planning. With taxes constantly increasing as a result of the government’s attempt to raise revenue, every financial decision must be reviewed to ascertain its tax consequences. It is the effect of income taxes on a person’s paycheck that determines the take-home pay and the amount of disposable income the individual has to spend. Income taxes directly affect the quality of life of every taxpayer. Businesses live or die by their ability to master the tax code. The welfare of all employees are affected by the obscure provisions of the Internal Revenue Code.
The IRS provides free tax information and services. IRS publication 910, Guide to Free Tax Services, describes the publications and services available to taxpayers. There are over 100 publications by the IRS containing tax information. Videotaped instructions for completing tax returns have been prepared by the IRS in both Spanish and English. They are available in some public libraries. Braille materials are also available at regional libraries in conjunction with the Library of Congress. The IRS offers the TELE-TAX service which is a telephone service that provides recorded tax information on over 140 subjects. The TELE-TAX service will also tell a taxpayer the status of a refund.
In addition, the IRS also operates a telephone service for hearing impaired persons who have access to TDD equipment. Call 1-800-829-4059.
The IRS provides toll-free numbers in every state for taxpayers to call regarding tax questions.
Congress mandated that the IRS create a Problem Resolution Program for taxpayers that are unable to resolve their problems with the IRS. A taxpayer may write to the local IRS District Director or call the local IRS office and ask for Problem Resolution Assistance. The problem resolution officer will advise the taxpayer of the Taxpayer’s Bill of Rights and help solve problems. While the problems resolution officer cannot change tax law or technical decisions, but he can, nonetheless, assist in other ways.
II. UNDERSTANDING TAXATION
Every person, business or entity that earns money must pay taxes. The amount is an increasing scale based on the amount of earnings. An individual taxpayer’s tax rate, filing requirements and standard deduction are determined by his filing status. The five filing statuses are:
1. Single. Unmarried or legally separated on the last day of the tax year. State law determines if a person if married or legally separated.
2. Married filing jointly.
3. Married filing separately.
4. Head of Household. A qualifying widow or widower with a dependent child.
5. Qualifying widow or widower.
Congress has provided tax exemptions. These are set amounts that taxpayers deduct from their income before calculating taxes. Tax exemptions reduce a taxpayer’s income before tax is computed. There are two types of tax exemptions which are personal exemptions and dependency exemptions. A taxpayer is entitled to one exemption for himself and, one for his spouse. These are the personal exemptions. An exemption for a spouse with individual income can only be taken if a joint return is filed. In 1990 each exemption was worth $2,050. For example, a married couple with $35,000 income will pay taxes on $30,900 after the personal exemptions are taken: $35,000 – (2) 2,050 = $30,900.
The dependency exemption of $2,050 is permitted for each dependent of a taxpayer. As with a personal exemption, each dependency exemption reduces the taxpayer’s gross income before tax calculation. There are five tests for dependency that must be met before an exemption is allowed.
1. Member of Household or Relationship Test. The dependent lives with the taxpayer or is a relative.
2. Citizenship Test. The dependent is a U.S. citizen or resident, or a resident of Canada or Mexico.
3. Joint Return Test. The dependent has not filed a joint return with his spouse.
4. Gross Income Test. Generally, a dependency exemption is unavailable if the person sought to be claimed has earned more than $2,050 for the year. This does not apply to the earnings of a child or a student under 24 years of age.
5. Support Test. More than half of the support of the person must be provided by the taxpayer during the year.
A situation may exist where several persons contribute at least ten percent (10%) to the support of a person, such as children supporting an elderly parent. In such a case, no one individual can meet the support test. When this happens, each person providing more than ten percent (10%) of the support may agree to let one claim the exemption. Each person agreeing not to claim the exemption must sign a written statement to that effect. Form 2120 is used for that purpose. It must be filed with the tax return of the person claiming the exemption.
Not everyone is allowed an exemption. The amount that a taxpayer may claim as a deduction is gradually reduced once his taxable income exceeds the level for his filing status.
Taxable Income Subject
Filing Status to Exemption Phaseout
Single $97,620
Married filing jointly $162,770
Married filing separately $123,570
Head of Household $134,930
Qualifying Widow(er) $162,770
If the taxable amount is less than the amount shown in the above table, the taxpayer continues to deduct the exemptions on the Form 1040 as usual. The amount of the exemption phaseout is computed using the tax rate schedules.
III. ACCOUNTING METHODS
The Internal Revenue Code requires all persons in business to elect one of two forms of accounting methods. The two methods of accounting are the cash method and the accrual method. The requirement for an individual to deduct business expenses as they are paid or to deduct them as they occur (maybe before they are paid) depends on the accounting method employed. Once elected, a taxpayer cannot change accounting methods without the consent of the IRS.
Under the cash method of accounting, the taxpayer reports all items of income in the year that they are actually or constructively received. The taxpayer will only deduct those expenses actually paid. This is the tax method that most individuals utilize.
Under the accrual method of reporting, a taxpayer reports income when earned; not when received. Likewise, expenses are deducted when incurred; not when paid.
Income is considered constructively received by a taxpayer when it is credited to a taxpayer’s account or is set apart in any way that makes it available to the taxpayer. Actual possession of the income is not necessary. If a person cancels a debt that is owed him by a taxpayer, the amount of the canceled debt is income to the taxpayer and must be reported. Income received by an agent of a taxpayer is constructively received by the taxpayer and must be reported.
Regardless of the method used, prepaid income is generally reported when received if the funds are available to the taxpayer.
If the taxpayer is on the accrual method of reporting, advance payments for services to be performed by the end of the tax year can be deferred from income until the taxpayer actually earns them by performing the services, Publication 538, Accounting Periods and Methods, covers in detail the advantages and detriments of both methods.
Once an accounting method is chosen it cannot be changed without IRS approval. A taxpayer, however, can use a different method for each business the taxpayer may have. If the taxpayer wishes to change his accounting method, Form 3115, Application For Change of Accounting Method, is used.
IV. FILING A TAX RETURN
*** END OF SAMPLE VIEW OF SECTION ***
VIII. THE EARNED INCOME TAX CREDIT
The Earned Income Tax Credit is a refundable tax credit available for a low-income worker who maintains a household in the U.S. that is the principal residence of the worker plus a child or children for over one-half of a tax year. The taxpayer must also meet the following requirements:
1. Be married and filing a joint return and entitled to a dependency exemption for the child or children, or
2. Be a surviving spouse, or
3. Be a person qualifying as a head of household whose unmarried child or children are part of the household.
The earned income credit is refundable to the extent that it reduces the tax below zero. An eligible taxpayer may elect to receive an advance payment of the credit through the taxpayer’s paychecks. Form W-5 can be used by a taxpayer to notify his employer that he chooses to receive the advance payments rather than wait for a tax refund after the return is filed.
IX. THE GASOLINE TAX CREDIT
A credit for federal excise taxes on gasoline and special fuels exists for fuel used for the following:
1. Farming purposes.
2. Non-highway purposes of a trade or business.
3. Operation of an intercity, local, or school bus.
A one-time credit or refund is allowed to the purchaser of a qualified four-wheeled diesel-powered vehicle, one with a gross weight of less than 10,000 pounds that is registered for highway use.
The credit is one hundred ninety-two dollars ($192) for a truck or van and one hundred two dollars ($102) for other vehicles. The credit reduces the basis of the vehicle and is computed on Form 4136 and attached to the taxpayer’s Form 1040.
X. THE ALTERNATIVE MINIMUM TAX
The alternative minimum tax was designed to assure that wealthy corporations and high-income individuals do not avoid taxation altogether through legitimate investments and tax planning. The calculation of the alternative minimum tax is figured on Form 6251. If the minimum tax is greater than the taxpayer’s regular tax, he must pay the alternative minimum tax amount.
*** END OF SAMPLE VIEW OF SECTION ***
XIV. CAN GIFTS BE USED TO REDUCE TAXES IN A FAMILY?
One of the best ways of avoiding or reducing taxes in a family is to split the income among the family members. Income splitting is beneficial: graduations in individual income tax rates reduce total income tax liability for the family when income is shifted to family members in a lower tax bracket. Two family members paying taxes on $25,000 each is cheaper than one paying taxes on $50,000.
A transfer to a child younger than 14 years of age might not result in a tax saving because the “kiddie tax” generally will require the income to be taxed at the parents’ rate.
XV. PARENTS EMPLOYING THEIR CHILDREN TO REDUCE TAXES
For parents owning a business substantial tax savings usually will result if a taxpayer is able to employ his children in the business. Hiring a child always results in income being shifted from the parent to the child.
The child’s wages are deductible as a legitimate business expense by the parent. To be deductible, the services must actually be rendered by the child. In addition, the child’s wages must be reasonable for the services rendered. Accurate record keeping is needed to document that the payments to a child are for work actually done and not gifts.
XVI. PROVIDING FOR A CHILD’S COLLEGE THROUGH THE
TITLE GUARANTY PROGRAM
The title guaranty program is relatively new but offers significant benefits to parents seeking to provide for their children’s future college education. Under this program a parent pays a lump sum to the trust established by the state’s tuition program and identifies the child as the beneficiary. Under the terms of the trust the child will be entitled to four years of college services at no additional cost to the parent. The trust may also provide cash refunds in the event the child does not attend the college.
This program provides a way for parents to prepay a child’s college education at a lower tax rate. The payment is viewed as a gift by the parent and applied to the $600,000 unified credit of the parent: the $10,000 annual gift exclusion is not available for the parent because the student is not immediately attending the college.
The increased value of the education over the amount the parent had paid is income to the child, once the child starts attending a college under this program. The increased value must be reported as income by the child. Still, there will probably be no taxes since the child will be in a low tax bracket.
For example, assume that a parent pays $15,000. Ten years later when the child attends college a four-year education costs $31,000. The income to the child will be $16,000 spread over the four college years. The child will report $4,000 per year income: the increased value of the education.
XVII. THE INVESTMENT TAX CREDIT
An investment tax credit is a special credit in the tax code for investment in a trade or business involving any of the following:
1. Qualified rehabilitation of an older building,
2. Investment in solar or geothermal energy equipment, or
3. Investment in qualified timber property.
The investment tax credit is combined with the targeted jobs tax credit, the alcohol fuels credit, the research credit and the low-income housing credit to make up the general business credit. Each of the credits is calculated separately and then totaled for the general business credit. The general business credit is used to apply credit limitation and carryback and carryforward rules.
The investment tax credit for rehabilitating old buildings is ten percent (10%) of the expenditures. The requirements for the tax credit are:
1. The credit is only available for non-residential buildings, and
2. The building must have been placed in service prior to 1936.
In addition, a twenty percent (20%) credit is available for certified historic structures listed in the National Register or located in registered historic districts and certified as being historically significant.
The basis of the building is reduced by the amount of the investment tax credit claimed.
The solar and geothermal credit was scheduled to expire at the end of 1991. Instead, its name was changed to “energy investment credit.” Now there is a ten percent (10%) energy investment credit for solar or geothermal energy equipment placed in service during the year. The credit is limited to such depreciable property that is constructed, reconstructed, erected, or newly acquired that meets certain required performance and quality standards.
A ten percent (10%) reforestation credit on an amortizable basis is allowed on any qualified timber property that a taxpayer acquires during the year. This basis may not exceed $10,000 ($5,000 if married filing separately). A qualified timber property is any woodlot or other site in the United States that contains trees in significant commercial quantities and that is held by the taxpayer for the planting, cultivating, caring for, and cutting of trees for sale or use in the commercial production of timber products.
*** END OF SAMPLE VIEW OF SECTION ***
XVIII. TAXATION OF SOLE PROPRIETORSHIPS
A sole proprietorship is a business that is totally owned and operated by just one person or a husband and wife and is not incorporated. The owner is taxed directly on all income from the business. The sole proprietor reports the business income and expenses on Schedule C of his Form 1040.
The sole proprietor must pay estimated tax and self-employment tax on business net income. A sole proprietor may take deductions for business expenses that are reasonable and ordinary. In addition, a sole proprietor may take a deduction of twenty-five percent (25%) of the health insurance premium for himself, a spouse and dependents.
XIX. TAXATION OF A PARTNERSHIP
A partnership is a legal entity composed on two or more individuals or companies to conduct a business, usually for profit. A partnership does not pay any taxes. The partnership merely reports all of its income and expenses by filing a tax return. Under the Internal Revenue Code, all of the income and expenses of a partnership is attributed to the partners according to their ownership interest in the partnership. The partners are required to include their share of the partnership income and expenses on their personal tax returns.
XX. TAXATION OF A REGULAR CORPORATION
A regular corporation is referred to in the tax code as a C corporation because that is the chapter of the tax code which deals with it. A C corporation is subject to a different taxing structure than an S corporation, partnership, or sole proprietorship.
The income of a C corporation is subject to double taxation. The corporate income is taxed first when the corporation files its corporate tax return for the net earnings of the corporation. The C corporation income is taxed again when the corporation pays dividends to its shareholders. The dividends that a shareholder of a C corporation receives are includible in the income of the shareholder on his Form 1040 Schedule B.
For example, assume that a C corporation has $1,000,000 in net profit, it pays approximately $340,000 in taxes. After it distributes the remaining $640,000 in dividends to the shareholders, they pay taxes on the amount they receive. Assuming that all shareholders’ tax rates are twenty-eight percent (28%), they will pay an additional $179,200 in taxes. The total tax on the corporate income of $1,000,000 is $519,200. In other words, the joint tax on corporate income exceeds fifty-one percent (51%).
XXI. TAX SHELTERS
Tax shelters are investments that offer the possibility of reducing the investor’s current income taxes through legal methods. There are many different types of tax shelters such as:
*** END OF SAMPLE VIEW OF SECTION ***
D. SIMPLIFIED EMPLOYEE PENSION (SEP)
A simplified employee pension (SEP) is a simple written plan that allows an employer to make tax deductible contributions towards the employer’s and the employees’ retirement. The SEP program allows the employer to make contributions to the Individual Retirement Accounts (IRAs) of each participating employee. A SEP may be established by an unincorporated employer thereby making the contribution to a self-employed participant “earned income.”
The annual SEP contribution of an employer excluded from the participant’s gross income is the lesser of fifteen percent (15%) of the participant’s compensation or $30,000. If the employer exceeds this amount, the participant will be subject to a six percent (6%) excise tax on the excess contribution. A SEP requires the following:
1. That the employer contribute to each employee who has reached the age of 21 years,
2. That each employee has worked for the employer three of the last five years, and
3. That each employee received at least the indexed dollar
amount of compensation for the year (in 1990, it was $342).
Any plan that discriminates by excluding otherwise eligible employees will not qualify for tax exemption. An employee can also contribute to the SEP-IRA subject to the normal IRA contributions limits.
E. REAL ESTATE SHELTERS
The most common tax shelter involves rental real estate. In the past few years, however, rental real estate as an investment has lost much of its tax saving potential. Passive activity tax laws no longer permit tax losses generated by passive real estate investments to be offset against the investor’s active income (his wages or stock dividends or bond interest).
In the face of these tax restrictions, investment in rental real estate should only be undertaken if the property can pay for itself. Relying on expected appreciation as a justification for purchase of a property may no longer be wise since passive losses from the property are not deductible against active income.
Anyone intending to invest in rental real property should be aware of the following tax characteristics affecting such property:
1. Passive Activity Rules. Unless an investor owns more than ten percent of the property or investment, the investment will be considered passive in nature. A limited partnership investment is considered passive regardless of how much the investor owns. If the investor meets the active participant test, he can deduct up to $25,000 of rental losses from non-passive sources. This $25,000 maximum is reduced for investors with over $100,000 adjusted gross income.
*** END OF SAMPLE VIEW OF SECTION ***
XXIV. TAXABILITY OF WORKERS COMPENSATION BENEFITS
Payments received for an occupational sickness or injury are fully exempt from tax if the payments are made under a workers compensation act or a state statute similar to it. The exemption also applies to payments to a survivor if they would otherwise qualify as workers compensation.
The tax exemption does not apply to retirement benefits received based on age, length of service, or prior contributions to the plan, even though the worker retired because of occupational sickness or injury. Should the worker later return to work and be assigned light duties while still receiving benefits, the benefits received thereafter are taxable. If “workers compensation” reduces social security or railroad retirement benefits the worker is receiving, part of the “worker’s compensation” may have to be included income. This issue is addressed in Publication 915, Social Security Benefits and Equivalent Railroad Retirement Benefits.
XXV. TAXABILITY OF BARTERING ACTIVITIES
Bartering is the trading of property for services or the trading of services for services without the payment of money. Under the Internal Revenue Code bartering is treated the same as the payment of money for the property or services. The persons receiving the bartered property or the services must include, the fair market value of the property or the services received on their tax returns as income. This is the government’s attempt to tap the underground economy of an estimated hundred billion dollars per year.
For example, assume that a painter paints a house and the paint job is worth $1,000. At the same time, the owner, a mechanic, does a $1,000 repair job on the painter’s truck. Each person has $1,000 income to include on their tax return.
If property or services are exchanged through a bartering club, the club is required to furnish the parties and the IRS a Form 1099B, Statement for Recipients of Proceeds for Exchange Transactions. The club is also required to withhold taxes on the bartering unless the parties furnish their social security numbers on Form W-9.
XXVI. INSTALLMENT SALE METHOD OF REPORTING GAIN
A special tax method of reporting gain from the sale of property is used when at least two payments are received by the seller over a period longer than a year. Installment sale reporting is not usually available for dealers in the property. Moreover, this installment reporting is not available for reporting losses from the sale. Under this method a percentage of each payment reflects the percentage gain on the sale. Example: A car is sold for $2,000. It had cost the seller $1,000. The profit (gain) is $1,000 which is 50%. Payments are $83.33 per month for two years. Therefore, one half ($41.66 per month) is gain from the sale and must be reported on the seller’s tax return.
Under the old law installment sale treatment was limited. The seller had to pay taxes on the full profit of the sale although full payment for the property would not be received till some time in the future. The advantage of current installment sale law is that the seller only has to pay taxes on the profits from the sale as they are received.
CHAPTER 2
INVESTMENT IN A HOME
The single most important investment that the average person makes is in a home. The American Dream is for a person to own his home. When the United States was first formed only persons of property could vote. Wealth, land and happiness have always been viewed as the same in America. The purchase of a home binds the buyer to the land more than any chain. The purchase of a home commits a person to make payments for as many as 30 years. Most of the liquid assets of a person will be used to make the mortgage payments. A sharp downturn in real estate prices can destroy years of appreciation. This chapter is designed to focus attention on the factors involved in a decision to buy a home. This chapter dwells on the issues of whether to purchase, when to purchase and how to purchase.
Once a purchase is made, the buyer must know the legal duties and responsibilities of a real estate owner. Real property law covers more than just the land itself. It also covers the rights and duties owed by the landowner to neighbors and even to trespassers. In the not-so-dim past an owner could do virtually anything that he wished on or with the property. Today, however, such unbridled control over property is past. Land use is now strictly controlled and regulated by zoning and environmental laws.
The rights and duties of landowners form a rich and diverse body of law. Every state has its own body of real property law, but all share similar views of residential homes and the obligations of homeowners. By knowing what is expected of a homeowner a person can determine if home ownership is in his best interests.
The purchase of a home is a major step in a person’s life. It usually involves dealing with lenders, appraisers, brokers and contractors. There will be application fees, loan fees, brokers’ fees, taxes, assessments and other obligations. Still, the purchase of a home is probably the wisest course of action. Everything simply hinges on the knowledge, preparation and financial condition of the purchaser.
I. WHETHER TO PURCHASE A HOME OR NOT
The answer to whether or not a person should purchase a home requires the answer to several subquestions such as:
1. Does the person have a stable job?
2. What size of house can the person afford?
3. How much of a down payment can be put down?
4. Where would the house be located?
Each of these questions overlaps the others. The questions are intertwined and reach into the very depths of the potential purchaser’s financial soul.
The most important question is whether the person has a stable job. No lender will even consider loaning to a person who has no job or whose job is apt to be terminated in the near future. A poignant and true example occurred to a couple who owned a home in Willits, California that was for sale. A buyer came forward, was approved by a lender and contracts were prepared for final signature. The buyer was terminated unexpectedly from his position because of a slump in business. The bank immediately canceled the loan. Had the man been fired a month later, the sale would have been completed. Even though, however, he would have been unable to make
the payments and ultimately would have lost both the property and his twenty percent (20%) down payment.
This true example drives home the fact that a person considering buying a home must have a secure job. Otherwise he takes the risk that loss of job will result in loss of the home and the equity in it. There is a common misconception that lenders are overly willing to help buyers who cannot make their payments. While that may be true in some cases, the truth is that most lenders cannot afford to wait an unlimited time for their money. The reason lenders require a down payment of 20% is to provide a margin of security at a foreclosure sale. They can sell 15% below market value and still receive their money.
The size of the house that the person needs may be different from the cost of the house that can be afforded. A newly married couple might only need a single bedroom home whereas a family of six may need a three bedroom home. Occasionally a buyer will purchase a smaller home than needed with the intention of immediately adding to it. This can be a cost-effective approach: it is usually cheaper to add than to buy with the addition already built. On the other hand there is the time and aggravation of getting building permits and dealing with contractors. A construction loan might be obtained from the same lender who is giving the purchase loan; another lender, however, may offer more favorable rates.
The bigger the home, the more it will cost to buy, the more it will cost to maintain, and the more it will cost in taxes. A person can quickly and accurately determine, in a general fashion, the cost of his needs by looking in the newspaper or at the multiple listings of a real estate agent. Since everyone seeks to sell his home for fair market value or more, these periodicals should contain a reasonable approximation of what a home will cost.
The buyer needs to know the maximum amount of down payment he must raise. Most commercial lenders will require the buyer pay between 15% and 20% of the sale price. There are, however, non-commercial lenders who do not require such high down payments. Moreover, many organizations offer home loans to their members with smaller down payments and lower interest rates than commercial lenders. In particular, qualified people should look to the following agencies:
1. Veterans’ loans. The Veterans Administration and most state veterans’ groups provide low interest loans with low down payments to veterans.
2. Special state loans. Many states have special loans for first- time homeowners. A real estate broker would be the best source of such information.
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Another source of homes is through tax sales and repossessions. These serve as the basis for those get-rich-quick seminars in real estate. A lucky person can find a bargain. In most cases the person will get a little break on price, but that may be offset by the time spent in waiting for the property.
A tax sale is when the local tax agency takes the property and auctions it to the public for back taxes. The property is purchased for just the payment of the back taxes if the buyer is the only bidder. The property doesn’t normally get to the tax sale if it is encumbered by a lender’s lien: if it is valuable, the lender redeems it far earlier in the proceedings. Usually the property sold at tax sales is undeveloped land that is not developable. Extreme care should be taken at any tax sale. Foreclosure sales by lenders are a good way to acquire property. In most states, upon default on a deed of trust (discussed below) a lender can have the property sold at a public auction. He must first comply with notice provisions or pursuant to a court’s mortgage foreclosure judgment. It is possible to purchase this property for the outstanding balance of the loans and the unpaid taxes at such auctions
The lender always bids his outstanding loan. He is not concerned with getting the highest price because everything over what is owed is paid to the debtor. Thus property can be bought for below-market value. If the lender is the highest bidder, the debt owed to the lender is reduced by the amount of the bid, and the lender takes title to the property. Once the lender owns the property, he wants to sell it. Most lenders are not in the business of selling property. They list with real estate brokers just like any other ordinary seller.
There is one difference between institutional sellers and ordinary sellers. The institutional seller tries to clear its books quarterly or at the end of the year. A nonrevenue producing item like a house is bad to have on their books. At these times a private citizen may offer to purchase a listed home directly from the institution at a significant savings. In a real case, a couple bought their home in this manner. The time was in a recent recessionary period and the house had been on the market for over a year. The couple offered the bank a ridiculously low amount. To their surprise, the bank counter-offered with a slight raise, and they eagerly accepted. The bank was grateful to unload a white elephant during a recession.
The best way to get such a bargain is to visit every bank and lending institution directly and speak with the home loan officer. Ask him if any homes have been repossessed. Ask about homes that have not yet been presented to an agent (at least the commission can be saved). If the homes are under the control of an agent, negotiate as for any home, knowing you must pay the commission.
A source of government real estate sales is through the General Services Administration. The GSA often sells excess real property through a sealed bid procedure. A person can obtain information about getting on the GSA list by writing to the U.S. General Services Administration, Federal Property Service, Office of Real Estate Sales, 819 Taylor Street, Fort Worth, TX 76102-6115. Phone number (817) 334-2331.
III. TAKING TITLE TO THE PROPERTY
There are many ways to take title to real property. For most people the way is through a deed that specifies the title is being transferred in fee simple absolute: all rights, title and interest in the property are being conveyed, and no other person or entity owns an interest in the property. A fee simple is the total ownership rights recognized by law. It is capable of full and complete alienability. It passes by inheritance to both lineal and collateral heirs of the owner. A fee simple will last forever if it is a fee simple absolute. If it is a fee simple defeasible, the ownership rights may be altered on the happening of certain conditions.
A fee simple absolute is the most complete and absolute ownership of real property permitted by law. A fee simple absolute is limited only by governmental powers such as zoning and eminent domain. A fee simple absolute lasts forever. It will not terminate in the future based on time or the happening of any event.
At common law a fee simple absolute had to be created expressly: It was necessary to use the language “and his or her heirs” to create a fee simple absolute. Example: The deed had to read “To George and his heirs” in order to create a fee simple absolute. The language “and heirs” did not create an estate in the heirs but was still needed to show that a fee simple absolute had been granted. Today South Carolina is the only state that requires the language “and heirs” be on the deed to prove that a fee simple absolute was granted. All of the other states now, either by law or judicial decision, hold that a fee simple absolute is presumed to have been granted unless a grantor states otherwise on the deed.
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C. TENANCY BY THE ENTIRETY
Only about twenty (20) states recognize tenancy by the entirety. It is a special joint tenancy estate between a husband and wife. Neither spouse can obtain a partition of the estate or defeat the right of survivorship of the other spouse. It cannot be terminated by the unilateral act of one spouse.
A tenancy by the entirety is terminated only by:
1. Divorce, which changes the tenancy into that of tenants in common.
2. Mutual agreement of all the joint tenants.
3. Execution against the property by a joint creditor of both spouses. A creditor cannot execute a judgment on one spouse against property held in tenancy by the entirety.
A tenancy by the entirety can be afforded special protection under the Bankruptcy Code. The Bankruptcy Code exempts a tenancy by the entirety from a debtor’s estate if the debtor’s spouse has not filed for bankruptcy relief and if the property is exempt under the debtor’s state law. This issue is discussed in more detail in Chapter 17. Generally, if a married couple wish to take title with rights of survivorship, they should do so under a tenancy by the entirety if it is available in their state.
VI. THE EFFECT OF EASEMENTS AND SERVITUDES ON THE PROPERTY
An easement is a liberty, privilege, or advantage which one may hold in the lands of another. It is a non-possessory interest. The holder of an easement has the right to use the real property for a certain stated use but does not have a general right to possess or occupy the land. The owner of the servient estate, the land subject to the easement, continues to have the right to full possession and enjoyment of his property subject only to the limitation that he cannot interfere with the special use of the property by the easement holder. There are a variety of easements, each of which have their own rights and term of existence.
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VII. A BUYER SHOULD LOOK FOR ADVERSE POSSESSION
It rarely happens, but there are legal situations where the person with title as owner does not actually own the property and may not know it. In such an instance, a buyer may be buying property that cannot be sold. This strange result occurs as a result of a legal doctrine called adverse possession. For homes located in cities, the chances of being involved in adverse possession are slight. The chances, however, increase as the property becomes more remote.
Title to real property of another can be acquired by adverse possession if the possession of the land is all of the following:
1. Open and Notorious. The possession is sufficient to put the owner of the real property on notice.
2. Hostile. The possession must be without the owner’s consent.
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IX. RECORDING A DEED
Most states require that all deeds, mortgages, powers of attorney and other instruments relating to the title of real property be recorded. The recordation is done in the recorder’s office of the county where the real property is located.
Generally, county recorder offices use two indices to aid in title search of the property: the grantor and grantee indices. Every transaction relating to real estate is listed in a chronological order according to the respective names of the grantor or grantee.
A few states use a tract index which lists all of the transactions involving particular pieces of property. Searches in tract indices are easiest to perform since all of the transactions affecting the title are listed in one document.
The purpose of recordation is to give notice to the world of the buyer’s ownership interest in the real property. Recording gives constructive notice to the world of the person’s claimed ownership from the date of recordation forward. Recording gives the court a basis to determine the conflicting claims of ownership where there are multiple sales or conveyances of the property.
All states have statutes (called recording acts) to determine the legal ownership of real property when two or more persons claim ownership of the same property. These acts vary from state to state but fall into three separate categories: notice, race and race-notice statutes. The rights of the parties in the real property is determined by who recorded their deed first and whether or not they knew of claims by the other parties.
A state’s recording act may still deny title to a purchaser of property. It is important that anyone buying property be aware of state’s recording acts and search the title comprehensively to ensure that the seller has valid title to the property.
A. NOTICE RECORDING ACT
About half of the states have a pure notice recording act: a good faith purchaser will acquire the property free of all conflicting claims even if he is not the first to record. A good faith purchaser is also called a bona fide purchaser: a purchaser without notice of conflicting claims of others. The important issue under this statute: when did the purchaser acquire notice of the other conflicting claims, not when was the deed recorded. For example assume that A sells a farm to B and later sells it again to C, who had no knowledge of the earlier sale. C gets title to the farm, and B must sue A for his damages.
B. RACE RECORDING ACT
Two states, North Carolina and Louisiana, have this recording act. Under this act the first purchaser who records wins. Notice of conflicting claims is irrelevant. The purchaser that first records his deed shears all rights in the property of anyone recording later. For example, assume that C knows of the sale to B and still buys and records his deed first. C acquires title to the farm.
C. RACE-NOTICE RECORDING ACT
Most states have a race-notice recording act: the first good faith purchaser that records will be recognized as the owner of the property. This requires that the purchaser both buy the property without knowledge of the conflicting claims of others and also be the first to record his deed.
A person who acquires his interest in a manner other than a sale, such as a gift, is not a purchaser. Therefore his interest in the property can be terminated by the subsequent recordation of a deed by a good faith purchaser.
Example: A gives the property first to B and then sells it to C and finally to D. D records first followed by B and then C. The property goes to D because he bought and recorded first in good faith without knowledge of the earlier gift to B and earlier sale to C.
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XII. FINANCING THE PURCHASE
The three most common methods of financing the purchase of real property are a mortgage, a deed of trust and an installment sales contract. Of the three methods the deed of trust is the most common way of financing real property.
A. MORTGAGE
A mortgage is a security interest in real property given by the owner to guarantee payment of a loan. The borrower is called the mortgagor and the lender is the mortgagee. Should the mortgagor default on the mortgage, the mortgagee can seek a judicial foreclosure on the property. If the court finds the mortgagor in default, it will order the property sold in a judicial sale. Most states allow the mortgagor to redeem the property within a year by paying the buyer the amount he paid at the judicial sale, not the amount originally owed.
If the sale proceeds do not satisfy the amount owed, a deficiency judgment for the balance may be obtained against the debtor if permitted under state law.
B. DEED OF TRUST
A deed of trust is a security interest in real property to secure payment of a loan or some other obligation. The borrower is called the trustor and the lender is the beneficiary. The trustor executes a promissory note for the amount of the loan. The payment of the loan is secured by a trust deed on the property for the benefit of the lender as the beneficiary. A trustee is appointed and is responsible for the fulfillment of the terms of the trust deed.
If the trustor defaults on payments on the promissory note, the beneficiary notifies the trustee of the breach. The trustee then gives the trustor (the borrower) notice that the property will be sold unless the default is cured within a statutorily mandated period of time. If the default is not cured (back payments made), the property will be sold at a public auction. The advantages of a deed of trust are twofold:
1. There is no power of redemption after the property is sold.
2. The lender does not have to go through the expense and delay of a judicial foreclosure.
A trustee usually has the option of selling the property at a private sale under the terms of the deed of trust or filing a lawsuit for judicial foreclosure. The only real advantage of filing a judicial foreclosure action (to sue in court) is that a deficiency judgment might be obtainable. Many states, however, have enacted anti-deficiency legislation which precludes a lender getting a deficiency judgment on any purchase money loan on residential real property.
A deed of trust is an interest in real property like any other. It can be sold, given away, attached or encumbered just like any other interest in real property. The method of transfer is the same for all purposes: the beneficiary of the deed of trust, who is also the holder of the promissory note on the property, executes an assignment of the deed of trust and has it recorded. Recordation of the assignment of the deed of trust transfers the deed of trust. It acts the same as a bill of sale for personal property or a grant deed for real estate.
C. DEED OF RECONVEYANCE
When a promissory note secured by a deed of trust is paid , a deed of reconveyance must be recorded. The recording removes the deed of trust from the title to the property and places the title solely in the name of the owner. The trustee listed on the deed of trust or any successor trustee must sign a deed of reconveyance and then record it.
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D. INSTALLMENT SALES CONTRACT
An installment sales contract is one where legal title stays with the seller until the contract is paid. In the event of the buyer’s breach, this type of contract results in the forfeiture of the buyer’s interest rather than a foreclosure on the property. Because of the harshness of the forfeiture, some states treat installment sales contracts as mortgages. These states require the seller to foreclose on the property in court in order to clear his title on the land.
If the seller elects to treat the property as a forfeiture, he is prevented by law from suing for damages or specific performance. The seller cannot keep the property and still demand payment for it. Clearly, an installment sales contract does not protect the buyer as well as a deed of trust or a mortgage. Sometimes, however, that is the only way the property can be purchased, especially where the seller is being asked to “carry back” the loan (take payments rather than sell for cash).
E. “DUE ON SALE” CLAUSE IN A MORTGAGE OR DEED OF TRUST
Many mortgages and deeds of trust contain clauses that state the entire balance becomes immediately due and payable if the property is sold or conveyed in any manner. The purpose of these clauses is to protect the lender from risky sales or assignments. These clauses have the effect of preventing the sale of the property without the lender’s approval unless the lender’s loan has been paid.
Federal law will enforce a “due on sale” clause if the loan is from a federally insured lender. Some states, such as California, have adopted legislation that prevent private lenders or state-chartered lenders from enforcing “due on sale” clauses if the value of the property exceeds the amount owed. Any trust deed which has a due on sale clause should be reviewed with an attorney familiar with the state’s real estate law to determine if the provision is enforceable.
F. DEFICIENCY JUDGMENT
In the case of a mortgage debt, if the judicial sale does not completely pay the debt, the mortgagee can sue the mortgagor for the balance remaining (the deficiency). A number of states have limited the judgment in such cases to the difference between the debt and the foreclosure price. Some states, including California, have anti-deficiency legislation that prohibits deficiency judgments on purchase-money mortgages. A purchase-money mortgage is one used to buy the property rather than improve it.
Many states do not permit a deficiency judgment on a deed of trust where the property was sold under the trust deed’s power of sale. If a deed of trust is foreclosed using a judicial foreclosure (suing in court for a judgment rather than selling the property under a power of sale in the trust deed), then a deficiency judgment may be possible provided there is no anti-deficiency legislation barring it.
An installment sale contract is treated like a mortgage in most states. In those states the seller is required to go through a judicial foreclosure to obtain a deficiency judgment. In other states the seller is permitted to foreclose without filing a foreclosure: the seller can sell the property under the terms of the installment contract and then sue the buyer for any deficiency as damages under breach of contract.
Whether the foreclosure is judicial in nature or by sale of deed of trust, it voids all junior liens and encumbrances. It does not affect a superior lien or encumbrance. For example, assume that George purchases a piece of property at a foreclosure sale on a second mortgage. The property had a first mortgage of $100,000 and a third mortgage of $50,000.00. The first mortgage still stays on the property, but the third mortgage is void. The holder of the third mortgage can sue the mortgagee personally for the balance owed on the third mortgage but cannot go against the new buyer of the property.
XIII. CO-OPERATIVES AND CONDOMINIUMS
One form of common housing ownership is that of cooperatives. A cooperative is a corporation which owns the title to the land and buildings thereon. The cooperative leases apartments in its buildings to its shareholders. The residents in a cooperative are thus tenants (they lease apartments in which they live) and owners of the cooperative (they are shareholders in the corporate ownership of the apartments). The residents are not direct owners of their apartments. They are entitled to reside there only as long as they pay the rent and obey the terms of the lease that they execute with their corporation.
Another form of common ownership of housing units is condominiums. In a condominium each person owns the interior of his unit plus an undivided interest in the exterior and common areas. Usually the condominium owners form an association or corporation to manage the condominium. Each owner finances the purchase of his unit by a separate mortgage on that unit. The condominium association has authority to levy assessments against the owners for maintenance, taxes and other proper purposes. Failure to pay these assessments gives the association the right to lien the property and to sue in court to collect payment.
XIV. HOMESTEAD
Most states permit an owner to claim a certain amount of equity in his primary residence, usually $40,000, as an exemption from attachment by creditors. In such states creditors cannot attach a debtor’s home if a homestead declaration was recorded and the debtor’s equity does not exceed the statutory amount. If the equity does exceed the statutory amount, the property is sold, and the statutory amount is returned to the debtor even if the debt is not paid totally. A declaration of homestead must be recorded in the county recorder’s office of the county where the home is located prior to the filing of any lawsuit by a creditor. Recording the homestead declaration after the lawsuit is filed does not perfect the homestead or afford any protection from creditors.
XV. IMPLIED WARRANTY OF FITNESS-FOR-USE IN THE SALE OF REAL PROPERTY
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XVI. ZONING
Every buyer must be concerned with zoning in the area where the property to be purchased is located. Location determines price and the value of the location is itself determined by the zoning in the area. Every state has the authority to enact all laws reasonably necessary for the health, safety and welfare of its citizens. This is known as the state’s police power.
Zoning is the term given to the laws enacted by a city, county or state that regulate the develop of land within its boundaries according to a general plan of development. The implementation of any zoning plan must comply with the constitutional provisions of due process and equal protection. If private property is taken for public use as a result of zoning, the owner must be paid the fair market value of the property. This is called eminent domain.
The government can so restrict the development of private property that no reasonable use of the property remains. In that event, the United States Supreme Court has held that inverse condemnation has occurred. Inverse condemnation is a violation of the U.S. Constitution’s Fifth Amendment as a taking without just compensation. Such a violative taking for public purposes can occur if the government requires dedication of easements or transfers of portions of the property in order to get building permits when such easements or dedications have no relationship to the project sought to be built. This is the hottest area of contention in zoning law. Regulatory agencies routinely demand unnecessary public easements across private property or dedications of land in conjunction with those necessary to grant building permits.
A buyer should inquire how the area is zoned. A home located in an area zoned for industrial use will be worth less than the same home in a residential area. The reason is that most people do not want to live next to steel mills, oil refineries or stock yards. Homes located in industrial or heavy commercial areas will appreciate at a slower rate than those homes located in residential areas. Since appreciation is one of the reasons for purchasing property, zoning is a factor that must be considered in any decision to purchase a home.
XVII. MINERAL RIGHTS AND WATER RIGHTS
Whenever a person buys property they should always buy the water and mineral rights of the property. All states permit water and mineral rights to be retained by a seller when property is sold: the seller will continue to own them even though the real property will be owned by the purchaser. In most states a person owning mineral and water rights has the right to go upon the property and develop them. If a person sells a 1,000-acre ranch and retains the mineral rights, he can go upon the property at any time and begin strip mining for minerals without having to pay damages for interfering with the surface owner. Such rights, however, can be limited by language in the deed that the seller retains the minerals but not the right to come on the surface to develop them (the right of entry). Where no right of entry is retained, the seller can only develop the property by subsurface access (digging a tunnel under the property or slant drilling a well).
Mineral rights are the ownership rights of all the minerals on a designated piece of real property. Mineral rights can be segregated from the land. Mineral rights carry with them a right to enter upon the real property surface or underground to search for and develop the minerals. This right of entry is called a “profit a prendre” and is a non-possessory interest in the land. A “profit a prendre” is an easement to enter upon and develop the minerals on the property. It can be terminated for the same reasons as an easement.
A riparian water right is the right of the owner of land bordering a stream to use all of the water necessary for his domestic purposes. The owner also has the right to use a reasonable amount of the water for non-domestic or business purposes provided he returns the water to the stream in an unpolluted state. The water from the stream may not be diverted beyond the watershed of the stream. A subterranean stream is treated the same as a surface stream. The owner has an absolute right to use as much water as he wants from water percolating to the surface. Many states, especially in the West, now hold that such use must be reasonable and that there may not be careless waste or pollution. Other states, such as Nevada, hold that all of the water belongs to the state and the owner of the land must perfect his rights to use the water on the property by application to the state.
The retention of mineral rights in homes located in cities usually is not a problem because zoning laws will usually prevent the seller from ever being able to mine for the minerals. In areas where mining is permitted, however, retention of rights could seriously affect the value of the property. Future buyers might not want to live under the threat of having their property invaded at any time. In the same vein water rights can be very important where water is obtained through wells rather than a water district. Buyers should be leery of purchasing property without access to water.
CHAPTER 3
REAL PROPERTY RENTAL
One of the most common forms of investment for individuals is the rental of real property. Most of the homes rented in the United States are not owned by huge real estate syndicates but by a husband and wife who are supplementing their income from the rental proceeds. There is no reason that individuals cannot invest and rent real property profitably.
The reason behind successful real estate rental is simple. Unless a person is living in a home he owns or is living with a relative, he is probably a tenant. For every tenant there is a landlord with superior ownership rights and control of the property. By renting property the landlord is supplying a basic need and should be amply rewarded for it. The degree to which the landlord is successful depends in large part on his management skill, the condition of the property, the location of the property, the investment in the property and the availability of other rental properties in the area. All of these matters must be given careful consideration before investing in real property.
At one time the landlord was supreme, and the tenant had virtually no rights in the premises. The property was rented “AS IS” under the doctrine of “caveat emptor”: “buyer beware.” The tenant’s occupancy was based solely upon the payment of rent regardless of the condition of the property. Over the years courts and state legislatures have greatly eroded the landlord’s omnipotent rights in the property. Tenants today have significant rights in their rented properties, and the violation of them by the landlord can result in serious fines and penalties. In addition many cities have enacted rent control laws which seriously restrict the landlord’s right to charge other than a fair market rent or less and impair the value of the property.
This chapter is designed to help people with their decision to invest in rental property. It is also intended to help those already in the business to understand their rights and obligations under the law. This chapter is designed to help the user operate a rental property profitably. After all, this is the reason the property was rented in the first place.
I. THE REASONS FOR RENTING REAL PROPERTY
There are only two real reasons for a person to rent real property, such as a home, to another person. The first reason is that the owner of the property wants to have someone on site to manage the property so that it will not be vandalized. This is an important reason. Any police officer will say that vacant buildings are prime targets for vandalism, dumping and other illegal activities. An owner is responsible for the acts committed on his property.
In many cities vacant buildings that have been vandalized or used by drug dealers have been condemned as nuisances and torn down. When that happens, the owner of the property is held responsible for the cost of the demolition.
The owner is doubly assaulted. In the first place the vandals destroy the building to such an extent that the owner cannot afford to repair it. In the second place the city destroys the building because of the damage caused by the vandals and bills the owner. The owner, though totally innocent, loses everything. It is clear why owners prefer to have tenants on the property to watch, even if they do not actually need the rental income.
The second and usual reason most people rent property is to make money. Real property is an asset and like any other asset can be used to make money. Real property can be sold and turned into cash, or it can be rented and generate a stream of income ad infinitum. Whether a person should get into the rental business depends whether he can make more money renting the property or investing elsewhere. In making that determination, several factors must be considered:
1. How much rental can be charged for the property.
2. How likely is the property to be rented.
3. What are the maintenance charges and taxes on the property.
4. What is the condition of the property.
5. What is the depreciation on the property.
6. What is the return on the investment.
II. INVESTMENT IN THE PROPERTY
Whether a person buys the rental property or inherits it, the property is an asset with value. The rental property should be sold if it does not generate a reasonable return on its value. In the 1970’s and 1980’s many real estate gurus touted negative investment in real estate. These experts advised people to invest in rental property even if the rental income would not make the payments. These experts believed that the owners should make up the difference because they reasoned that the unimpeded escalation of real estate prices in the major markets would continue forever. Their cry was, “The only thing they’re not making any more is land.” These experts believed that the owners would make a huge killing when the land was ultimately sold through astronomical appreciation occurring on real estate.
In all fairness that did happen for a few years and many people did make killings in real estate. Many investors, however, financially died by following that advice. When the savings and loan industry collapsed in the 1980’s, real estate throughout the United States plummeted. The Federal Resolution Trust Corporation (FRTC) took over the failed savings-and-loan industry list of properties and sold them at bargain rates. As real estate prices collapsed, tenants found they could rent homes and other real property cheaper and moved. This left the owners with negative investments in a precarious situation. They were forced to reduce their rents to keep tenants and pay more out of their pockets to meet their high mortgage payments or default on their loans and lose the property. Many of the owners lost their property to the Resolution Trust Corporation who then sold at depressed prices. This action by the FRTC drove the real estate prices ever lower. The savings-and-loan system collapse cost thousands of real estate investors their life savings.
The example of the savings-and-loan debacle shows that no one should ever invest in real estate in a financially negative fashion, nor should they rely on appreciation in the property for their profit. A real estate investor should expect a reasonable profit from the property immediately and should not expect an appreciation for sale but instead expect the property to retain the same value. If the property rises in value that should be viewed as a Godsend, but it should not be expected. The property should be sold if it drops in value so that it no longer generates a reasonable return.
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IV. LEASING THE PROPERTY
Once a person decides to rent property to another, the owner should execute a written lease with the potential tenant. By definition a lease is a transfer of real property for a period of time, called tenancy, by a person with a greater interest in the real property. The person granting the lease is called a landlord or lessor. The person receiving the lease is called a tenant or lessee. The consideration paid for the lease is called rent. The rights of the parties to a lease are governed by the specific type of lease that is used and the terms and conditions of the lease contract.
The lease should always be in writing although, by law, a written lease may not always be required. The Statute of Frauds, a law adopted by all states, requires a lease greater than one year on real property be in writing to be enforceable.
There are exceptions to the requirement of a writing. The most important exception is that of a lease. In such a situation, the lease or contract will not have to be in writing in order for its terms to be enforced. Although not always required by the law, common sense dictates that all leases be in writing for the benefit of the landlord. All-purpose leases are sold in all stationary stores for approximately five dollars; so it makes sense to use them to avoid potential problems.
A. A PERIODIC TENANCY
A periodic tenancy is a lease that runs from period to period such as month to month or year to year. It is automatically renewed for another period until terminated. Termination of a periodic tenancy occurs by giving proper notice to the other party of the intent to terminate the lease prior to the end of the current term. In most states, unless the parties agree otherwise, the notice requirements for the termination of a periodic tenancy are:
1. For a month-to-month lease, 30 days notice.
2. For a quarter-to-quarter lease, one quarter’s notice.
3. For a year-to-year lease, six months notice.
Unless valid notice is given, the landlord cannot evict a holdover tenant from the premises. For example, For a month-to-month tenancy, the landlord must give 30 days notice before the expiration of the term or else the lease does not legally terminate. The tenant has a right under the law to remain on the premises until a valid notice is given by the landlord.
B. A TENANCY-AT-WILL
A tenancy-at-will is a lease in which either party may terminate at any time. Unless the parties have expressly agreed that they intend the lease to be a tenancy-at-will, the court will treat it as a periodic tenancy. A tenancy-at-will terminates by operation of law when:
***END OF SAMPLE VIEW OF SECTION ***
B. MAINTENANCE OF COMMON AREAS
The common areas of multi-unit buildings are not part of a tenant’s leased property. The responsibility remains with the lessor to maintain the common areas in a safe manner. This would affect an individual lessor when he is renting a duplex, triplex or other multi-tenant property. There are always areas of shared access which come under the auspices of the landlord.
Lessors have been found liable for negligence in maintaining the common areas when injuries occurred. The lessor must use ordinary care to make the area safe for tenants and invitees (business guests) to the property. The latest extension of liability for common areas occurred when courts found lessors liable for crimes committed by third parties. The California courts have held, for instance, that lessors were negligent when they failed to install locks on gates leading to the property. Criminals went through those gates and attacked a woman tenant. The courts held that the landlord knew the property was in a high crime area and should have taken the minimum precaution of installing locks on the gates.
C. QUIET ENJOYMENT AND CONSTRUCTIVE EVICTION
Every lease agreement contains an implied covenant of quiet enjoyment. The covenant implies that the landlord will do nothing to interfere with the possessory rights of the tenant. In other words, if there is something that affects the tenant’s right to enjoy the property quietly, and it is within the landlord’s reasonable power to correct the situation, the landlord’s failure to correct is an interference with the covenant of quiet enjoyment.
Constructive eviction is some act or failure to act by the lessor when he has a duty to act which makes the property uninhabitable. The following conditions for constructive eviction must be met:
1. The act or failure to act must be by the landlord or his agent, not third parties.
2. The results of the act are to render the property uninhabitable.
3. The tenant must vacate the premises as a direct result of the landlord’s act. If the tenant does not vacate there is no constructive eviction.
A tenant may declare the lease terminated because of the constructive eviction and sue for damages suffered as the result of the eviction or sue for the return of possession of the property and damages suffered. The covenant of quiet enjoyment and constructive eviction go hand in hand. Simply, constructive eviction is such a serious violation of the tenant’s right to quiet enjoyment that the tenant must move. The best example is the violation of housing codes which make the property uninhabitable. In such an event, the landlord may be sued by the tenant for the costs of having to vacate the premises.
Based upon the foregoing discussion, a landlord should make sure that the property is maintained in accordance with the appropriate housing codes and should exercise common sense. If the property is maintained in accordance with those minimum standards, the landlord will have nothing to fear in court. Furthermore, the costs of such maintenance are deductible business expenses which actually improve the life expectancy of the property. Slumlords who fail to maintain their property are sacrificing reasonable and steady long term growth for short term profits.
VII. TENANT’S OBLIGATION TO MAINTAIN THE PROPERTY
A tenant has no duty to make any substantial repairs to the property unless the lease agreement imposes an express duty to do so. The tenant does have the duty to make minor repairs and to take other steps necessary to prevent damage by the elements. If the tenant does not make the minor repairs, the tenant will be liable for the damages caused because the minor repairs were not made. He, however, will not be liable for the actual cost of making the repairs.
***END OF SAMPLE VIEW OF THIS SECTION ***
IX. TENANT ABANDONMENT OF THE LEASE
When a tenant abandons property with time still remaining on the lease, the landlord has the following options available:
1. The landlord may consider the abandonment as an offer to surrender the property. If the landlord accepts the surrender and resumes possession of the property, the tenant is relieved of further liability on the lease. The fact that the landlord enters the property to make repairs or offers to rent the property to another on behalf of the tenant does not constitute acceptance of the surrender.
2. The traditional option, still available in many states, allows the landlord to do nothing and simply sue the tenant each month for the rent as it becomes due or wait for the end of the term and sue for the whole amount.
Many states require a landlord to attempt to mitigate his damages and try to rent the premises and apply the rent received to the damages owed by the tenant. The tenant is then liable for the difference. If the property cannot be rented, the tenant is liable for the full remaining rent owed for the unexpired term of the lease.
X. “HOLDING OVER” BY A TENANT
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XII. RETALIATORY EVICTION
Retaliatory eviction is the eviction of a tenant for reporting housing codes violations to the proper authorities. Many states, such as California, make it illegal for a landlord to evict a tenant for reporting housing code violations. In many states a landlord may be fined for committing a retaliatory eviction. Many defendants in an unlawful detainer action allege retaliatory eviction as a defense even though it may not exist. A “retaliatory eviction” defense goes hand in hand with the “implied warranty of habitability.” Tenants often claim that they refuse to pay rent because of the substandard condition of the property. If the claim is true, the landlord may be prevented by law from evicting the tenants and be precluded from collecting rent until the premises are improved to the standards of the housing code.
XIII. A TENANT’S DEFENSES TO AN UNLAWFUL DETAINER ACTION
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XIV. SELF-HELP BY THE LANDLORD AGAINST A HOLD-OVER TENANT
It used to be permitted for a landlord to lock a tenant from the premises after the lease expired. This form of self-help was widely used. A person need only to look at the movies of the 1940’s and 1950’s to see how hold-over tenants were then treated. It was a routine practice in the past to evict tenants behind in their rent.
Few states now permit a landlord unilaterally to evict a tenant. All states have unlawful detainer statutes to evict tenants wrongfully in possession. The unlawful detainer action is a summary procedure and is given preference on the court’s calendar. Most states today recognize that unilateral eviction can result in breaches of the peace and have abolished it altogether. Most states have created a tort (civil wrong) for “forcible entry and detainer” to prevent a landlord from resorting to unilateral eviction of a tenant. “Forcible entry and detainer” is a tort whereby a person, usually the landlord, unlawfully evicts a tenant from the leased premises. States which do not permit unilateral eviction remedies to the landlord will find the landlord liable for damages if he forces a tenant to be evicted or interferes with his possession of the property. California, for example, makes it a crime for a landlord to shut off utilities to a tenant for any reason and fines a landlord $100 per day for any “forcible entry or detainer” act.
XV. A WRIT OF POSSESSION
If the landlord wins in an unlawful detainer action, the court will enter a judgment in the landlord’s favor. The court will also issue an order that the tenant vacate the premises by a certain date. The clerk of the court will issue a certified order called a “writ of possession.”
If the tenant fails to move out by the allotted time, the landlord takes the writ of possession to the local sheriff or marshall’s office. A police officer will be dispatched to oversee the removing of the tenant’s possessions from the premises. The tenant’s possessions are taken from the premises and either left on the street (if the tenant is present) or placed into storage and sold to cover their storage fees after a statutory waiting period (if the tenant is not present).
XVI. SECURITY DEPOSITS
A security deposit is a payment in addition to rent that is a guarantee against damages to the premises. From this security deposit the landlord pays to repair any damages caused by the tenant. A security deposit is not rent. The purpose of the security deposit and its uses are clearly defined by statutes in most states. Many states require a security deposit to be kept segregated in an interest bearing account. A security deposit is refundable. The laws of many states, including California, impose penalties on the landlord that wrongly fails to return a security deposit which, in most states, must be refundable.
A landlord is required within a matter of days (usually 10) after termination of the lease to inform the tenant in writing as to how the security deposit was applied to satisfy the damages allegedly caused by the tenant. The landlord then must return the balance of the deposit. If the tenant feels that more of the security deposit should have been returned, the tenant should sue the landlord in small claims court for the amount in dispute plus any damages that the state law imposes on a landlord for misusing a security deposit.
XVII. FIXTURES
A fixture is personal property that is attached to the real property in such a way as to be considered a permanent part of the real property. Under common law all fixtures became the property of the owner of the property. Thus any improvements to the real property that were made by the tenant are owned by the landlord and cannot be taken by the tenant when the lease ends.
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XVIII. STATUTORY LIEN
Under the common law a landlord was not given a lien on the tenant’s property for unpaid rent. The laws of many states now give a landlord a lien for rent on the property of their tenants and on the crops grown on the leased land. The tenant still retains legal title to the property along with the right to possession, but a lien is attached to them.
The property to which the statutory lien of a landlord may attach depends on the statutes of each state. Most states that allow the lien permit it to attach all of the tenant’s property on the leased premises. A few states limit the landlord’s lien to certain types of property: growing crops on the leased land, fixtures used in a trade or business, or animals on the leased land.
The statutory lien must be enforced in accordance with the laws of the state involved. A lawsuit must be filed for enforcement. In some states recording a notice or filing a UCC-1 form with the secretary of state will serve to give notice to the world of the lien. Such notice will prevent the property from being sold without the landlord being paid. The lien gives the landlord some preference as a secured creditor should the tenant file for bankruptcy.
A landlord may waive his statutory lien both intentionally by his express agreement or unintentionally by his conduct. In most of the states that permit the lien, if a landlord permits the tenant to remove the property without asserting the right of his lien, the lien is waived forever on that property. When the landlord permits the tenant to sell the property on a promise that the proceeds will go to the landlord, the court will find a waiver. If the tenant then decides not to pay the landlord, the landlord must still sue the tenant.
CHAPTER 4
COLLECTING DEBTS IN SMALL CLAIMS COURT
Money is hard to get and even harder to keep. Therefore, everyone should always pay their just debts. Unfortunately, many people are professional deadbeats. These people deliberately run up debts for services or property and refuse to pay. Such people count on the fact that litigation through the normal court system is expensive and that it would usually cost more to collect the debt than it is worth. The cost for an attorney is usually at least $150 per hour. The normal debt collection runs at least $5,000 in attorney costs. Unless there is a written agreement that the prevailing party will get attorney fees, each side must pay their own attorney fees. It is this reality that the unscrupulous use to avoid paying their just debts.
In response to this situation, all states have adopted laws establishing small claims procedures. Under these laws, small claims, usually no more than $5,000, are heard before special judges, commissioners or attorneys serving as judges pro tem. The small claims court employs simplified procedures which make it easier for the parties to present their cases. Small claims courts are truly the people’s court. For most individuals a small claims appearance will be their only contact with the judicial system except for the occasional traffic ticket.
Small claims court exists as an alternative to the highly structured, complex and expensive traditional court system. Small claims courts are a cheap, fast and efficient means to settle disputes concerning small amounts of money.
There are many “How To” books on the market that instruct a person as to what he must do to file a small claims action. This chapter addresses most of the fundamental concerns people have concerning small claims court without having to buy expensive books that merely expand this information. Through this chapter the average person should be able to understand the small claims court procedure. The reader should be able to go to the clerk of the small claims court, get the forms and the local rules of court and intelligently start the action.
The reason this chapter is appearing in this book is to educate people on the advantages and simplicity of the small claims court. There is no reason that a person should forgive debts of hundreds or thousands of dollars because it is not cost effective to hire an attorney to sue for such money. Money represents a person’s future and safety. Money’s protection and its recovery from those who should not have it makes the knowledge contained in this chapter vital. Knowledge is power, power is money, and money is security. It is important to know how to go to small claims court to preserve one’s financial interest.
I. DEFINITION OF A SMALL CLAIMS COURT
The small claims court is a specially created court in which most disputes can be tried inexpensively and quickly. The rules of the court are simple and court procedure is relatively informal. Lawyers are not permitted to present or try the case. Claims vary from state to state. In California, for instance, disputes of $5,000 or less can be heard in small claims court. The regular filing fee for most small claims courts is between $6 and $15.
A small claims case is usually heard within forty (40) to seventy (70) days from the filing of the claim. While most small claims cases involve money damages, most small claims courts have the power to grant other remedies. For example, most small claims courts have the authority to grant injunctive relief which means authority to order a person to do or not do something (mandamus or injunction) if the value of the act ordered or restrained is within the monetary limits of the court.
II. FILING A SUIT IN SMALL CLAIMS COURT
Nearly anyone can sue in small claims court. The person bringing the suit is called the plaintiff and the person being sued is the defendant. An individual can sue other individuals or businesses and vice versa. Most states deny collection agencies the right to sue in small claims court, nor can someone file a small claims action for another. Most states deny assignees, persons who buy the debt of another, to sue in small claims court for collection of that debt.
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V. THE DEFENDANT
The plaintiff must state the names and addresses of the defendants: the people or business being sued. Therefore, the plaintiff must know the identity of the defendant. If the defendant is a business or corporation, the business’ legal name and address can be found with the city’s licensing agency, the tax assessor’s office, the fictitious business names files in the county clerk’s office, or the office of the secretary of state’s corporate division. All corporations incorporated in a state and foreign corporations doing business in a state are usually required to designate a person to receive process (service of complaints) for the corporation.
The correct names and addresses of the defendants are needed so they can be properly identified and served with the complaint, which is required before the court will hear the case.
VI. PRESENTATION OF THE PARTIES BEFORE THE COURT
Because attorneys generally are not permitted in a small claims action, both parties must represent themselves. In the same vein a corporation may appear in small claims court only through an employee or an officer or director of the corporation. A corporation may not be represented in small claims court by someone whose job is to represent the corporation in small claims court. In other words, a corporation cannot use an attorney in court if the function of the attorney is to represent the corporation on small claims actions.
Certain businesses and entities other than corporations, such as partnerships or joint ventures, may appear in small claims court only through a regular employee of the entity. The representative may not be someone whose sole job is to represent the business entity in small claims court. A trust may be represented in small claims court by the trustee of the trust.
VII. THE MONETARY LIMITS OF A SMALL CLAIMS CASE
The most important consideration in a small claims case is the amount of the claim sought. A plaintiff cannot exceed the jurisdictional limit of the court. If a plaintiff asks for more than the court is allowed to award, the entire case may be dismissed. If the plaintiff sues for less than is owed, he forever waives the balance. For example, assume that the plaintiff is owed twenty thousand dollars ($20,000) and sues for five thousand dollars ($5,000), the plaintiff forever loses the right to sue for the remaining fifteen thousand dollars ($15,000). The plaintiff could have sued in a regular court for the full $20,000, but he might have waited years to have the case heard and incurred large fees and costs preparing for the trial.
VIII. FILING FEES
There is always a filing fee for any complaint filed in any court. Courts are not free. In California the basic fee is $6 per case. Multiple filers, those with over 13 cases per year, $12 per case in California. In most states a person unable to pay the filing fee can request the court grant a waiver of fees. This waiver is called a “forma pauperis,” Latin for “form for a pauper.” If the plaintiff qualifies for the waiver, the fee is waived and subsequently recovered if the plaintiff wins. Put it another way: if the plaintiff wins the case, the defendant pays the filing fee as a court cost to the plaintiff.
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XI. SERVICE OF THE COMPLAINT ON THE DEFENDANT
A defendant must be served (presented the small claims complaint) in such a manner that the court will know that it was done. The procedural requirement must be correctly followed or the action may not proceed and may be dismissed altogether.
A plaintiff cannot serve the small claims action on the defendant. In some states, such as California, the court clerk will mail the complaint to the defendant’s address by certified mail. Service is complete if the defendant signs for it. The fee for this is $3 in California. If the defendant does not accept delivery of the certified mail, the plaintiff must serve the defendant with the small claims complaint in another way.
The defendant can also be served by personal service. Personal service requires a person over 18 years of age to deliver the complaint to the defendant personally. A sheriff will do it for about $25 or a commercial process server will do it for about $50. Once the complaint is filed, a proof of service is filed with the court stating the date and location of service. The case will not be dated for trial until proof of service is filed with the court.
In most states the defendant may be served by substitute service. Substitute service requires the process server to leave a copy of the complaint with an identified person at the business or residence of the defendant and to mail a copy of the complaint to the defendant at that address within 10 days. Proof of service must be filed by the process server stating the name of the person who accepted the complaint.
XII. FAILURE OF THE DEFENDANT TO APPEAR AT TRIAL
If the defendant does not appear at trial, the court first will determine if the defendant was properly served. The court will determine if service was valid. If service was procedurally invalid, the court will dismiss the case for want of jurisdiction over the defendant. If service was valid, meaning the complaint was properly served on the defendant, the case will continue.
Judgment is not automatic for the plaintiff just because the defendant fails to appear. The plaintiff must still put on evidence proving his entitlement to damages. This is called a “prove up” hearing. The judge will hear only the plaintiff’s case and decide if damages should be awarded. Just because a defendant does not appear does not mean that a judge can award damages. Perhaps the plaintiff cannot show liability or there would be a violation of state or federal law.
If the plaintiff wins the action, the court will issue its judgment. Part of the judgment will be an award for the damages suffered by the plaintiff, the court costs in bringing the suit and the amount of interest permitted under state law.
XIII. DEFENDANT MAY FILE A COUNTERCLAIM AGAINST THE PLAINTIFF
The defendant may file a claim against the plaintiff in small claims court. The claim does not have to be over the same fact pattern as the plaintiff’s claim. Example: The plaintiff may sue over a car accident, and the defendant may countersue over a broken refrigerator totally unrelated to the car accident.
The defendant’s claim is subject to the same restrictions as the plaintiff’s claim. The defendant may not sue for damages over the court’s jurisdictional limit and must comply with the statute of limitations. Any amount exceeding the limit is forever waived, as with the plaintiff’s claim.
The defendant may file his complaint in the regular courts, municipal court, superior court, district court or whatever that state calls its courts or even in federal court if appropriate. The plaintiff’s small claim action will be transferred to the regular court if it arises from the same fact pattern as the defendant’s action. In regular court the plaintiff may then increase his claim for damages and hire an attorney to handle the action as a regular lawsuit.
XIV. PRESENTING THE CASE BEFORE THE JUDGE OR JURY
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XV. THE SMALL CLAIMS JUDGE
Most small claims court judges are full judges of the local court. Many states permit private attorneys to sit as temporary small claims court judges called judges pro tem. In order to hear a small claims case as a judge pro tem, the attorney must have the written consent of both parties. If both parties agree to have a private attorney serve as the judge, the attorney will hear the case and render the decision in the same manner as a regular judge. The judgment of an attorney serving as a judge pro tem is treated for all purposes as a valid court judgment. Generally, pro tem judges are not used if the case is to be tried by a jury.
If the parties do not stipulate to the use of a private attorney, the case will be continued to a time in the future when a regular judge is available. Usually, the first notice to the parties that a regular judge is not available is on the date of trial, when the clerk asks the parties to stipulate to a private attorney.
XVI. THE APPEALABILITY OF A SMALL CLAIMS JUDGMENT
In most states, including California, a plaintiff may not appeal the judgment of a small claims action. If the plaintiff loses, the case is over and cannot be relitigated.
The defendant, however, can appeal the judgment of a small claims court. Usually in an appeal, the case is retried in a regular court and before a real judge. The new trial is called a “trial de novo”, which means a completely new trial. In California, small claims appeals are heard in Superior Court. In California, when a small claims case is appealed, both parties may then use attorneys, but that is the exception to the general rule that attorneys may not appear in small claims cases.
In like manner, a plaintiff is entitled to appeal a judgment against him awarded to the defendant on the defendant’s claim, and a defendant is not entitled to appeal a loss of his claim against the plaintiff: the defendant’s counterclaim places him in the position of plaintiff. For example, assume that a plaintiff sues a tenant for $3,000 back rent. The tenant, who is the defendant, sues the plaintiff for $2,000 retaliatory eviction. The court rules for the defendant and awards him $1,500, and he cannot raise the argument that he should have been awarded more.
Some states, such as California, permit a judge to fine a defendant for filing a frivolous appeal. In California, if the court finds that the appeal was frivolous, it can award the plaintiff $250 as attorney fees. It is rare that the court will find the appeal was frivolous. “Frivolous” means the appeal was without merit and intended solely to harass, delay or encourage the other party to abandon the claim. If state law permits sanctions for filing a frivolous small claims appeal, there is no harm in asking for them.
XVII. COLLECTING THE JUDGMENT
Once the court issues a money judgment, the prevailing party, the person being awarded the money, becomes a judgment creditor of the losing party, who is now the judgment debtor.
The judgment may specify that the amount of money is to be paid in full to the judgment creditor or allow the judgment debtor to make periodic payments. Periodic payments are usually ordered in the judgment only if the parties entered a settlement agreement ordering them. Interest is usually computed on a judgment from the date of its award. The legal rate of interest varies from state to state but is around 10% per year.
Once the judgment is issued it is up to the judgment creditor to collect. Collecting a judgment is the most frustrating part of the small claims process. A judgment does not guarantee payment. A judgment debtor may be without assets, “judgment proof”, or be uncooperative, causing extra effort or costs.
The court is not a collection agency. It will not collect the award for the judgment creditor. It will supply orders and documents to help collect the judgment. Often an attorney or collection agency is hired to collect the judgment.
A. ATTACHMENT OF WAGES
The court issues its judgment in favor of the prevailing party. The prevailing party is the winner and can be the plaintiff winning on his complaint or the defendant winning a judgment against the plaintiff on the defendant’s claim. The judgment is taken by the winner to the clerk of the court. The clerk of the court issues a writ of execution containing the information in the judgment.
A writ of execution is a court order directing the sheriff or marshal to take control of or levy upon the assets of the losing party to satisfy the judgment. It is the responsibility of the judgment creditor to tell the marshal or sheriff where the property is located so it can be seized.
Wages can be attached (“garnished”) to pay the judgment. Most states have laws to prevent employees being fired because their wages have been attached.
All states provide debtors statutory exemptions from collections. A debtor is allowed to earn a certain amount of money in wages and have a certain amount of property that cannot be attached or seized to satisfy the judgment. Only property over these statutory amounts can be taken to satisfy a judgment.
B. SEIZURE OF REAL PROPERTY
Real property can be seized and sold by a marshal or sheriff executing a small claims judgment. Every state has its own procedure for execution on real property. The sheriff or marshall advertises in a newspaper of general circulation that on a certain date (usually after 30 to 60 days notice to the debtor) the real property will be sold to the highest bidder at a public auction at the sheriff or marshal’s office.
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D. EFFECT OF A DEFENDANT’S BANKRUPTCY
When a debtor files bankruptcy, there is an immediate “automatic stay” on any collection lawsuits being filed against the debtor. A person in bankruptcy cannot be sued in small claims court. Any judgment taken against a person while a bankruptcy proceeding is pending is void and unenforceable.
Furthermore, under the bankruptcy law, all judgments obtained within three months of a debtor’s bankruptcy are set aside and must be relitigated again in the bankruptcy court. Older judgments are treated as unsecured claims in the bankruptcy proceeding except for judicial liens against real property. That means they are paid in a percent equal to the ratio of debts to assets in the estate after secured debts and allowable expenses have been paid. Assume, for example, that a creditor has an unsecured judgment of $4,000 against a bankrupt debtor. Assume the bankrupt debtor’s estate is $20,000 after payment of all allowable debts and expenses and the unsecured debts are $80,000. The creditor’s debt will be 5% of the distributable estate: $1,000. Moral: A creditor should attempt collection immediately after the judgment is obtained in order to assure full recovery.
E. SATISFACTION OF THE SMALL CLAIMS JUDGMENT
When everything works right, the party with the judgment, the judgment creditor, is paid in full or whatever lesser amount that might be agreed among the parties. The judgment creditor is required to file a form with the court after the judgment has been paid, called a “satisfaction of judgment.” The recordation of satisfaction of judgment removes the liens placed on the debtor’s property by the prior recording of an abstract of judgment.
Failure to record a satisfaction of judgment could expose the judgment creditor to a lawsuit for slander of title. Failure to file (record) the satisfaction of judgment would keep a lien on the debtor’s property and thus prevent the defendant from obtaining loans or selling his property. Such would make the creditor liable for extensive damages.
F. EXAMINATION OF THE DEBTOR FOR ASSETS
It is the judgment creditor’s responsibility to collect the award, and the creditor is given certain rights that help him. Many courts require the debtor to file a statement of assets once the judgment is entered. Using this statement of assets, the creditor is able to obtain the writ of execution from the court clerk. All states permit the creditor to apply for an “order to appear for a judgment debtor’s examination.” This is a court order for the debtor to appear on a certain date and time to be questioned under oath about his money and property.
A judgment debtor’s exam is usually limited to one every six months until the judgment is satisfied. In addition, most states require a debtor to file a financial statement and list all of the assets he owns. A debtor is required to file it as a tool for the creditor in discovering property that can be seized and sold to pay the judgment.
XVIII. SMALL CLAIMS SUITS FOR BAD CHECKS
Small claims courts were established primarily to handle bad check complaints. These are complaints for bad checks of relatively small amounts. Most people have seen a list of bad checks in small restaurants to embarrass the writer. Every state has some type of bad check law that permits a business, and in some instances individuals, to sue for several times the amount of the bad check. In California, Civil Code Section 1719 permits a suit to be filed for value of the check plus three times the amount of the check. The additional amount will be at least $100 with a maximum of $1,500.
Some states, like California, require that the debtor be given notice by certified mail of the bad check before the court will award the additional amount. Anyone given a bad check can always sue in small claims court for the amount and for the penalty also.
XIX. VALIDITY OF SMALL CLAIMS JUDGMENT
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PART II
INVESTMENTS
This section deals with the most common types of investments the average person might consider. Not every type of investment is discussed. This book is not directed toward wealthy individuals. Such will have financial advisors to render advice on investments far more complicated and expensive than the average person can afford. This book is aimed at the middle class person who cannot afford to pay $150 per hour to financial planners to invest $50 per week.
The only assured way to die wealthy is to save slowly. The investments discussed herein are not get-rich-quick schemes. There are a few sure means of getting rich but they are very hard to achieve with certainty such as winning a lottery or marrying a wealthy spouse. There is a line in an old Three Stooges movie where Curly opens a book entitled, “How to Make a Million.” He reads, “How to make a million: find someone with two million and ask for half.” If such advice works, it’s great advice.
The advice herein is basic and simple. Essentially, it can be summarized as “pay as little taxes as legally possible and invest all disposable money in good stable investments”. As to the investments that a person may choose, the most common are discussed in this book. There are discussions on stocks, bonds, mutual funds, money market accounts, commodities, limited partnerships, annuities, and real estate investment trusts among others. Both benefits and risks attendant to each type of investment are discussed. There is no reason why a careful, prudent investor cannot develop a financial plan to accomplish steady, safe growth of an estate. It is toward that end that this book is directed.
CHAPTER 5
LIMITED PARTNERSHIPS
Limited partnerships are one of the most popular forms of investments. A limited partnership shares some of the characteristics of both a general partnership and a corporation. A limited partnership is neither a general partnership nor corporation. It also has certain investor drawbacks that neither of the above possess.
Investments in limited partnerships have resulted in a great deal of litigation over the propriety of the actions taken by the general partners. A true example of such was a California lawsuit for an accounting brought by some of the limited partners against the general partners concerning operation of a public golf course. The general partners had entered a special operating agreement with the golf course and received substantial benefits without disclosing that fact to the limited partners. After discovering the existence of the special operating agreement, the limited partners brought a lawsuit alleging that the arrangement violated the fiduciary duties of good faith and fair dealing which the general partners owed to them. This was a complicated case that occurred because neither the general nor limited partners fully understood their respective rights and obligations under California partnership law or the partnership agreement.
This chapter is dedicated to providing the basic information as to what limited partnerships are, how they operate and the role which a limited partner plays. People invest in limited partnerships to make money while not taking needless risks with their investments. This chapter is geared to explaining how limited partnerships operate so that the average person can understand the presentation of a person selling a limited partnership and be able to evaluate the true risks and rewards of the investment.
I. THE UNIFORM LIMITED PARTNERSHIP ACT
The National Conference of Commissioners on Uniform State Laws wrote the Uniform Limited Partnership Act (ULPA). Also created was the Revised Uniform Limited Partnership Act (RULPA). One of these acts has been adopted by every state except Louisiana. In addition, the Uniform Partnership Act applies to limited partnerships except where it is inconsistent with provisions of the ULPA or RULPA or state law.
The ULPA and RULPA provide the rules on how a limited partnership is to operate in situations not covered in the limited partnership agreement: the ULPA and RULPA fill the blanks of a limited partnership agreement. The partners can agree not to use some of the ULPA provisions. There are some ULPA and RULPA provisions required by state law that cannot be altered or stricken from a limited partnership agreement.
II. WHAT IS A LIMITED PARTNERSHIP
A partnership, whether general or limited, is two or more persons or entities working together as co-owners to run a business for profit. The Internal Revenue Code defines a partnership in Section 761(a) as:
“A syndicate, pool, joint venture or other unincorporated organization through which…any business is carried on… and is not a corporation, trust, or an estate (meaning sole proprietorship).”
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III. PARTNERSHIP PROPERTY
Under the Uniform Limited Partnership Act, property which is titled in the partnership name is owned by the partnership. A partner who contributes property to a partnership relinquishes ownership in the property. Likewise, property purchased with partnership funds is owned by the partnership.
The property held by a partnership can be legally sold, transferred or conveyed only by the partnership. Since partnership property is owned by the partnership, it cannot be directly attached to satisfy any court judgment taken against any partner, limited or general. A limited partner’s ownership interest in a partnership can be attached and sold by a creditor but not the underlying property in the partnership. This is a very important aspect of partnership law.
An investor loses all individual rights in property contributed to a limited partnership. Assume a limited partner contributed a farm to the limited partnership worth $1,000,000 and is to receive $1,000,000 back upon termination. The limited partner has no legal right to request the return of the farm instead. In the same vein, creditors of the limited partner cannot sue the partnership for return of the farm. The rights of creditors of a limited partner against the partnership are limited to an attachment and sale of the partner’s interest in the partnership, not a recovery of property contributed to the partnership. This means that partnership interests are treated like stock in a corporation. The value of the stock is determined by the percentage value of the entire business and not by the value of the property that an individual person contributed to buy the stock or partnership interest.
IV. POWERS OF A GENERAL PARTNER IN A LIMITED PARTNERSHIP
Under both the ULPA and the RULPA, a general partner of a limited partnership has all of the powers of a partner in a regular general partnership. All partners have certain basic rights in a general partnership. These rights are:
1. The right to insist on a partnership accounting and the right to have the books examined by an outside accountant.
2. The right to dissolve the partnership in accordance with the terms of the partnership agreement or, if none, the Uniform Partnership Act of the state.
3. The right to restrain the partnership from performing acts prohibited under the partnership agreement.
4. The right to bring a legal action for breach of the partnership agreement.
These are implied rights in any partnership agreement. Provisions in partnership agreements that waive such rights are usually found to be invalid and against public policy.
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V. ACTS REQUIRING CONSENT OF LIMITED PARTNERS
In a general partnership, each partner has full authority to act on the partnership’s behalf in the normal course of its business. Each partner can bind both the partnership and the other partners to contracts even if the other partners never authorized or approved the contracts. This unlimited power on the part of one partner to bind the partnership and the other partners is the biggest concern of most investors. Partners may agree to limit their authority to bind the partnership or act on its behalf.
People dealing with a partnership are entitled to assume, unless informed otherwise, that any partner has the right and power to act for the partnership in the normal course of its business. Even though a partner may have limited authority to act for the partnership, the apparent authority of the partner may nevertheless bind the partnership to contracts with third parties. Contracts entered with people who did not actually know that the partner lacked the authority to bind the partnership are binding on the partnership.
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Most states permit limited partners to participate in the following matters without losing their protected status:
1. Vote on the dissolution of the partnership.
2. Vote on the election or removal of general partners.
3. Vote on the admission of new limited partners.
A limited partner can, unlike a general partner, conduct a business in competition with the partnership unless prohibited by the partnership agreement.
VII. FIDUCIARY DUTY OF ALL PARTNERS
By law every partner, both general and limited, is an agent of the partnership. Each partner owes a fiduciary duty to the partnership and to the other partners to act in their best interests. Some of the important things that partners cannot do alone are:
1. A partner may not usurp a partnership benefit. This means that a partner must give the partnership the right of first refusal on any business opportunity that the partner comes across which may be of benefit to the partnership. Example: the partnership is in the paving business and a partner finds out that a school is intending to repave its parking lot. The partner cannot bid on the job for himself without first informing the partnership of the job and giving the partnership the chance to take the job itself.
2. A partner may not divert partnership assets for the partner’s own personal use. Such conduct is a breach of trust and may even expose the partner to criminal liability.
3. A partner must fully disclose all material facts of any business dealing affecting the partnership and its affairs to the other partners.
A partner who breaches any of these duties may be sued by the other partners for their lost profits or other damages suffered as a result of the partner’s misconduct. Where the partner has usurped a partnership benefit (taken it for himself), the partner may be ordered to pay all of the profits realized from the transaction to the partnership on the theory that the partnership should have received those profits instead.
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X. LIMITED PARTNERS
Anyone can be a limited partner. Individuals, corporations, trusts, general partnerships, limited partnerships can all be limited partners in a limited partnership. Example: Abel Limited Partnership may be a limited partner along with Boxer Corporation and George Investor in the Ajax Limited Partnership.
Furthermore, a general partner may also be a limited partner in the same limited partnership. Although such a general partner is still liable for partnership debts, the limited partnership share of his investment is treated as a limited partnership contribution.
XI. TAXATION
A partnership is subject to its own peculiar tax treatment under federal tax law. Most unincorporated associations and trusts that conduct business are taxed as though they were corporations. Partnerships, however, are treated differently. In a partnership, the income is attributed to the partners in accordance with their percentage of partnership interest. The partnership pays no income tax itself on the federal level. For example, if a partnership earns $1,000,000. It will pay no taxes. The partners will have to include the $1,000,000 on their tax returns. Assuming a 28% personal income federal tax rate, the partners will pay $280,000, not the total $519,200 that a C corporation and its shareholders must pay.
The partnership does not pay any taxes on the income from the partnership. All partnership profit or loss is passed through to the partners. The partnership files its Form 1165 partnership return and its K-1 to inform the IRS on the profit or loss allocation to each partner. Each partner is treated for tax purposes as a self-employed individual and is required to estimate his share of the partnership income and make estimated IRS quarterly payments.
Unless a limited partnership does business in a state which has no income tax (of which there are very few and getting fewer), it will have state tax laws with which it will have to comply. Limited partnerships are usually treated by the state tax codes in very nearly the same manner as they are treated by the Internal Revenue Code: as “pass-through vehicles” for the partnership. All profit or loss of the partnership “pass through” which mean that they are attributed to the individual partners according to their ownership interests in the partnership.
The effect of this pass through of profit or loss is that the partnership is not taxed, and there is no double taxation of the partnership income (as there is with a regular corporation’s income). Individual state laws can vary from the federal tax law on specific items, but they are quite similar in concept.
XII. TAX DIFFERENCES BETWEEN A PARTNERSHIP AND A S CORPORATION
Partnerships provide more flexibility than S corporations in a few areas:
1. Partnerships may admit anyone as a partner and may have any number of partners. S corporations are limited to 35 members of special status.
2. Partnerships can divide profits and losses in a manner not related to the partners’ ownership interest. S corporations must divide profits and losses among the shareholders in accordance with their percentage of stock ownership.
In most cases these differences are not important because the S corporation usually does not want additional shareholders and does want profit and loss allocated according to shareholder investment. The important difference between S corporations and partnerships is that there is no personal liability on the part of the shareholders for the corporation’s debts. In comparison, general partners (but not the limited partners) are personally liable for the partnership debts.
XIII. COMPLIANCE WITH FEDERAL SECURITY LAWS
The sale of a general partnership interest is not a security under the Securities and Exchange Act and can be sold without having to be registered or exempted from registration with the Securities and Exchange Commission (SEC). On the other hand, laws concerning sale of a limited partnership interest are quite different. The sale of a limited partnership interest, by contrast, is considered a security. Therefore before a limited partnership interest can be sold, it must be registered with the Securities and Exchange Commission unless the sale qualifies for an exemption from registration.
There are several exemptions from this Federal registration requirement which most small limited partnerships meet. The exemptions are:
1. An intra-state exemption under section 3(a)(1) of the Securities and Exchange Act. This is the most popular exemption for small companies. It is available where all the partners reside in the same state where the partnership is incorporated and doing business.
2. The sale of the partnership interest is a non-public offering under section 4(2) to sophisticated investors, and no advertisement or solicitation was done.
3. The sale complied with Regulation D requirements of the SEC. This exemption requires adherence to strict disclosure provisions to the investors.
The partnership may sell its interests without interference by the SEC if it fits an exemption.
A limited partnership must also comply with state security laws. A limited partnership must either be registered to sell its interests in every state that it intends to sell or be exempt from registration under a state’s law. No person should ever invest in a limited partnership without first being assured that the limited partnership has complied with all registration requirements or is exempt from registration. The potential investor should ask to see all information proving that a permit or exemption was issued for the sale of the interests. If an exemption is being claimed to avoid a registration, the investor should ask to see an opinion letter from an attorney that the exemption is truly available for the limited partnership.
XIV. COMPLIANCE WITH STATE SECURITY LAW
All states require that limited partnerships selling their interests in the state either have a permit to sell the partnership interest or that the sale fall into one of the state’s statutory exemptions. Just as with the SEC, all states have some type of exemption for registration of securities. Usually, a partnership of less than 35 partners, as in California and Nevada, can simply sell the limited partnership interests and notify the secretary of state or record a certificate of limited partnership. The recordation gives notice that such limited partnership interests have been sold. The partnership is not required in most states to identify the names of the thirty-five or less limited partners to whom it sold the partnership interests.
Most states follow federal law and hold that the sales of general partnership interests are not securities. California, however, makes that determination on a case-by-case basis depending on the degree of control that the general partners actually exert over the partnership.
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It is important that every investor verify that a state permit or that a valid exemption exists. If the state department of corporations or security department determines that the partnership does not qualify for an exemption, it will issue a cease and desist order. This is an immediate administrative order to stop selling the partnership interests and return all monies collected. Since most businesses, in such a situation, have already spent the money, they are forced to close and default on repaying the investors. Regulators do make mistakes, but they, unlike the poor citizens, have government immunity to protect them from the damages their results cause. In one of the most important security cases in California history, William Moreland vs. Department of Corporations, (1987) 194 Cal.App.3d.506, the plaintiff sold gold ore along with a contract to refine it once a refinery was built. The California Department of Corporations concluded the transaction was a security and issued a cease-and-desist order. There never was a question of fraud. In fact, the government’s own assays showed that the gold ore contained even higher concentrations of gold than the plaintiff had advertised. The government’s contention was simply that the plaintiff needed a security to sell it. The plaintiff’s operations were immediately halted under the cease-and-desist order. The plaintiff fought the matter in court for 18 months and was, eventually, forced to file for bankruptcy. Although he ultimately won the case, both the plaintiff and his investors had suffered millions of dollars in needless losses because of the agency’s misinterpretation of the security laws. The plaintiff could not sue the state for his damages suffered as a result of the improperly issued cease and desist order because of state immunity. The irony is that the investors, whom the government was supposed to protect, also suffered because their investments were adversely affected by the client being wrongly forced out of business. The holding of this case has helped to develop California’s security law and actually served as a basis for a CBS “60 MINUTES”.
CHAPTER 6
STOCKS
Stocks are the title instruments of ownership of a corporation. A corporation issues a fixed number of shares in itself. These shares divide the ownership of a corporation among the shareholders. The shares are called stock. Control of the corporation is determined by the will of those who own a sufficient total number of the shares of stock which have been sold.
Stocks have always been a primary focus of investment. In exchange for purchasing their stock, investors become shareholders and get the right to share in the net profit of the corporation each year. The profit is paid in the form of dividends. Particularly successful companies may, in addition to a yearly dividend, see a steady increase in the value of their stock.
The price of a stock is governed by three important factors: yearly productivity of the company, net asset value and public perception of the company. Yearly productivity is the performance of the company itself. Net asset value of the company is the value of the company after all debts have been paid. By dividing net asset value by the number of outstanding shares, a person can determine the actual value of each share. The third factor that determines the price of the stock is public perception. Most stock prices have no relation to net asset value; they are based upon a belief that the company will make more money in the future. Many companies pay excessive dividends rather than reinvest in the company. Consequently, yearly productivity is high but net asset value is low, and public perception is high because of the high dividends. On the other hand, many companies with low productivity but the possibility of great potential have high stock prices. For example, the company Genetech was the first company in the private sector to engage in genetic research. Genetech’s stock prices have been very high despite relativity low productivity. However, given the recent accomplishments of the company, the patience of its investors is predicted to be amply rewarded.
I. STOCK EXCHANGES
The stock of public companies is sold through one of thirteen stock exchanges in the United States. The two largest and most recognized exchanges are the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX). The stock exchanges have sold the right to use the exchange to purchase and sell stock to member stock brokerages such as Paine Webber, Prudential-Bache, Merrill Lynch, Sherson-Lehman and others. This right to trade on an exchange is called “having a seat.” A stock exchange has requirements a company must meet before its stock can be sold on it. Under the New York Stock Exchange regulations a company must have earnings of at least $2.5 million dollars and more than 2,000 shareholders. Each exchange determines its own trading requirements.
Besides the more traditional stock exchange, there is also the “over the counter” (OTC) market. Companies which cannot or do not want to be traded on the major stock exchanges can sell their stock over the counter (OTC). Many of the major corporations are traded over the counter. Over the counter trading is conducted through NASDAQ which is a computerized network system rather than the trading floor arrangement utilized by the exchanges. The stock of start-up companies will usually be sold on the OTC market because these companies do not qualify for the major exchanges.
II. CHOOSING A STOCK BROKERAGE
There are two types of stock brokerages: full-service brokerage and discount brokerage. Full-service brokerage provides investment advice while the discount broker merely buys and sells the stock as the client orders. There is a large difference in price. A full-service broker charges a fee of 6% of the value of the transaction on every purchase or sale for a client’s account. On the other hand, the discount broker usually charges less than one-half percent. The difference in price is because the discount brokerage has reduced overhead: it does not have to maintain a research department.
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Regardless of the type of brokerage house used, it should be guaranteed by the Securities Investor Protection Corporation (SIPC). This means that the accounts with the brokerage house are insured by a government-sponsored agency for $50,000 or less in the event the broker goes out of business. Given the fact that several brokerages have experienced financial troubles in the last few years, it makes no sense to keep any stock over the insured amount with a brokerage. The investor can split investments among several brokerages or take possession of the securities. If the investor intends to keep the stock for many years, it probably would be better to take possession of the stock. By the time the stock is actually sold the broker who originally purchased it may no longer with the company.
III. SOURCES OF INVESTMENT ADVICE
In the last ten years, there has been an explosion of easy-to-use investment advice regarding investments. Every major newspaper lists the daily trades of stock traded on the public exchanges. There are literally hundreds of advisory services available to the inquiring investor. The most common sources of information are investment treatises such as “Standard and Poor’s” and “Dunn and Bradstreet.” These give a complete history of every company traded on an exchange, including its profit and loss statements and balance sheets. By looking up a particular company a person can usually obtain sufficient information to determine whether to invest. Most public libraries and almost all college libraries have business sections containing such treatises.
There are hundreds of investment newsletters along with financial newspapers such as the “Wall Street Journal” and “Barron’s.” The most beneficial source of financial information is probably television. Public television carries the financial show “The Nightly Business Report” that is the finest financial show of its type. No serious investor should make a decision without first becoming familiar with the working of the financial world. “The Nightly Business Report” gives better long-term investment advice than probably any brokerage. Its guests are usually the top analysts for the major brokerages; so the viewing audience gets the best and most direct access to the best financial minds.
IV. TYPES OF STOCK
A company may issue two types of stock: common stock or preferred stock. Common stock is, as the name implies, ordinary stock with all the normal incidence of ownership such as the right to vote and the right to receive ordinary dividends. Preferred stock is stock with special rights. Preferred stock is usually issued by a company in order to attract investment capital.
Preferred shareholders occupy a premier location in the hierarchy of the corporation. The rights of the preferred shareholders are superior to those of the common shareholders. Many preferred stocks guarantee that the shareholders will receive a fixed dividend regardless of whether the company makes money or not. On the other hand, a common shareholder will receive a dividend only if the company makes money, and the amount of the dividend is not guaranteed. If there is not enough profit to pay the preferred dividends, the obligation to pay remains in arrears until there is sufficient profit. No dividends will be paid common shareholders until all arrearages for the preferred dividends are paid. The dividend rate for preferred stock does not change. No matter how the company’s earnings change, the preferred rate does not change. Sometimes, this works to the investor’s disadvantage. In a very successful company the common shareholders will earn more in dividends than the preferred shareholders. Such is usually not the case. In most instances the preferred shareholders receive a greater return than the common shareholders.
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V. OPTIONS
A kissing cousin of a share of stock is a stock option. This “option” is the right to buy or sell stock at a certain price. Option trading is simple in concept but tricky in application. With the assistance of an exceptional broker an investor can make the proverbial killing. With a less than exceptional broker the investor will be killed, gutted, stuffed and mounted.
Options work by the investor purchasing from another person the right to buy or the right to sell a certain amount of a company’s stock for a designated price, called the “strike price,” on or before a specified date. If the option is not exercised by a specified date, it lapses. In the parlance of the industry an option to buy stock at a certain price is called a “call” option while an option to sell stock at a certain price is called a “put” option.
The following is an example of a call option. The stock of Gabriel Petroleum is selling for $10 per share. The investor thinks that the stock might go to $15 per share. The investor can buy a call option for $1 per share to purchase the stock at the price of $10 per share by December 31. The investor purchases 5,000 options for the price of $5,000. On October 13, the price of the stock has risen to $15 per share. It will cost $50,000 to exercise the option (5,000 shares times $10 exercise price). The stock is worth $75,000 (5,000 shares times $15 per share). If the investor exercises the option, he will make $20,000 profit ($25,000 increase in value minus $5,000 option price). If the investor does not have sufficient money to exercise the option, he can go to the bank and pledge the option as security for a loan. The bank will loan on such an option contract and be paid immediately from the proceeds from the exercise of the option. If the price of the stock does not rise, then the investor will lose his entire $5,000 investment in the options.
A sell option, called a “put,” is the reverse of a call option: a person agrees to purchase stock from the investor at a certain price before the exercise date. A put option works when the investor believes that the stock will go down in value. The investor will make money on the difference between the strike price and the actual drop in value. The following is an example of a put option. Gabriel Petroleum stock is selling for $10 per share. The investor believes that the stock will go down in value. The investor buys a put for $1 per share for 10,000 shares at the price of $8 per share by December 31. The stock drops to $6 per share. At $6 per share, the investor buys 10,000 shares for $60,000. The investor then exercises the option and forces the person bound by the put to purchase the 10,000 shares at $80,000 ($8 per share). The profit is $10,000 ($20,000 difference in price minus the option price).
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Options are purchased just like stock through a stock broker. There are options available for most major stocks. In addition, there are options for managed portfolios such as mutual funds. What should always be borne in mind by any investor is that an option is a gamble concerning the market price direction a stock will take. A wrong guess or a move not as sufficient as anticipated will result in loss of the option payment. A correct guess, on the other hand, means profit.
VI. MARGIN TRADING
To make huge profits in the stock market, a person must own a large number of shares. As mentioned before, one way to obtain those shares is through an option. An option, however, must be renewed, or it terminates on the expiration date. An investor may have to renew an option as often as four times per year. This could result in a large outlay of cash just to maintain the option, reducing the profit of the transaction. One alternative to the use of an option is for the investor to control stock which he cannot afford: through margin trading.
Margin trading is basically the purchase of stock on credit through a stock broker. As with most purchases on credit, an investor pays some money and borrows the remainder from the brokerage house. The Federal Reserve Board regulates the amount of money which a person must place on a margin account. The amount required to be placed on margin accounts has been as high as 65%.
The reason for the substantial placement on a margin account is that the Federal Reserve Board seeks to avoid what happened at the beginning of the Great Depression. Prior to the 1929 crash, it was possible to purchase securities on margin for as low as ten percent (10%). As a result, there were tens of millions of “paper” millionaires. When the crash hit, margin calls (demands for additional payments on the loans) were made. When the demands were not satisfied, the stocks in the margin accounts were sold and the accounts liquidated. Millions of people were suddenly rendered destitute. The Federal Reserve Board has been charged with implementing procedures to ensure that such unrestricted margin trading does not occur again.
Margin trading works by increasing the number of shares which an investor controls. As long as the stock increases in value there is no problem. The investor borrows the amount needed to cover the loan. The broker waits until redemption of the stock in order to get paid. If the stock falls below an agreed value, the broker is authorized to make an immediate demand for additional payment or to sell the stock to cover its loan.
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VII. SHORT SELLING
Another means of trading in stock which a person doesn’t own is through the technique of short selling. As with a put, short selling is based on an educated gamble that the stock price will go down. When stock is sold short, the seller sells stock which he does not own, a neat trick only permitted in security sales through a broker. It works because the stock is borrowed from the broker. When the price goes down, the investor purchases replacement stock and gives it to the broker. The investor realizes a profit between the price of the stock at sale and the price of the replacement.
An example of short selling: An investor sells 10,000 shares of Gabriel Petroleum through a broker for $10 per share. The investor does not own the shares. The broker covers the sale. The investor receives on paper $100,000. In reality, the broker holds the funds as security for replacing the stock. When the stock falls to $8 per share, the investor purchases 10,000 shares for $80,000 and gives them to the broker. The investor then takes the $20,000 profit minus the broker’s commission.
The downside is obvious. If the stock does not fall or, heaven forbid, actually rises, the investor will suffer severe economic hardship. In the above example, if the stock rose $2 per share instead of falling, the investor would have to pay $20,000 more plus commissions to cover the short sale.
CHAPTER 7
BONDS AND GOVERNMENT SECURITIES
Two related types of investments are bonds and government securities. This chapter will focus on the similarities and the differences of these types of investments. Such investments should only be undertaken after careful consideration of many factors. No one should ever assume that a bond is safe because it is from a major corporation or guaranteed by a state. Nothing in life is guaranteed except death and taxes. A prudent investor never forgets this truism.
I. BONDS
A bond is an instrument of debt. It is a debt instrument wherein the buyer of the bond lends money to the issuer of the bond in an amount equal to the face value of the bond. The bond issuer is usually a corporation or a government entity. The issuer makes payments equal to the interest rate specified in the bond for the period of time covered by the bond. Upon reaching the maturity date of the bond, the issuer pays the entire principal (face value) of the bond. The payments of the interest are sometimes called “coupon payments” because at one time the holder of the bond had to detach coupons from the bond and submit them before an interest payment would be made.
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II. CAPITAL GAIN AND LOSS TREATMENT
Investments in bonds are treated like any other investment. Gains or losses incurred in the sale or trade of bonds are subject to capital gains tax. If a bond is sold for a profit, the amount of the profit is subject to capital gains tax. On the other hand, if the bond is sold at a loss, the amount of the loss is subject to capital loss provisions of the Internal Revenue Code.
III. FEDERAL BONDS
The federal government, in order to operate with its ever-increasing federal deficit, must sell bonds to supplement the shortfall from taxes. Congressmen never consider reducing pork barrel handouts to lessen dependency on federal bonds. A few years back, there was trade tension with Japan. The U.S. wanted Japan to open its markets to American manufacturers. When members of Congress suggested trade sanctions, Japan announced that no American federal bonds would be sold in Japan. When Japan stopped purchasing federal bonds, a minor financial crisis ensued. Japan and the U.S. government quickly reached an agreement. American financial policy revolves around the U.S. being able to sell its bonds. The primary customers for American bonds besides Japan are the large institutional investors, such as pension plans and mutual funds.
The federal bonds with which most are familiar are the famous T-Bonds (Treasury Bonds). In addition, the Treasury issues the U.S. Savings Bond, which it has promoted for decades as a means for a person to save for a child’s college education. Treasury bonds offer the maximum protection for an investor. The federal government stands behind the bond and guarantees full payment.
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Savings bonds are the type of bond most familiar to the small investor. Savings bonds are sold in denominations ranging from $50 to $10,000. Such bonds first appeared during World War II and have been sold ever since. In the 1970’s a new version of savings bond, the series EE, was introduced. Unlike other federal bonds, the interest rate on the series EE bond has a variable yield. The yield is adjusted every six months to equal the current yield on five-year Treasury notes. The Treasury also guarantees that the interest on series EE bonds will never drop below 6% provided the bonds are held for at least 5 years.
The interest of EE bonds is not paid to the buyer by installments. Instead, the interest accumulates until the bond matures. Upon maturity the principal is paid with the accumulated interest. As with T-Bonds, the interest is not exempt from federal taxes. The interest is exempt from state and local taxes.
There is a unique tax advantage in using EE bonds for a child’s college education. If the bonds are purchased in the child’s name and mature after the child reaches age 14, the value of the interest on the bonds will be taxed to the child and not the parents. The child will usually pay taxes at the lowest tax rate, rather than at the parent’s rate which could reach 33%. This would be a substantial savings. Persons holding EE bonds can exchange them in increments of $500 for class HH savings bonds. Class HH bonds pay annual interest at a rate of 6% per year payable semiannually.
IV. MUNICIPAL BONDS
As does the federal government, state and local governments also issue bonds to raise operating capital. The appeal of municipal bonds is that the interest on state and local government obligations is generally tax exempt. This includes obligations of a state or one of its political subdivisions, the District of Columbia, a possession of the United States, or one of its political subdivisions used to finance governmental operations. This includes interest on certain obligations issued after 1982 by Indian tribal governments recognized by the Secretary of the Treasury as having the right to exercise such sovereign powers.
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Tax-exempt bonds pay less interest than regular bonds. The advantage of the tax-free bonds over most regular bonds is that the amount of total income after taxes is greater. The following is a chart of the interest a taxpayer would have to be paid on a regular bond to match a tax-free bond yield:
INVESTOR
TAX RATE …………………………..TAX-EXEMPT YIELDS
………4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
REGULAR BOND YIELDS
15% 4.74% 5.88% 7.06% 8.24% 9.41% 10.59% 11.77%
28% 5.56% 6.94% 8.33% 9.72% 11.11% 12.59% 13.89%
31% 5.80% 7.25% 8.70% 10.14% 11.59% 13.04% 14.49%
Municipal bonds are a major source of revenue for state and local governments. As shown above, corporate bonds have to pay a higher interest than municipal bonds for an investor to obtain the same after-tax benefit. The Tax Reform Act of 1986 reduced the types of municipal bonds that can be federally tax exempt. Prior to the 1986 Act all municipal bonds were tax exempt. Now as a result of the 1986 act, the following municipal bonds are taxable or exempt according to their uses.
1. Those municipal bonds issued for government construction purposes (roads, schools, dams, etc.) and that finance regular government operations are exempt.
2. Those municipal bonds that are issued to pay for a particular municipal project or program (such as student loans or industrial development) are exempt for regular tax purposes, but the income is included in calculating any alternative tax liability.
3. Those municipal bonds issued to pay for non-governmental uses such as stadiums, convention halls, etc. are fully subject to federal taxes.
An investor should discover before purchase whether or not the municipal bond will be totally or partially tax exempt. Besides the tax-exempt qualities of municipal bonds, there is an additional attraction in that no premature call is allowed for at least 10 years. This means that the investor can still receive the higher interest even in a time of falling interest rates.
V. PURCHASING MUNICIPAL BONDS
There are 6 different ways a person can invest in municipal bonds. Each method has its own advantages and disadvantages:
1. Individual Bonds
2. Open End Municipal Funds
3. Closed End Municipal Funds
4. Unit Investment Trusts
5. Single State Municipal Funds
6. National Exempt Funds
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D. UNIT INVESTMENT TRUSTS
The first bond funds were the Unit Investment Trusts (UITs) that appeared in 1961. UITs, as with closed end funds, have a fixed number of shares. Units in the UITs are purchased from brokers for about $1,000 per unit. The fund uses the investment to buy municipal and government bonds. Investors in UITs collect regular interest payments until the bonds in the UIT mature and members are paid off.
The main advantage of UITs is that there is no active management; therefore no annual management fee. In addition, the investors know with certainty when their investment will be returned (the maturity date of the bonds). For that reason UITs tend to perform better than single-state funds by .6% annually. UITs have a sales charge of 2% to 5%. The units can be resold to the issuer at any time for net asset value. Prospecti for UITs can be obtained from brokers. The largest UITs are managed by Nuveen and Van Kampen Merritt.
E. SINGLE STATE MUNICIPAL FUNDS
Some municipal funds limit themselves to the municipal and governmental obligations of one state. The purpose for having a municipal fund limited to one state’s obligations is to give the residents of that state a tax advantage. Bonds purchased by residents of that state are usually exempt, not only from federal taxes, but also state and local taxes as well. Example: A Californian in the 11% state tax bracket who buys into a California exempt fund at 7% would have a taxable equivalent yield of 7.85%.
The advantage of the state tax exemption has a downside: its diversification is limited to bonds in the state. Many single state funds invest primarily in long-term bonds, which are a good investment in times of steady or dropping interest rates. If interest rates rise, however, as is feared with the Clinton economic plan, long-term bond prices will fall. A hedge against rising interest rates is to invest in intermediate single-state funds. These generally offer only about 80% of the return of the long-term bond funds. On the other hand they carry only about 60% of the risk of loss should interest rates rise sharply because they have few or no long-term obligations. Single-state bonds can be purchased as open-end funds, closed-end funds, UITs and individual bonds. The number of single-state muni funds has grown dramatically. In 1991 there were 400 such funds with $67 Billion in assets. In June 1993 the number had grown to 655 with $81 Billion in assets..
F NATIONAL EXEMPT FUNDS
The alternative to single-state funds is multi-state funds. Many investors will find they fare just as well or even better with a top- performing national muni fund. Many investors so hate paying state taxes that they willingly accept lower returns from a single-state muni fund to avoid preparing state tax forms. The major advantage of national muni funds is they offer a more diverse portfolio. Single-state muni funds must limit their investments to just one state whereas the national muni-fund can choose from throughout the United States.
TOP PERFORMING MUNICIPAL FUNDS
The following table lists some of the top performing no-load municipal funds through 1992:
Single State Municipal Funds
FUND TOTAL RETURN AVERAGE
Jan 1, 1987 to Jan 1, 1992 1992 YIELD
Vanguard New York Insured 62.50% 5.95%
Scudder California Tax Free 61.80% 5.34%
Safeco California Tax Free 61.19% 5.70%
Scudder New York Tax Free 60.32% 5.33%
Dreyfus New York Intermediate 5.48%
Boston Co. Tax-Free California 5.28%
National Municipal Bonds
FUND TOTAL RETURN AVERAGE
Jan 1, 1987 to Jan 1, 1992 1992 YIELD
Dreyfus General Municipal Bond 70.13% 6.55%
Financial Tax-Free Income 68.53% 5.60%
United Municipal High Income 59.50% 6.36%
Vanguard Municipal Bond 58.35% 5.65%
Intermediate-Term Portfolio
USAA Tax-Exempt Intermediate Term 52.77% 5.92%
Eaton Vance National Muni 51.50% 6.57%
Putnam Tax-Free High Yield 53.51% 5.97%
VI. BOND INSURANCE
As with any asset, a purchaser of a municipal bond may wish to have it insured. Bond insurance guarantees that the buyer will receive the interest and principal payments if the issuer of the bond defaults. The need for bond insurance has not been great in the past. Defaults in municipal funds are rare, amounting to less than 1% of all municipal funds. Recently, however, many local and state governments have experienced economic hardship. In fact, Standard and Poor’s down-graded more municipal funds than it upgraded in 1993.
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VII. CORPORATE BOND
Corporate bonds are similar to government bonds except they are issued by corporations. They are not in any way, shape or form tax-exempt. Because corporate bonds are not tax-exempt, they must pay more interest than tax-free bonds in order to generate the same after-tax return for the investor. Moreover, they are not insured against a risk of loss. Some bonds, however, are collateralized by hard assets, thereby being more secure than bonds that depend only on the financial success of the company.
A corporation, no matter how large, may fail because of a downturn in the economy or a sudden surge of lawsuits for some past activity. A case in point could be the tobacco industry. If people suddenly begin succeeding in their lawsuits against cigarette companies for causing cancer, the companies will be rendered bankrupt virtually overnight. Such a scenario, of course, has not happened yet.
Since the value of corporate bonds is directly related to the strength of the company, it is an absolute requirement for the concerned investor to determine the stability and worth of a company before purchasing its bonds. Two of the major bond rating companies are Standard and Poor’s and Moody. Standard and Poor’s rates companies as AAA, AA, BBB, BB, or B on corporate bonds. Moody’s ratings are Aaa, Aa, A, Baa, Ba, or B. As the rating drops on a bond, the risk of the company defaulting on the interest payment rises considerably: the lower the rating, the greater the risk. The average investor should not invest in bonds below AA unless he is gambling. Bonds with ratings lower than A are often called “Junk Bonds.”
Corporate bonds also carry with them the real threat of a premature call. Unlike government bonds, corporate bonds usually do not have a restriction preventing their recall for a certain period of time. In prolonged periods of low interest companies routinely recall their high interest bonds and refinance with lower yielding bonds. Corporate bonds are more volatile and more actively traded than government bonds. Their higher interest (than government bonds) engenders in corporate bonds a chance of greater capital gain, which is the reason for the investment in the first place.
VIII. ADVICE
Bonds are not ownership interests in the company issuing the bonds. Bonds are best described as loans: the holders of the bonds are creditors of the company. Bondholders therefore will be paid before shareholders in the event that the company is ever liquidated. This means that bondholders of a company are better protected than shareholders of the same company. On the other hand, while bonds may be safer investments than stock, the true appreciation of value and profit comes from stock, not bonds.
An investor must balance the two needs of profit and security when deciding to invest. Generally, municipal bonds are a better investment than corporate bonds for a working person. A working person normally is in a middle or high tax bracket and his income from corporate bonds is subject to substantial taxes. A retired person, however, with little earned income, usually is in a low tax bracket. For him, corporate-bond-interest taxes may be of negligible impact and, as such, it might make better financial sense to invest in taxable bonds rather than tax-free bonds.
IX. T-BILLS
Besides T-Bonds, the U.S. Treasury raises money for the federal government through the sales of T-Notes and the more common T-Bill. Treasury Bills, known as T-Bills, are short-term obligations of the federal government. They are bought as follows: $10,000 for the first T-Bill and increments of $5,000 thereafter. T-Bills mature in varying lengths of time from three months to a year. The attraction of T-Bills lies in the fact that they are safe, exempt from state taxes and totally liquid: they can be sold easily and quickly. T-Bills do not pay interest through coupons; they are treated similarly to savings bonds. The face value of the bond reflects the payment of principal and interest at the time of redemption. The difference between the purchase price and the maturity price is the interest on the T-Bill.
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Unless the purchaser has requested otherwise on the Tender for Treasury Bills, the Treasury automatically will send to the buyer the face value of the T-Bill upon maturity. The purchaser can request that the proceeds of a matured T-Bill automatically be rolled into new T-Bills through noncompetitive bidding on the tender form. The Treasury will honor this automatic rollover feature only on the first maturity. Each subsequent rollover will require the filing of a specific request which can be obtained from a Federal Reserve Bank. A person requesting a “Tender for Treasury Bills” can get one from the Federal Reserve Bank in Washington, D.C. 20551, (202) 452-3000 or Columbus, Ohio 43216, (614) 846-7050.
T-Bills are not for the average investor. The $10,000 minimum investment is rather high. In addition, T-Bills have a restriction on them that the seller may not resell the T-Bills within 20 days of purchase or 20 days of maturity. On a 90-day T-Bill, this means that the investor has only 50 days to sell the T-Bill in the event his personal or financial circumstances change. Moreover, if the T-Bill is purchased through a broker or bank, the commission fee further decreases the profit of the T-Bill.
X. T-NOTES
The last major investment option of the Treasury Department is the Treasury Note known as the “T-Note.” Unlike T-Bills, which mature in terms of a year or less , T-Notes are federal obligations with a term of two to 10 years. As with T-Bills, the price to be paid by an investor for newly issued T-Notes is set at a Treasury auction. An investor purchases T-Notes in the same fashion as T-Bills.
T-Notes have a significant advantage over T-Bills in that they are sold in smaller lots. T-Notes maturing in less than five years are sold in $5,000 increments. T-Notes maturing more than five years are sold in lots of $1,000. The interest that is paid on T-Notes is usually a little higher than for T-Bills and is paid every six months to the owner until maturity. Interest on T-Notes and T-Bills is subject to federal taxation but exempt from state taxes. T-Notes do not have a call feature: Treasury cannot force a redemption when interest rates fall.
XI. OTHER GOVERNMENT SECURITIES
Besides the U.S. Treasury, there are other federal agencies which issue securities and notes. Some of these agencies are the Federal Home Loan Bank, the Federal National Mortgage Association (FNMA, called “Fanny Mae”), and the Government National Mortgage Association (GNMA, called “Ginny Mae”), among others. A list of such bond issuers can usually be found in the Wall Street Journal or another financial source.
*** END OF SAMPLE VIEW OF CHAPTER ***
CHAPTER 8
ANNUITIES
I. INTRODUCTION
Avoidance or deferral of taxes should be the cornerstone of estate and financial plans. The Government, both state and federal, have announced sweeping new taxes in order to pay for their projects. The money to finance the ever-widening sphere of government involvement can only come from the taxpayers. The only people who receive government benefits for free are the poor. Everyone else subsidizes those benefits through their taxes.
There is nothing wrong in a person wishing to keep as much income as he can as long as he does so in a legal manner. It has always been the tenet of American taxation that no person can be forced to pay any more taxes than he is legally required to pay. A person can legally reduce his tax obligations and provide for a better retirement by financial planning. This chapter deals with one method of retirement planning: tax deferred annuities.
A tax-deferred annuity, also called a deferred annuity and often just an annuity, acts substantially like a pension plan. Actually, it is an insurance policy. The general concept of an annuity is simple, the person makes either a lump sum payment or he makes regular payments to an insurance company until he reaches a certain age. When he reaches that age, the insurance company then begins paying him a fixed amount, based on the annuity contract, for the rest of his life. In some annuities the payments are continued for the life of the surviving spouse. Upon the death of the insured, or in some cases also the insured’s spouse, the annuity terminates. No payments under an annuity are made to the family of the insured upon the death of the insured person or spouse.
A company’s rate for an annuity is based on the life expectancy of the insured. All insurance companies have actuarial tables which compute the average life expectancy for a variety of individuals. These tables have proven so accurate that the IRS has used them to develop their own tables for valuing gifts with retained interests. Using these tables, insurance companies have set their rates based on the probability of having to make payments and the likelihood of making a profit from the policy. Simply, an insurance company charges the lowest premiums for those it feels are most likely to die before or soon after payoff starts. Premiums rise in a sliding scale to keep pace with greater likelihood that the insurance company will have to pay more in benefits. In short, the insurance company makes money if the insured dies early, and the insured makes money if he lives a long time.
II. FIXED-RATE VERSUS VARIABLE ANNUITIES
The payments which a person receives under an annuity depend on whether it is a fixed-rate or a variable annuity. This means whether the benefits to be paid are based upon a fixed or a varying interest prior to maturity and first benefit payment. An annuity which will pay a fixed and certain amount upon maturity is not influenced by changes in the rate of inflation; it is called a fixed annuity. The payments of a fixed annuity will not be increased by inflation during the period prior to maturity. Consequently, the payments received upon maturity may not be adequate to meet the insured’s needs.
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Insurance companies do not charge a sales fee for an annuity. Most annuity contracts charge an early withdrawal fee for withdrawals made prior to maturity. This fee cannot exceed a fixed percentage of the annuity, usually 5%. Most insurance companies do not charge a fee for early withdrawal after the policy has been in place for five years. An annuity which carries the withdrawal penalty past five years should not be purchased: the insured would be excessively punished if the annuity were canceled because the insured could no longer meet payments yet still was not allowed to withdraw.
When a variable annuity is purchased, the insurance company guarantees a minimum below which the annuity’s interest rate will never fall. This rate is usually guaranteed for the first six months of the annuity. The minimum interest rate is usually less than the commercial rates of banks or mutual funds. When compared against the after-tax return of bank and mutual fund accounts, however, variable annuities are usually higher.
A collateral advantage of an annuity is that most insurance companies will permit the insured to convert the annuity into other types of policies or investments handled by the insurance company without having to pay additional sales or commission charges. The lack of sales charges are important considerations in choosing an annuity. The costs involved in the sales are borne by the insurance company: added pressure on it to make a profit.
IV. TAXES
Annuities are purchased by an individual with after-tax money. There is no tax deduction available for the purchase of an annuity. The tax advantage comes when the annuity starts to pay. When the insurance company starts to pay on the annuity, the percentage of the payment which relates to the purchase price is not taxed. What is taxed is the growth of the value of the annuity: the interest income.
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B. Installment Payments. This is the option most often chosen by an insured who is married. Under this option, payments are made to the insured over a fixed period of time. They do not correspond to the life of the insured. Upon the death of the insured, if the payment period has not expired, the payments are continued to the designated beneficiary. Any payments which continue after the death of the insured will be included in the estate of the insured and may be subject to estate taxes. Since the payments are spread over a finite set of years and not the life expectancy of the person, the tax burden may be more or less depending on the number of years involved.
C. Life Income. The most popular form of annuity is income for life. The main reason that most people have for purchasing an annuity is to provide for security in their later years. A steady, guaranteed stream of income allows them to plan for that retirement. Most people who purchase annuities elect this option in which the insurance company guarantees that a fixed amount of payments will be made for life. The payment benefit is based on the premium paid and the actuarial life expectancy of the person. There is no adjustment for inflation under this option.
D. Interest Only. The fourth option is an election to receive, after maturity, only the yearly interest from the policy. The benefits which the insured receives are interest income and are fully taxable. The principal, the insured’s payments for the annuity, are paid to the insured’s designated beneficiary upon the insured’s death. This principal is included in the insured’s estate for the calculation of estate taxes.
Many insurance companies give the insured the option of combining two or more of these alternatives. Example: The annuitant might take a lump sum payment at maturity of a fixed amount and leave the remaining value of the annuity in the account to generate monthly payments for life. Before an annuitant makes the election to receive the payments under the matured annuity, he should consult with a tax and estate planning professional to determine what method or combination of methods would be best.
VI. CONVERTING ORDINARY INSURANCE
It is possible for a person to convert whole life insurance into an annuity without incurring tax. Under the IRS rules, the exchanging of an insurance policy for an annuity does not result in a taxable situation provided the insured person does not take any cash from the transaction. The insured person may have to pay taxes on any cash that he receives which represents interest on the cash value of the policy. Such interest would probably be very slight given the low cash values of most insurance policies in the early years of their existence.
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CHAPTER 9
COMMODITIES
One of the most lucrative and by far the most dangerous type of investment is commodity trading. In commodity trading a person is buying an actual item: gold ore, silver bars or even grapes. The investor gambles that the price of the item will rise enough in the future to offset the storage fees of the commodity and the lost interest.
Commodity trading has three downsides. The first is that the price may not rise and might fall. The second is that investment in the commodity is not generating income while waiting to be sold. Example: Buying gold that rises from $400 an ounce to $440 per ounce is a 10% capital gain, but the actual return was less than 2% per year if it took four years to do it. Third, storage must be deducted from the profit.
This chapter will discuss the major commodity investments available to an investor. Generally, the average investor should avoid commodity investments unless he brings a degree of specialized skill to the transaction.
I. GOLD
No discussion about commodities is complete that does not mention gold. Gold is the best overall commodity. It is not perishable, can be stored cheaply in the safe deposit box of a bank and is readily tradeable. Gold is no longer the standard upon which the money supply of nations is based. The actual supply of gold in the world is immense. Over 600 million ounces of gold is mined every year. There will never be a gold shortage.
Fluctuations in the value of gold are man-made by inflation and uncertainty of world events. Gold prices climb in response to fear of world-wide financial panic or war because these occurrences dramatically affect the stability of the financial world. The Gulf War is an excellent example. During the beginning three months of the war, gold experienced a slight growth in prices. As the world realized that Iraq would not destroy the middle East oil fields, the price of gold dropped to its pre-war state. Those persons investing in gold in the hope of a prolonged rise in price lost big. On April 28 1993, the price of gold closed at $353.60 per ounce: an increase of $0.60 per ounce. The February 1995 future price for gold closed at $370.70, an increase of $1.40 over a 21-month period: a very low predicted increase in value. This indicated the financial community expected the economy not to experience great growth or inflation in the next few years.
Gold has an advantage. In a deflation it tends to drop in value slower than other investments. It has been a safeguard against financial disaster for thousands of years. When inflation is rampant, gold prices also soar. The only time that it is not good to be in gold is during a prolonged period of stable growth: other forms of investments almost always outpace gold.
Gold is the easiest commodity to purchase. It is sold in bars and gold coins which can be purchased outright by most coin stores for a slight premium. In addition, gold stocks and gold mutual funds exist. The investor can purchase stock in gold mining companies rather than the gold ore. For small amounts of gold, the investor should purchase gold coin even though a premium is charged for it by the coin store. For larger amounts of gold, he should purchase the gold in bullion form: in bars. The bars must have the assay mark of purity from a major assayer. The gold must then be safely stored, usually in a safety deposit box. Banks may also agree to insure the gold kept in their safety deposit boxes, but the fee may be high and further erode the profit margin of the gold.
II. SILVER
The day of the silver barons is past. Silver was once called the poor man’s gold because of its many uses and the great demand for it. Once silver backed our economy and Williams Jennings Bryan won the Democratic nomination for President based upon a speech predicting the nation being crucified on a cross of silver when the silver standard was abolished. Today there is a glut on the market, and, unless a person has intimate knowledge of the market, silver is no longer a good investment. The best example of this is what happened to one of the richest men in the world. Bunker Hunt tried to corner the silver market in the 1970’s and was unable to do so. There was simply too much silver available. On top of losing nearly a billion dollars, Mr. Hunt was fined by the government for both buying and selling silver. The price of silver is now only a fraction of what it was in the 1970’s. On April 28, 1993, the price of silver closed at $4.18 per ounce. During the Hunt era, silver approached $50 per ounce.
**** END OF SAMPLE VIEW OF SECTION ****
III. PLATINUM
The third major metal in which people invest is platinum. This is a metal with defined uses and is generally only produced in South Africa. The actual production of platinum world wide is not as great as gold. South Africa, which produces most of the world’s platinum, maintains an annual production of 3.5 million ounces. World-wide gold production is over 600 million ounces. The relatively small amount of new platinum on the market each year explains why a marginal increase in its world-wide availability causes dramatic swings in prices.
The main use of platinum is in catalytic converters for automobiles. These converters, however, have been steadily improved: less platinum is needed. In addition, since 1987, Russia has entered the platinum world market. Platinum prices have stabilized. In 1987, platinum reached an all-time high of almost $600 per ounce for a few months. Much of that price was pure speculation. The price quickly dropped over 23% in the October 1987 crash. By comparison gold prices remained relatively stable.
A small amount of platinum is used in jewelry and some high tech defense applications. Decreases in defense spending, including research and development, will reduce the demand for platinum and lower the price.
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IV. PERISHABLE COMMODITIES
Brokerages sell future contracts for all types of food crops. A “future” is a term of art in the investment commodity: a contract to receive a certain amount of a commodity in the future. The price paid for the future is based upon when in the future the commodity is to be delivered. Future prices can either climb or descend depending on the financial community’s perception of the commodity: will there be a surplus or shortage on the delivery date.
The system works in the following manner. Farmers sell some or all of their crop before it is planted with an obligation to harvest and deliver on a certain date. The company which buys the crops then stores them and sells contracts to investors for each month of a year. The market determines the price of the future by speculation as to whether there will be a shortage of the crop on each delivery month.
For example, on April 28, 1993 the future price of March 1994 soybeans is $6.10 per 5,000 bushels. That means that an investor can purchase 5,000 bushels of soybeans for delivery in March 1994 for $30,500. In March 1994 the investor has made $250 in profit if the price of soybeans has risen to $6.15 per bushel. The investor can take delivery of the soybeans and store at his own expense. Most investors simply sell the contract on delivery date for the current price. The purchaser then takes delivery and puts the soybeans to use.
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V. FINANCIAL FUTURES
Another type of investment is in financial futures. This is the purchase of money for delivery in the future. An investor buys contracts to purchase foreign money at the future prices. Example: The Swiss Franc was sold on April 28, 1993 for delivery in March 1994 at $0.6919 per Franc. If the exchange rate has risen to cover the future’s price and commission on the delivery date, the investor will make a profit. Otherwise, a loss will be sustained. Such trading is not an investment for the timid or the trusting.
In 1987, a friend was contacted by a company trading in financial futures. The deal seemed good. He invested $10,000. In the space of a few months, due to uncertainty in the market, he made a profit on paper of $7,000. He refused to take his original principal and trade only on the gain. In the space of a month, the financial market started to drop steadily. With the contract delivery date approaching, he was calling his broker daily. He was repeatedly assured that the drop was temporary, that it would turn. Finally, the broker’s supervisor called in an attempt to calm his fears. He was told that the market would turn and, if by chance it did not by delivery date, he could make up any losses on the next contract. At this point his wife called. He was told to sell now. This time, he listened. While he lost $4,000 on the sale, had he not sold out he would have lost it all: the exchange rate on the delivery date was less than he paid for the contract.
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VI. LEVERAGED ACCOUNTS
Another source of investments that has appeared in the last few years is the leveraged account. It is usually offered only by questionable brokerages. These accounts work by the brokerage arranging a package deal with the investor for the purchase of a commodity. The brokerage has an arrangement with a bank whereby the investor borrows money from the bank to buy the commodity. The bank takes a substantial down payment and holds the commodity, which is usually gold, silver or platinum. The bank also charges a storage fee for holding the security. The contract is only for a short period of time, usually a maximum of six months. The bank has the right to make margin calls when the price of the commodity drops below a certain amount. The broker takes a substantial fee for arranging this transaction.
A client was contacted in 1987 by Morgan Whitney, a precious metals “telemarketing” organization. Numerous statements were made concerning the future of platinum, much of which turned out to be false. The client invested in a plan whereby a loan was arranged with Safra Bank to purchase platinum. After the price dropped considerably, the client contacted the broker. On that day, however, there was a slight increase. He was convinced to invest more by additional false information. Immediately after the purchase, the platinum continued its slide. The client lost almost his entire investment. In 1990 Morgan Whitney was placed into receivership by the Federal Trade Commission; it was found to have employed high-pressure “boiler-room” sales tactics. A class action suit was filed against Morgan Whitney and Safra Bank alleging violations of federal anti-racketeering and securities laws. The suit was certified in March 1991. Roughly $20,000,000 are claimed to have been lost by thousands of investors. The attorneys handling the case are Lief, Cabrasser & Heimann, 275 Battery Street, 30th Floor, San Francisco, CA. 94111. Any person who was involved with Morgan Whitney should contact this firm to determine if they have any interest in the lawsuit.
No person should get in a leveraged account. Buy the commodity outright or buy a future through a reputable brokerage but never consider entering into a leveraged account. Such investments are not for the average investor.
CHAPTER 10
MUTUAL FUNDS
I. INTRODUCTION
Mutual funds are the most common form of security investment. Mutual funds are investment pools formed and managed by large brokerages. The manager of the fund sells interests in the fund based upon the daily value of the fund. The fund then takes the money from the investors and purchases securities such as stocks, bonds and commercial paper. The investors in the mutual fund share the collective profits and losses of the fund based upon their percentage of ownership in the fund. The managers of mutual funds charge between % to 2% of the net assets of the fund as a managerial fee each year.
Mutual funds, through the ability to pool investments, permit a wider degree of diversification (thus safety), than that which is available to the lone investor. By virtue of ownership of shares in a mutual fund, an investor has an interest in hundreds of companies through the stocks and bonds of those companies held by the mutual fund. Because of this diversification, failure of one or two companies will not devastate the fund.
The investors in the mutual fund have no control over the investments made by the fund. The only option available to an investor for poor performance by the fund is for the investor to sell his stock. Lack of control by investors may seem to be a drawback. The variety of mutual funds on the market, however, and the competition they generate for invested dollars assure no mutual fund will stay in business long with a history of poor management and poor returns.
Mutual funds only invest in securities. Mutual funds do not loan money nor do they invest directly in real estate or commodities. Because their investments are in securities, mutual funds live or die by the fluctuations of the stock and bond market. Mutual funds are easily traded, just like stock. In addition, most mutual funds offer phone and wire redemptions.
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Besides safety, the other reason for investment in mutual funds is profit. In 1990, the bank CD rate was 8%. Today the bank CD rate is less than 4%. By comparison, stocks and bonds have traditionally had a return 4% to 5% higher than bank CDs and T-Bills. The returns for the top 20 mutual funds for the last three years have averaged 12%. By comparison the average return for the Standard and Poor’s 500 was 10.8% for the last three years. Mutual fund investments have clearly been, in the past, more profitable than bank CDs and government securities (such as T-Bills).
II. INVESTING IN MUTUAL FUNDS
With over 4,000 mutual funds on the market the first problem to be faced in investing in a mutual fund is the most critical. How does a person choose a mutual fund? As stated above, there are mutual funds for every type of investor. First and foremost every investor should have a set of investment objectives before entering into an investment. An investor should first decide whether the objective is to achieve long-term growth or an immediate income flow. If the objective is to achieve steady, secure, long-term growth, the investor will want to invest in growth funds. Otherwise, the investor should concentrate on an income fund. Generally, the closer a person is to retirement, the more interest he has in receiving income rather than capital growth. A retiree not working probably wants additional immediate income. On the other hand, a young person generally is more concerned with capital appreciation because he usually is able to support himself without dipping into savings while the investment in the fund is left to appreciate for retirement purposes.
Once a person has defined his financial objectives, the next step is to study the type of mutual funds of interest. There are several good annual surveys that rate the performance of the major mutual funds. Some of the best surveys are put out by Forbes, Money, and Consumer’s Reports. Almost all financial magazines have annual summaries. The summaries are excellent means of comparing the performance of funds with similar investment portfolios. The funds should be compared both on a long-term basis (over the last 10 years) and on a short-term basis (over the last two years). This will give the investor reasonable insight into the ability of the fund’s management to predict problems and opportunities and make successful decisions. It is an old adage in the financial community: “Anyone can make money in good years; it takes a good businessman to make money in bad years.” By comparing the various funds over a period of time, both in good and bad economic years, the true strength and performance of a fund can be judged.
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III. OPEN-END VS. CLOSED-END MUTUAL FUNDS
Mutual funds are divided into two categories: “open-end” mutual funds and “closed-end” mutual funds. There are differences between the two which affect the profits to be realized.
An open-end fund is one in which the mutual fund can issue and sell any number of shares to the public. Most mutual funds are open-end funds. By being able to sell continually, an open-end fund has the opportunity to grow to an immense size. There can be a drawback in investing in an open-end fund: it can grow to such a size that it experiences management problems. A large fund dedicated to investing in small companies may find it difficult to place all of its funds. The result could be that the company has large amounts of unused cash in its treasury. These cash reserves reduce the fund’s returns.
Investors in an open-end fund buy and sell shares through the fund itself. The number of shares changes daily as investors enter and leave the fund. The market value per share of an open-end fund always equals the net asset value (NAV) of the fund: the value per share of all the fund’s assets.
In contrast to open-end funds, there are closed-end funds. A closed-end fund operates similar to a corporation: only a fixed amount of shares are sold. These shares are then traded back and forth in a manner similar to stock. A closed-end fund will never issue more shares in itself, nor will it “buy back” or redeem any existing shares. Because the fund cannot sell new shares, it does not have the ability to raise funds to expand investment diversification. On the other hand, because the fund is closed, the investors do not worry about an influx of investors causing the fund management to invest in riskier stocks and bonds to maintain the yield for the new investors. There are not many closed-end mutual funds: probably less than a couple of hundred of the 4,000 mutual funds. Of the 251 companies which began trading on the NYSE in 1992 only 87 were closed-end funds. The number of closed-end municipal bond funds increased from 103 in 1992 to 189 in 1993.
***END OF SAMPLE VIEW OF SECTION ***
It is not wise to purchase the initial offering of a closed-end fund. While there may not be a commission charged, there is usually an underwriting fee of 8%: $8 will be used to pay the underwriter for each $100 invested in a new closed-end fund. Only $92 of the investment will be available to purchase assets. On the other hand, closed-end funds purchased after the initial offering will have no underwriting fee, and any commission (on a loaded fund) will still be less than the underwriting fee.
The following table lists a few of the major performing closed-end funds for the first five months of 1993 and over a three-year period ending on June 1, 1993. Such performance is only illustrative of past performance and no guarantee of future performance.
EQUITY FUNDS
FUND NAV INCREASE JANUARY 1 THROUGH JUNE 1, 1993
NAME
Anchor Gold and Currency 27.0%
Cohen and Steers Realty Income 16.1%
Petroleum and Resources 14.8%
FUND NAV ANNUAL INCREASE THREE YEARS ENDING JUNE 1, 1993
NAME
First Financial 39.4%
Southeastern Thrift & Bank 31.6%
Cohen & Steers Realty Income 22.1%
MUNICIPAL BOND FUNDS
FUND NAV INCREASE JANUARY 1 THROUGH JUNE 1, 1993
NAME
Van Kampen Merritt, Invst. Grade N.J. 12.1%
Van Kampen Merritt Insured Municipal 11.7%
Van Kampen Merritt, Cal Quality Municipal 10.9%
FUND NAV ANNUAL INCREASE THREE YEARS ENDING JUNE 1, 1993
NAME
Nuveen N.Y. Performance Plus 14.8%
Van Kampen Merritt Muni Income Trust 14.7%
Putnam Investment Grade Municipal 14.6%
TAXABLE BOND FUNDS
FUND NAV ANNUAL INCREASE THREE YEARS ENDING JUNE 1, 1993
NAME
Alliance World Dollar Income 28.1%
Emerging Markets Income 21.5%
Latin America Dollar Income 18.4%
FUND NAV ANNUAL INCREASE THREE YEARS ENDING JUNE 1, 1993
NAME
American Opportunity Income 23.1%
American Government Income 22.7%
Franklin Multi-Income 21.9%
In addition to domestic closed-end funds, there are international closed-end funds as well. Investment in such funds should be carefully evaluated. Since 1990 the market values of the European closed-end funds have fallen an average of 5.1%: the worst of all closed-end funds. Some forecasters believe, however, that European utility stocks will experience a great run when European interest rates go down. These forecasters favor such diverse closed-end funds as GT Greater Europe, which sold in June 1993 at a 10.2% discount, the New Germany Fund which sold at a 10.3% discount and Global Health Sciences at an 11.6% discount.
FOREIGN CLOSED-END FUNDS
FUND NAV INCREASE JANUARY 1 THROUGH JUNE 1, 1993
NAME
Turkish Investment 71.0%
ASA Ltd 68.4%
Japan Equity 61.8%
FUND NAV ANNUAL INCREASE THREE YEARS ENDING JUNE 1, 1993
NAME
New World Investment 35.0%
Chile Fund 34.5%
Mexico Fund 29.2%
IV. LOAD VERSUS NO-LOAD FUNDS
Mutual funds are sold as either a load or no-load fund. A load fund is a mutual fund which charges a sales fee for the purchase of its shares. A person who invests in a load fund pays a premium for the shares in the fund. The investor starts out in a hole. If the sales fee is 6% the fund must increase 6% just for the investor to get the money back that he invested. Stockbrokers are paid commissions for selling these shares: a major incentive to sell load funds.
In contrast to the load fund is the no-load fund. In simplest terms, a no-load fund is a mutual fund which does not have a sales fee tacked onto the price of the shares. Many brokers are not interested in helping potential investors purchase shares in a no-load fund: there is no sales commission.
While a no-load fund does not charge a sales fee, it charges a higher management fee. A good no-load fund will make more money for the investor than a good load fund. Of course a badly invested or mismanaged no-load fund will not do as well as a well-managed load fund. No-load funds are identified in most financial newspapers with the abbreviation N.L. across from their name. A list of no-load funds can be obtained by writing to the No-Load Mutual Fund Association at 475 Park Avenue South, New York, NY 10016.
V. B SHARES IN A LOAD FUND
A cross between a load and no-load fund is a fund which offers what is known as “B shares.” The holder of a B share does not pay a sales charge at the time of purchase. He pays the charge later when the bond is sold. The normal sales charge is between 4% and 5%. The buy-now pay-later feature of the bond is attractive: it puts more of the investor’s money to work immediately. An investor of $50,000 in a load fund of 5% would only have shares worth $47,500 in the fund while an investment in B shares would result in shares worth $50,000. Dividends are paid based upon the amount of shares a person owns; so a person investing in B shares would own more shares and receive a greater dividend.
An attractive feature of B shares: the load which will be paid upon sale is reduced by usually one point per year. If B shares are held for a period of time (six years in some cases) the load will be reduced to zero. At that point the B shares will be converted without a charge to normal A shares (shares on which the load has been paid). As of October 1993 there were 42 mutual funds which offered B shares. One of the largest funds offering B shares is Oppenheimer Management Corporation that offers B shares with 13 of its funds.
A downside exists for B shares: persons investing more than $100,000 do not do as well in B shares as smaller investors. Big investors get break points (a reduction in load points) and load is usually waived completely on million dollar investments in A shares. In contrast, there are no break points for B shares. As such, a big investor who sells early pays the full sales charge. Some brokers recommend and push B shares just to avoid having to give the break points.
*** END OF SAMPLE VIEW OF SECTION ***
VI. CLOSURE OF A FUND
In April 1993, the Small-Cap Value Fund, the Strong Common Stock Fund and 14 of the 75 top performing stock funds listed by the Morningstar Mutual Funds advisory service temporarily stopped selling interests to new investors; they continued selling new shares in the funds to existing accounts. More closings were anticipated in view of the large influx of new investment into the funds. The reason given for the closure of the funds was to limit the funds’ sizes so as to continue their objective of investing in smaller companies.
Occasionally a fund is closed because the management feels that it is getting too big to manage properly. This concern occurs most often in funds which invest in small growth companies. The stocks of small growth companies have fewer shares outstanding than the major corporations. With only small quantities of stock available for purchase, small growth companies are tougher to manage for funds with large dollar amounts to invest.
Another reason to close new sales of a fund temporarily is that the fund has no place to invest all the money investors want to place with it. Investors want to invest in successful funds and can overload a dramatic fund. In the face of such a demand, the funds face the prospect of reducing their standards for investment so as to retain their successful rate of return. Such an action increases the risk for all investors. By the same token money not invested by the fund will dilute return to investors because fund earnings will not be as high.
Even though a fund may be closed to direct sales to new investors, it is still possible to purchase interests in it. Investors can seek interests in the funds through discount brokers who trade in fund shares or through a current investor in the fund.
*** END OF SAMPLE VIEW OF SECTION ***
VII. TAX TREATMENT
Mutual funds pay their investors the profits earned from trading in the securities held in the funds’ portfolios. Investors desiring an income stream have the dividends paid directly to them. Investors desiring capital growth have the distributions reinvested into additional shares. Reinvesting the profits, however, does not mean the investor does not have to pay taxes on the distributions.
Tax treatment of these mutual fund capital gains is tricky. Most mutual funds make capital gain distributions in December. A person purchasing shares in a mutual fund prior to the distribution will have part of the purchase price returned when the capital gain distribution is made. The investor then has to pay taxes on fund profits which he never realized (the profits were realized by those holding the shares during the time of the profit-making activity). When purchasing shares of a mutual fund late in the year, the investor should determine the fund’s dividend date. If the date is near, he may prefer to delay purchase until after the capital gain distribution.
There is no like-kind exchange treatment for mutual funds: switching investment from one mutual fund to another is a taxable event. In like manner, redeeming shares in the mutual fund is a taxable event. The difference of the purchase price and sales price is income. An investor can control capital gain by directing which shares are to be sold. Each share of a mutual fund is sold for its net asset value on the day of sale. An investor who purchased 100 shares at $13.92 on April 14 and 100 shares at $13.98 on May 1 has 200 shares with an average price of $13.95 per share. For tax purposes, however, gain or loss will be calculated on which shares are sold. If on May 3, the 100 shares of April 14 stock are sold for $13.92, then the investor will have no gain per share. By contrast, if the May 1 shares are sold, there is a loss of $.06 per share ($13.98 per share purchase price minus $13.92 sales price). Unless an investor directs which shares are to be sold, the I.R.S. will determine that the shares with the lowest cost were sold which means that the investor will pay the highest tax. Information on the tax treatment of mutual fund distributions is covered in I.R.S. Publication 564. Telephone 800-829-3676.
VIII. RATINGS
An investor should compare performance of mutual funds before investing. The investor should read the prospectus of each fund he is considering. The following are some of the top performers from the years 1988 through 1992. In considering the returns remember that most mutual funds suffered losses and actually lost money for their investors in 1990. The Standard and Poor’s stock index finished down by 3% for 1990. Stock mutual funds as a whole did far worse. Given that background, it can be seen why ratings of stock funds are taken as an average over five years to equalize the fluctuations of good and bad years.
***END OF SAMPLE VIEW OF SECTION ***
XIII. RECOMMENDATIONS
Investment in mutual funds is at an all-time high. The reason for this is clear. Mutual funds make money. Stock mutual funds have outperformed most other investments over the past 10 years. As with any investment, however, there is a risk associated with mutual funds.
The main consideration in any investment strategy is that of inflation. It makes no sense to make an investment which will give the investor less purchasing power in the future than the present value of his money. A proper investment will have a rate of return equaling or exceeding the rate of inflation. For the last 10 years the rate of inflation has averaged 3.8% per year. By comparison the money market accounts of banks paid an average interest rate of 7.1%: investors in bank money market accounts could have earned 3.3% over the inflation rate. In other words, the purchasing power of the money in the bank account increased by 3.3% each year (an investor could buy 3.3% more goods for the money in the account than in the previous year).
While bank money market accounts did exceed the rate of inflation, stock mutual funds did significantly better. Stocks have averaged 16.8% annual return per year for the last 10 years: a return equal to 13% over the rate of inflation. In other words, the purchasing power of money invested in stocks, as a whole, has more than doubled since 1983.
The best way to buy stocks for the average investor is through a mutual fund. The best type of mutual fund for the average person is a no-load mutual fund. The investor should choose a mutual fund based upon the factors discussed in this chapter.
It is better to make a series of purchases in a mutual fund. Several investments will equalize the costs of the shares by reducing the risk of purchasing all of the shares on a date when share prices are unusually high. It is a good idea to invest with a company which manages several mutual funds. This makes it easier to transfer money between any member of the family of funds. Moreover, many companies that manage several funds send consolidated statements listing the performance of all funds in the investor’s portfolio rather than sending separate statements for each fund.
The key is to make money. The investor should choose a mutual fund that satisfies his personal requirements for safety, growth and income.
CHAPTER 11
MONEY MARKET VEHICLES
I. INTRODUCTION
There are three types of similarly named investments that are in fact very different in their operation, safety and return.
1. Money market accounts.
2. Money market certificates.
3. Money market mutual funds.
Money market accounts and money market certificates are operated and sold by banks. Money market mutual funds are offered by brokerages and mutual fund families.
The common name of the accounts, “money market,” defines the type of investment vehicle: safe, short term items such as T-Bills, T-Bonds, T-Notes, and stable corporate bonds. The investments of a money market fund are intended to earn higher interest than the average short-term interest rate.
Money market funds appeared in the financial community in the early 1980’s. They were an immediate success, and investors withdrew their low-paying savings and CD accounts by the billions and invested in the far more lucrative money market fund. To compete, banks created a new checking account called the money market account. The banks’ money market accounts are similar in name only.
The history between the Money Market Account and the Money Market Fund is one motivated and exacerbated by competition and agreed. Money market funds first hit the financial community in the early 1980’s and were an immediate success. As a result, investors withdrew, by the billions, their low paying savings and CD accounts and invested in the far more lucrative money market fund. Yo compete, banks created a new checking account called the money market account. The bank’s money market accounts share a similar name but there the similarity ends.
II. MONEY MARKET FUND
Money market funds are huge investment accounts run by brokerages. The price of the shares of the fund are calculated by dividing the daily asset value of the fund by the number of shares outstanding. The fund uses its liquidity to purchase high-yielding short-term investments. Because of the huge amount of money invested in the money market fund, the fund is able to purchase large amounts of diversified securities. This pooling of investor funds permits the acquisition of a diverse portfolio of securities with an emphasis on safe governmental securities.
*** END OF SAMPLE VIEW OF SECTION ***
The money market fund makes its profits solely from the interest that is paid on the securities held in its portfolio. The fund calculates its investors’ current market return on a daily or weekly basis. This frequent calculation of the investors’ interest in the fund exposes the investors to market swings. The money placed in a money market fund, unlike a bank account, is usually not insured. This means that the value of those securities may go down, like any stock. Because the purchased securities can decrease in value, money market accounts usually invest deeply in safe government securities and diversify extensively. The interest that a money market fund pays to its investors is the profit made from its operation and is directly related to conditions of the financial market. In 1981 money market funds paid as high as 17% while in 1989 the average money market fund paid 9%.
The interest on money market funds is usually subject to federal and state taxes. There are a few money market funds that are federally tax exempt and a few more which are also state tax exempt. Tax exemption occurs in those narrow instances where the fund limits itself to certain state obligations.
The main alternative to money market funds that offers liquidity and investment is direct investment in T-Bills. Money Market Funds offer the following advantages and disadvantages as compared to direct T-Bill purchases:
1. The amount needed to invest. T-Bills are sold in increments of $10,000. The average investor does not have $10,000 to invest solely in T-Bills. The money market fund combines the investments of several persons in order to purchase the T-Bills.
2. Liquidity. Money market funds are extremely liquid. A person can close a money market account simply by writing a check. A T-Bill must be sold prior to maturity, usually by going through a broker, which takes at least a week or two.
3. Costs. Money market funds carry a 1% operating fee. A T-Bill can be purchased directly from the Treasury without a fee.
4. Taxes. Treasury bills are exempt from state taxes whereas most money market funds are not exempt. This can be a significant factor if the investor resides in a high tax state such as California or New York.
Most investors choose money market funds for the greater liquidity and convenience, despite the one percent management fee.
*** END OF SAMPLE VIEW OF SECTION ***
There is an abundance of literature available to help assist in the choice of a money market fund. Consumer Reports, Standard and Poor’s, Moody’s, Wall Street Journal and Barron’s are among sources of information regarding performance. For the average investor, safety, stability and return are the most important factors. By comparing one fund’s characteristics with another the best one can be chosen. It is not difficult to identify mutual funds. The business section of the Sunday edition of every major newspaper will carry the Friday closings for all the mutual funds. The immediate earnings of all the funds can be compared. The information on how to invest the funds is not given. More detailed information can be obtained by consulting the authorities already listed in any large public or college library or by calling a broker, who will send a prospectus (offering history) for the fund.
III. MONEY MARKET ACCOUNT
A bank’s money market account is promoted as the equivalent of a money market mutual fund. The bank’s money market account does permit smaller investors to invest in higher interest bearing accounts. It also permits the investor to write a limited number of checks each month (usually between seven and 10). Because of the small number of checks permitted, a money market account does not replace the normal bank checking account. The bank rates of return on the money market account are calculated on a daily or weekly basis and are higher than the normal bank checking account.
One advantage of the bank money market account is that it is insured by the FDIC for $100,000: the account cannot suffer capital losses like a money market mutual fund.
**** END OF SAMPLE VIEW OF SECTION ****
IV. MONEY MARKET CERTIFICATE
Banks and savings and loans offer what is known as money market certificates or T-Bill accounts. These accounts exist just to invest into T-Bills. The money market certificates pay an interest rate equal to the 26- week Treasury Bill. The T-Bill is sold on a discounted basis: less than face value. As a result, the T-Bill pays a slightly higher interest rate than the money market certificate.
An example of how the money market certificate works: a T-Bill is sold for a discount of 6%. For a $100 T-Bill the price is $94 ($100 minus the 6% discount). The real rate of interest is not 6% on the face value but 6% on the purchase price of $94 which is a real interest rate of 6.38%. As the interest rate increases the difference between the discounts and the real interest rate increases: the investor makes more money.
One drawback with the purchase of a money market certificate is a reduced degree of liquidity. The smallest T-Bill is $10,000 with a total broker fee of about $50 for its purchase and sale. The larger the T-Bill being bought and sold, the lower the broker fee paid on the purchase.
When a T-Bill is sold prior to maturity, the investor receives all the interest earned prior to the sale. By contrast, the money market certificate is more expensive to close. Closing a money market certificate within 60 days after purchase exposes the investor to significant penalties, which actually cut into the principal. If a money market certificate is closed after ninety days, the investor loses all of the interest for the first ninety days and will only receive regular passbook interest for the remaining term up to the cancellation date. It is easy to see that T-Bills are much more liquid than money market certificates.
*** END OF SAMPLE VIEW OF CHAPTER ***
CHAPTER 12
REAL ESTATE INVESTMENT TRUSTS
I. DEFINITION
One of the most interesting investments available to small investors is the REIT (Real Estate Investment Trust). A REIT is not heavily taxed: the profits are passed through the trust to the investors, similar to a partnership or S corporation. Another advantage is that a REIT permits many persons to invest, pooling their funds to participate in larger, more lucrative projects.
A REIT is defined under section 865 of the Internal Revenue Code as being a corporation, trust or association which meets the following requirements:
A. INCOME SOURCE REQUIREMENTS
In order to qualify as a REIT, three income-source tests must be met, in addition to the other requirements:
1. The first test: 95% of the trust’s gross income must come from investment.
2. The second test: 75% of the gross income must come from real estate investment.
3. The third test: the amount of short-term gain from stock or securities held for sales to customers plus the profit from disposition of real property interests held less than four years must not exceed 30% of the gross income.
B. INVESTMENT DIVERSIFICATION REQUIREMENTS
In order to be treated as a REIT, at the end of each quarter of a tax year the trust must have:
1. At least 75% of the trust’s total assets invested in real estate, cash, cash items and government securities.
2. No more than 25% of the total assets can be in non-government securities. No more than 5% of the gross assets can be invested in any issuer’s securities, and no more than 10% of any issuer’s securities can be held.
C. GENERAL REQUIREMENTS
In addition to income source and investment diversification requirements a REIT must meet the following general requirements:
II. TAXATION
A. TRUST
Once a corporation, trust or association qualifies as a REIT, it will be taxed only on the taxable income that it retains. This fact is the most important aspect of a REIT: it does not pay taxes on the distributions made to the investors. In this instance, a REIT is similar to a S corporation. The REIT is taxed at ordinary corporate tax rates only on the income that the trust retains and does not distribute. A special federal tax code section holds that when a REIT retains more than 5% of its ordinary taxable income and foreclosure property, then all of its income will be taxed unless special deficiency dividend rules apply. The tax on these undistributed capital gains is determined by using whichever of the two following tests produces the lower tax:
1. The first test: excess of long-term capital gain over net short-term capital loss taxed with REIT’s other taxable income at regular corporate rate.
2. The second test: undistributed capital gains taxed at the alternative tax rate.
Capital gains which are distributed are taxed to the investors who are the REIT’s beneficial owners or shareholders. The REIT cannot deduct for dividends received or for net operating loss.
There is a special tax imposed on REITs if it engages in prohibited transactions. A REIT is prohibited by law from quick sales or “turn-arounds” of property. There are two exceptions: (1) foreclosure property (discussed below) and (2) sale of property held longer than four years. A REIT is taxed 100% on net income derived from prohibited transactions: the government takes all the profit.
*** END OF SAMPLE VIEW OF SECTION ***
B. INVESTOR
The income an investor receives from a trust is taxed. Ordinary income of the trust is taxed as ordinary income, even if the investor is a corporation. Corporate investors are denied a “dividend received” deduction for the distributions they receive from the REIT.
A capital gains distribution from the REIT is a long-term capital gain for the investor: sale of assets held over one year. The REIT is required to give investors written notice of the amount of distribution to be treated as capital gains distribution within 30 days of the close of the REIT’s tax year. Dividends declared and made payable and actually paid by a REIT in October, November, December or January are considered paid and received by shareholders on December 31 of the tax year.
An investor loss on sale or exchange of a beneficial interest in a REIT owned less than six months is a long-term capital loss to the extent of any long-term capital gain distribution from the beneficial interest.
III. INVESTING IN A REIT
A REIT offers several significant advantages to an investor. The first is that it provides for more money for investment: a pooled situation. Larger real estate projects can be undertaken. The larger the real estate project, the greater the return on investment for the investor. Secondly, a REIT usually is managed by a professional real estate expert who should have greater expertise in real estate management than the investors, offering a better potential to protect and increase the investor’s assets.
In some ways a REIT is similar to a mutual fund: in both situations the investors pool their assets, and a professional manages them. The major difference is that a REIT invests in real estate and the mutual fund invests in securities. Because of the practical advantages of REIT, there are telemarketers who attempt to get investors to invest in a project over a telephone.
Financial forecasters predict rents will continue to rise and fuel the above-average growth of REIT dividends. On the other hand, some forecasters feel that the REIT market has reached its max for the near term and feel that rents and cash flows are too high now to grow again. Such forecasters recommend investing in real estate stocks abroad, where the market for such is relativity new.
The best advice for a person wishing to invest in REITs: do all of the homework attendant to investing in a security. Review the prospectus; calculate returns on investment. Decide whether investment through a mutual fund or directly through purchase from a broker is best. A point to remember: a REIT sold through a broker will have a commission fee attached to it; purchase of a no-load mutual fund which invests in REITs will not have a commission charge. The commission on a REIT may be reduced if it is purchased through a discount broker who does not render advice but merely executes a client’s order to buy or sell. Discount brokers, such as Charles Schwab, are easily found in phone books and business publications.
PART THREE
INDIVIDUALS IN DEBT
Living with debt is a fact of life for many. Most people live their lives of quiet desperation from paycheck to paycheck with never more than enough savings to last a few months in the event of a personal calamity: loss of a job, a court judgment or extraordinary medical bills.
Bankruptcy is one option for people who have a mountain of debts. Bankruptcy is discussed in detail in its own chapter. In the Living with Debts chapter, the discussion is devoted to educating people about their rights as debtors. On the other hand, it is not written in stone that the person will lose everything he owns or that bankruptcy is the only alternative.
This Part Three discusses both living with debts and the alternative of starting over again through the use of bankruptcy. Financial planning always involves a personal debt relationship. It is impossible for the average person to manage his finances without having a good grasp on debt. When a person does not have a good grip on his debt, he must adopt a strategy to handle that situation. That is the purpose of this part.
CHAPTER 13
LIVING WITH DEBTS
Our society survives on debt. Nearly everything purchased in this country is done on credit. The major credit card companies are everywhere. Just about every store accepts one or more credit cards: Visa, MasterCard, Discover, American Express, Diner’s Card. If everyone had to pay cash for their purchases, the economy would stagnate. Our economy is one of conspicuous consumption. Fashions change every year, and women must purchase a new wardrobe to stay in fashion. Cars are designed to be functionally obsolete every five years. We are conditioned to buy new and replace the old even if it isn’t necessary. Progress is purchased at the expense of debt.
Because a person owes money does not mean he is a deadbeat. Once it did but it does no longer. There are few people who are not in debt to someone for something. A medical doctor will owe up to $100,000 in student loans for his education. Nearly everyone buying a new car must finance the car. There are few home purchases for cash. Nearly everyone uses a credit card, and few are paid completely at the end of each month.
Our nation and our society both work through debt. While debt in a society can be good, a great deal of debt for an individual is bad. Living with debt is an ordinary consequence of living in a modern society. Few people are immune from it. Even Donald Trump, a multi-millionaire, has debt obligations which he must satisfy. There is nothing wrong in owing money as long as the debtor meets his financial obligations on time. The problems arise when he can no longer make the payments. At that time he is apt to make his worst mistakes in financial planning. This chapter is devoted to helping a person understand and manage his debts and live with peace of mind.
I. SECURED VERSUS UNSECURED DEBTS
There are two types of debt: secured debt and unsecured debt. Secured debt is a debt whose payment is backed by collateral. When a secured debt is not paid, the creditor (person to whom the debt is owed) may employ the state’s legal procedure, repossess (take possession of) the collateral and sell it. The proceeds from the sale of the collateral are applied to the amount of the secured debt. To the extent that the proceeds do not cover the amount of the secured debt, the creditor becomes an unsecured creditor. A secured debt is created by a written security agreement or clause in the purchase contract which specifically identifies the property that is collateral for the debt.
Here is an example of how a secured debt works. A person buys a living room suite for $5,000. The furniture store finances the sale and agrees to take payments. Under the contract for sale the furniture is pledged as collateral for the debt. The furniture store retains the right to repossess the living room suite upon failure to make a payment. Subsequently, the buyer misses several payments; the furniture store repossesses the furniture and sells it at a public sale. The buyer owed $3,700 and the sale brought in $2,300. The buyer therefore owes the furniture store $1,400. Since all of the collateral has been sold, the store must get a judgment before it can collect the remaining $1,400. To the extent of $1,400, the furniture store is an unsecured creditor.
*** END OF SAMPLE VIEW OF SECTION ***
Exemptions exist to help the debtor and the debtor’s family at the expense of the creditors. Exemptions are created by specific state law and are determined solely by the language in the exemption statutes. Exemptions are usually divided into three types: family exemptions, head-of-household exemptions and specific-property exemptions.
A. FAMILY EXEMPTIONS
Many states have family exemptions that apply only when the debtor is married. These states employ special schedules for exempt property: less unsecured property can be taken from a debtor with family than from a single debtor or a head of household. The reason for the higher family exemption: someone has to support the family of the debtor. No state will permit all of the unsecured property to be taken and the debtor’s children to be rendered destitute.
B. HEAD-OF-HOUSEHOLD EXEMPTIONS
A head of household is a person, married or not, who has a legal or moral obligation to support the people living with him. The head-of- household definition is similar to the federal tax exemption definition for head of household: the household must consist of family relatives, and the head of household must provide more than half of the support of at least one member of the household.
Under most state laws a head of household has more exempt property than a single person for the same reason that a family debtor has higher exemptions. The state wants to minimize the harmful effect on innocents of the attachment of a debtor’s unsecured property.
C. EXEMPT PROPERTY
Each state determines what property is exempt under its own laws. Most states, however, exempt the same types of property although not the same value amounts. The following are the major exemptions permitted by most states.
1. PERSONAL PROPERTY
All states grant some degree of exemption for personal property. Usually, the value of the exempt unsecured personal property is $3,000 to $15,000. As part of the personal property which is exempt, most states include the value of food needed for reasonable support. A debtor cannot buy a supermarket of food and claim that all is exempt. The value of insurance policies usually is exempt as are welfare, social security and disability benefits. The most commonly exempted form of personal property is household goods, including furniture. Household goods are determined to be ordinary household items of ordinary value (not antiques) that are needed for ordinary use and comfort. Most states also permit one unsecured motor vehicle with a value of less than $1,500 to be exempted. In addition, all states permit personal clothing of ordinary value to be exempted.
2. WAGES AND EARNINGS
An unsecured creditor must file a lawsuit against the debtor in order to get paid. At trial the creditor will present his case, and the court will enter a judgment against the debtor if he has no defense. The judgment orders the debtor to pay a certain amount of money to the creditor. The creditor can then begin to garnish (levy, attach) the debtor’s earnings in order to pay the judgment.
All states place a limit on the amount of earnings which can be taken from a debtor’s wages. Every state has set a limit of earnings free from attachment. Most states set the limit at 30 times the federal hourly minimum wage: approximately $175 per week. No creditor can attach a debtor’s wages unless the earnings, after taxes, are more than the exemption: only the excess can be seized.
3. PROPERTY USED IN TRADE OR BUSINESS
Most states permit unsecured property used in a trade or business to be exempt. The purpose is to leave the debtor with the ability to earn a living to support his family. The value of this property varies from state to state but is usually around $1,500. By “trade or business” most states mean vocational occupations such as mechanics, plumbers, etc. Most states do not consider professions such as lawyers, doctors, architects to be trades, and the unsecured property used in their businesses is not exempt in those states. Some states, however, do permit the professional library and instruments of a professional to be exempt for the same reason as property used in a trade or business.
4. TENANCY-BY-THE-ENTIRETY PROPERTY
Only about 20 states recognize tenancy by the entirety. It is a special joint tenancy estate between a husband and wife. Neither spouse can obtain a partition of the estate or defeat the right of survivorship of the other spouse. It cannot be terminated by the unilateral act of one spouse.
A tenancy by the entirety is terminated only by:
1. Divorce, which changes the tenancy into tenancy in common.
2. Mutual agreement, whereby they agree to terminate the tenancy.
3. Execution against the property by a joint creditor of both spouses. A creditor of just one spouse cannot execute against in a tenancy by the entirety.
The following states permit a debtor to exempt tenancy-by-the- entirety property from seizure by creditors for debts in which the debtor’s spouse is not liable (both spouses had not incurred the debt on the property, only one spouse put the debt on the property) or the debt was not for necessities for the couple:
DELAWARE DISTRICT OF COLUMBIA FLORIDA
HAWAII MARYLAND MASSACHUSETTS
MICHIGAN MISSOURI NORTH CAROLINA
OHIO PENNSYLVANIA TENNESSEE
VERMONT VIRGINIA WYOMING
Most states treat tenancy-by-the-entirety property as ordinary joint tenancy property. In most states a debtor’s interest in joint tenancy property can be seized and sold to pay his obligations. On the other hand, those states recognizing tenancy-by-the-entirety property do not permit creditors of just one spouse to take the debtor’s interest in the tenancy-by-the-entirety property because the interest of the non-debtor spouse would be affected.
5. HOMESTEAD EXEMPTION ON THE DEBTOR’S HOME
Under most state laws, a debtor is permitted to claim an exemption for his equity in real or personal property that he uses as a residence. There is a dollar ceiling on the exemption. Some states also permit spouses who are filing bankruptcy to each claim the full amount of the homestead. Most states do not permit this “doubling” of the homestead.
*** END OF SAMPLE VIEW OF SECTION ***
A second example more common and beneficial to the debtor exists where the debtor does not have enough equity to cover the homestead exemption. In such a situation, the debtor should sell non-exempt assets and apply the proceeds to the loan on the home. This will increase the debtor’s equity in the home to the homestead amount. For example, the debtor’s home is worth $40,000, with loans of $37,500 on it, $2,000 costs of sale and a maximum homestead exemption of $7,500. In addition, the debtor has a non-exempt bank account of $2,000. The debtor will have a homestead exemption of just $500. The bank account will be lost to creditors in any collection action if the debtor uses the bank account to reduce the $37,500, the debtor’s equity and homestead exemption will increase to $2,500.
The following is a list of homestead exemptions by state. Exemption amounts occasionally are raised so a person in debt should always be aware of not just the homestead exemption but all of the other ones as well.
ALABAMA Under Alabama Code statute 6-10-2 there is a $5,000 homestead exemption on real property or a mobile home. The property cannot exceed 160 acres. A homestead declaration must be recorded before any sale of the property. A husband and wife may double this exemption (each take the full amount).
ALASKA Under Alaska Code statute 9.38.010 there is a $54,000 homestead exemption. If joint owners file for bankruptcy, the total exemption is still only $54,000. It can’t be doubled.
ARIZONA Under Arizona Code statute 33-1101 there is a $100,000 homestead exemption. A married couple may not double this exemption.
ARKANSAS Under Arkansas Constitution sections 9-3, 9-4 and 9-5 along with statute 16-66-210, there is a homestead exemption for a head of household. The amount of the exemption depends on the size of the homestead. For a homestead no greater than one quarter acre in a city, town or village or 80 acres elsewhere, the entire homestead is exempt. If the homestead is more than one quarter acre but less than one acre in a city, town or village, or between 80 to 160 acres elsewhere, the maximum exemption is $2,500. Above one acre in a city, town or village, or more than 160 acres elsewhere, there is no exemption. A married couple may not double a homestead exemption. For a single person the homestead exemption is $800, and for a married person, not head of household, the exemption is $1,250 under statute 16-66-218.
*** END OF SAMPLE VIEW OF SECTION ***
WYOMING Under statutes 1-20-101 and 1-20-104 the homestead exemption is $10,000 for real property and $6,000 for a house trailer. A married couple may double this exemption. The property must be occupied by the debtor at the time of filing for the exemption in order to get this exemption. A spouse or child of a deceased owner may claim this exemption. Under court decision In re Anselmi 52 B.R. 479 a debtor is permitted to exempt a tenancy by the entirety provided a discharge is not being sought for the debts of both spouses.
III. ADVICE
A person who is head-over-heels in debt with “no way out” has two options: do nothing or file for bankruptcy protection. The debtor should ask two questions to determine which is best for him. How much unsecured property do I have which is exempt from creditors? Is it likely that I will acquire more exempt property before I die?
If the answers to the above questions are “none” and “no” respectively, the debtor is judgment proof. A judgment-proof debtor is one from whom, even if he does not file for bankruptcy, the creditor will never be able to collect any judgment. A debtor who is judgment proof will never have any unsecured property which is not exempt. Therefore creditors will never be able to attach any property of the debtor for payment of their debts.
***END OF SAMPLE VIEW OF SECTION ***
The cost for bankruptcy filings is high. The filing fee is $175, and the cost of hiring an attorney is between $750 and $1,000, depending on the problems arising in each case. There are, however, several do-it-yourself bankruptcy books on the market. These books contain forms and filled-in examples which the average person can purchase for around $20. A person wishing to file his own bankruptcy petition can do so with relative ease and certainty that it is being handled correctly. The next chapter addresses some of the general considerations by a person who does file for bankruptcy protection.
CHAPTER 14
FILING CHAPTER 7 BANKRUPTCY
No discussion regarding financial planning would be complete without touching upon bankruptcy. A Chapter 7 bankruptcy petition is the most common type of bankruptcy petition which is filed. Chapter 7 bankruptcies are known as liquidations because the entire property, less exemptions, is taken and sold by the Trustee. The proceeds are divided among the debtor’s creditors. To the extent the creditors remain unpaid, the debts are discharged. The debtor can start with a clean slate.
It is this fact that a debtor can start over with a clean slate which makes bankruptcy a significant tool to consider in financial planning. A person deeply in debt but with a potential of receiving money in the future can declare bankruptcy and discharge all of the debts. Then when the anticipated money is received in the future, the debtor’s old creditors cannot attach it. For example, once came into a law office seeking advice. She explained that she was co-liable with her ex-husband for over $100,000 in debts. Having no way of paying off the debts, it was clear that she was effectively judgment proof. Her father, however, was ill and upon his death she would inherit a house worth about $150,000. Even with the state’s homestead exemption, there would still be a significant amount of equity for her creditors to attach. By declaring bankruptcy, her creditors received nothing because she was judgment proof. Upon her father death two years later, she inherited the house free of any creditor claims. She subsequently sold the house and then used the proceeds to start a small cafe.
Many wealthy businessmen have gone through bankruptcy during their climb to wealth. The discharge of their debts gave them the opportunity to start again and continue their ascent. While it might be evidence of a person’s strength of character to strive to pay off all of their obligations and die broke, it is often foolish and unnecessary. The bankruptcy law exists to permit people to start again when facing an insurmountable pile of debt. Not to take advantage of the right to discharge such debts legally is poor financial planning.
I. STEPS IN A BANKRUPTCY ACTION
A Chapter 7 bankruptcy proceeding is methodical, procedural and entirely predictable. The steps begin with the debtor first determining the correct court and ends with the receipt of the final discharge. The entire case is a logical progression from one step to another. Once he understands the steps, the debtor will appreciate the orderly nature of the bankruptcy procedure and be more at ease.
A. SELECTING THE PROPER BANKRUPTCY COURT
Every state has at least one bankruptcy court. Congress has divided some states into judicial districts and have created a bankruptcy court for each judicial district. The debtor is required to file the bankruptcy petition with the bankruptcy court in the area where the debtor lives. When there is more than one bankruptcy court in a state, the bankruptcy court closest to the debtor’s home is probably the one where the debtor should file. To be sure, the debtor should call the court and ask the clerk if the debtor’s home is covered by that bankruptcy court.
B. EMERGENCY FILINGS
There are occasionally situations where the debtor does not have the time to complete the full petition before some type of foreclosure action by a creditor occurs. Under Bankruptcy Rule 1007(c) it is possible to file just the basic petition along with the list of creditors so as get an automatic stay.
*** END OF SAMPLE VIEW OF SECTION ***
E. TRUSTEE’S MANAGEMENT OF THE ESTATE
After the creditor’s meeting, the trustee takes possession of the non-exempt property in the estate. The Trustee converts the estate into cash by selling it which will yield proceeds after the costs of sale and any liens on the property have been paid. For example, if the debtor owns a non-exempt truck that could be sold for $2,000, only $500 is owed on it and the cost of sale is $200, the trustee takes and sells the truck as a result it leaves $1,300 to satisfy creditors.
Following the sale, the net proceeds are first used to pay any cash exemptions permitted to the debtor under the law. The remaining amount is then spread among the unsecured creditors of the debtor in proportion to their percentage of the total unsecured claims against the estate.
The debtor has the right to purchase non-exempt property from the trustee for cash or by trading exempt property for it.
F. MOTION TO REDEEM SECURED PROPERTY
Following the meeting of creditors, the debtor may ask a secured creditor to redeem exempt property (purchase the property) that is collateral for the creditor’s secured debt. The debtor will offer payment of the fair market value of the property. If the creditor agrees to the sale, there is no reason to have a court motion. In such an instance, a written agreement between the debtor and creditor is sufficient to bind each.
When the creditor disagrees, usually because the debtor wants to make payments while the creditor wants the fair market price to be paid in full, the debtor must move for a court order requiring the creditor to take the purchase price in installments.
Many bankruptcy courts will not force a creditor to take the payments in installments. If the entire purchase price cannot be paid within 45 days of the order permitting redemption, the creditor can repossess the property and return all previous payments.
***END OF SAMPLE VIEW OF SECTION ***
J. DEBTOR’S REOPENING OF THE ESTATE
The bankruptcy court has full discretion to reopen a case when good cause is shown. Any interested party, creditor, debtor or trustee may ask the court to reopen the case for cause. There is no definition of cause. The court decides when the circumstances of the case are such that a sense of justice requires the case to be reopened.
There is no express time limit for making a motion to reopen an estate for cause. The motion must state those facts giving cause to reopen the case. The court hears the arguments for reopening. After the hearing on the motion, the court renders its order. If the motion is granted, the order cannot be attacked in a collateral action. The reopening does not automatically reinstate the trustee. If the reopening of the case is just to discharge an earlier unnamed creditor or to change an exemption, no purpose is gained by appointing a trustee. The judge simply enters the appropriate order and closes the estate again.
A debtor seeks to reopen a case for one of two reasons. The first: to discharge a creditor’s debt that was mistakenly omitted. The second reason: the debtor wishes to amend the exemptions in the original petition, usually because of after-acquired property.
Once the court determines that the equities of the case justify reopening, the newly added creditor and other creditors whose interests will be affected are given an opportunity to present their opposition. After the motion is presented, the court will decide whether the debtor’s requested relief is proper. Generally, it is difficult for a debtor to convince a court to reopen a case. The debtor must do all possible to assure that all creditors and property are duly listed in the initial filing.
II. EFFECTS OF BANKRUPTCY UPON THE DEBTOR’S HOME
A. INTRODUCTION
One of the prime concerns in any bankruptcy is the effect that it will have on the debtor’s home. Will the home be lost? Will the debtor lose all of the equity in the home? Is the debt on the home loan dischargeable? What happens to judgment liens from lawsuits on the property? All these questions immediately leap into the mind of anyone considering bankruptcy.
In addition, there are additional considerations. The first is that a bankruptcy will not stop a foreclosure from occurring if the payments are not made. While filing bankruptcy will delay the foreclosure for a few months, it will not bar it completely. To do so would result in simply giving the property debt-free to the debtor. Such is just not done for secured real property. Instead of simply giving the home to the debtor, federal and most state laws offer exemptions for the debtor’s equity in his home. This exempted amount of the debtor’s equity in the home is called the “homestead exemption.” In most bankruptcies the homestead exemption is the most important exemption in the entire estate. A few states do not permit a homestead exemption, but most do. For that reason this chapter will deal with it in detail.
*** END OF SAMPLE VIEW OF SECTION ***
Fortunately, it is cheap to check on the state exemptions. The debtor can simply go to a set of the state codes, which is present in all law libraries and many public libraries, and search the particular code section for the exemption in question. It is unlikely that an exemption will be revoked or reduced in amount. If changed, the exemption will be increased to the debtor’s benefit, and new ones might be added. All law libraries have books on bankruptcy such as Cowans Bankruptcy Law and Practice and Collier on Bankruptcy. Law libraries are in law schools, in every state capitol, and in most county seats and large cities. All are open to the public. The debtor should also consider consulting a bankruptcy attorney. If a foreclosure is being undertaken by a creditor, the debtor must consult an attorney because of the complexity of the law and the procedures that must be followed. Even with the cost of a consultation with an attorney, it is usually much cheaper for a person to do his own bankruptcy.
B. SETTING ASIDE A JUDICIAL LIEN ON A HOME
A judicial lien is a court judgment that the debtor pay a certain amount of money to a designated person. A judicial lien derives from a lawsuit which resulted in a monetary judgment against the debtor. When such a judgment is recorded, it creates, by operation of law, an automatic lien against all the real property of the debtor in the county where the judgment was recorded. The recordation of any judgment automatically places a judicial lien on the home of the debtor.
The judicial lien impairs the homestead exemption unless it is removed. For example, assume that a debtor is entitled to a homestead exemption of $7,500. The debtor owns a home with a fair market value of $40,000 which has a mortgage of $19,000 on it. The debtor has an outstanding judicial lien on all his real property of $14,000 arising from a judgment for an automobile accident. Assume the cost of sale of the home is $2,000. After sale the debtor will receive only $5,000 as a homestead exemption.
*** END OF SAMPLE VIEW OF SECTION ***
In practice, the only joint tenancy property of a debtor that has ever been held exempt is that of tenancy by the entirety. The following states permit a debtor to exempt tenancy-by-the-entirety property when the debts of both spouses are not being discharged. That means both spouses are not filing bankruptcy either separately or jointly or that both spouses had not incurred the debt on the property: only one spouse put the debt on the property or the debt was not for necessities for the couple:
DELAWARE DISTRICT OF COLUMBIA FLORIDA
HAWAII MARYLAND MASSACHUSETTS
MICHIGAN MISSOURI NORTH CAROLINA
OHIO PENNSYLVANIA TENNESSEE
VERMONT VIRGINIA WYOMING
The U.S. Fourth Circuit Court of Appeals which includes Maryland, North Carolina, South Carolina, Virginia, and West Virginia held in Ragsdale vs. Genesco 674 F.2d 277 (1982) that a creditor can reach property held as tenancy by the entirety, in a bankruptcy, where both of the spouses are liable on the creditor’s claim. A similar result was in the Sixth Circuit Court of Appeals, in the case In the Matter of Grosslight 757 F.2d. 773 and the Third Circuit Court of Appeals in the case In re Tricket 5 C.B.C. 2d 85.
It is important for a debtor to both know if his state permits property to be held as tenancy by the entirety between spouses and if the property will be exempt in a bankruptcy. In the case In re Ford 1 C.B.C.2d 840 it was held that under Maryland law, tenancy by the entirety was exempt under bankruptcy law. In the case In re Weiss 2 C.B.C.2d 426 it was held that since under New York law tenancy-by-the-entirety property could be sold under execution, it was not exempt. In the case In re Gibbons 13 C.B.C. 759 (1985) it was held that tenancy by the entirety held by a debtor in Rhode Island was not exempt.
If a married person is filing bankruptcy separately and owns property jointly with the spouse, he should consult an attorney to determine if the joint property can be exempted under state law. If debtor lives in one of the tenancy-by-the-entirety states, and the non-filing spouse is not obligated to pay the debt on the property, the debtor’s interest is exempt. Consulting an attorney to determine if such property is exempt can prevent a mistake and save a great deal of money.
III. FORECLOSURE ON DEBTOR’S HOME
A. INTRODUCTION
Usually the act that finally results in the debtor filing for bankruptcy relief is foreclosure on the debtor’s home. Foreclosure happens in accordance with state law based upon the lender’s security agreement on the property. There are two general types of security agreement that a lender may employ. The remedies the lender has resulting from a borrower’s breach depend on the type of security agreement employed. The two types of security agreement are a deed of trust and a mortgage.
A deed of trust has become the preferred means of security lien on real property and is employed in most states. Under a deed of trust, the borrower (called the “trustor”) signs a promissory note for a loan on the property. The promissory note is then secured by a deed of trust given by the borrower (trustor) to a third party (trustee). Under the deed of trust the trustee is given the authority to sell the property. The trustee does not need additional permission to sell if the borrower fails to make the payments.
***END OF SAMPLE VIEW OF SECTION ***
Some states, like California, have anti-deficiency legislation on purchase-money residential property. Most states give the borrower one year to redeem the property sold as a result of a mortgage foreclosure as opposed to a sale under a Deed of Trust. The borrower redeems the property by paying the buyer the price paid for the property at the judicial sale. Because a borrower might redeem the property, many potential buyers are not interested in bidding on the property at a mortgage foreclosure sale. That, plus the fact that judicial foreclosure on a mortgage can take a year, explains why lenders prefer deeds of trust. Regardless of which method of foreclosure is used, both security agreements give the lender the right to accelerate the loan on default and immediately declare the entire outstanding balance entirely due and payable. It is this debt acceleration that usually results in the filing of bankruptcy.
B. AUTOMATIC STAY
Once bankruptcy is filed any attempt by the creditor to foreclose on the debtor’s home or any other property is stopped in its tracks under the automatic stay of the bankruptcy law. Until the automatic stay is lifted, no creditor can repossess or sell any property of the debtor. At first blush, it seems that filing a bankruptcy petition would protect all of the debtor’s property, even the home. Such protection, however, is only fleeting. The important points to remember are that:
1. Most Chapter 7 bankruptcies are closed within four months; and
2. Purchase money security interests are not dischargeable.
In addition, the lender on the property can and will, unless the back payments are paid, make a motion with the court to lift the automatic stay as it relates to debtor’s home. If the debtor cannot reinstate the back payments and make the future payments, the court will usually lift the stay and permit the foreclosure to continue.
Any proceeds left over after the sale are first used to pay the lender and then to cover the sale. The remaining proceeds are split as follows: the debtor is given the amount of the homestead exemption and the rest, if any, is given to the trustee for payment to the debtor’s creditors.
***END OF SAMPLE VIEW OF SECTION ***
V. EFFECT OF BANKRUPTCY ON THE DEBTOR’S PENSION
A. INTRODUCTION
Under bankruptcy law, a debtor’s pension and retirement benefits are assets of the debtor’s estate. To be able to keep some or all of the pension, the debtor’s pension must be exempt, in whole or part under whichever schedule of exemptions, state or federal, that the debtor employs. Many pensions are not exempt under state or federal law. These pensions can and will be lost in a bankruptcy filing.
If a debtor is retired and receiving benefits prior to the filing of the bankruptcy petition, many states will exempt 75% or less of the pension benefits if they are needed for support. The deductibility often depends on whether the debtor is using state or federal exemptions. Pensions that are exempt under state exemptions are not always exempt under federal exemptions, and vice versa.
*** END OF SAMPLE VIEW OF SECTION ***
B. EXEMPTING A PENSION UNDER FEDERAL LAW
Bankruptcy Code Section 522(d) creates a list of exemptions. The federal exemptions can be used in place of debtor’s state exemptions provided the laws of his home state permit him to use these exemptions in place of the state’s own permitted exemptions. Only the following 13 states and the District of Columbia give the debtor an option to use the federal exemptions in place of the state exemptions:
CONNECTICUT HAWAII MASSACHUSETTS
MICHIGAN MINNESOTA NEW JERSEY
NEW MEXICO PENNSYLVANIA RHODE ISLAND
TEXAS WASHINGTON WISCONSIN
VERMONT
Under Bankruptcy Code Section 522(d) only those pensions under ERISA (Employee Retirement Income Security Act) are exempt to the extent needed for support. Almost all private retirement plans are covered by ERISA; most state and local government pension plans are not. Before a person residing in one of the above states or District of Columbia elects to use the federal exemption, it is critical to know if his pension is covered by ERISA.
In the same vein it is easy to discover if a plan is covered by ERISA. The employee merely calls the pension plan administrator and asks if the plan is covered. The employer and the union, if there is one, should have the name and phone number of the plan administrator readily available. If the pension plan is not governed by ERISA, the federal pension exemption cannot be used, and the person should consider using the state exemptions instead.
Regarding the determination of which pension benefits are exempt under the federal exemptions, Section 522(d)(10)(E) reads:
(E) A payment under a stock bonus, pension, profit sharing, annuity, or similar plan or contract on account of illness, disability, death, age, or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor, unless
(i) such plan or contract was established by or under the auspices of an insider that employed the debtor at the time the debtor’s rights under such plan arose;
(ii) such payment is on account of age or length of service; and
(iii) such plan or contract does not qualify under section 401(a), 403(a), 403(b), 408 or 409 of the Internal Revenue Code of 1954 (26 U.S.C. section 401(a), 403(b), 408 or 409).
Under the federal exemption, only that part of the pension that is “reasonably necessary for the support of the debtor and any dependent of the debtor” is exempt. To determine the amount of the benefits from an ERISA pension that are exempt, the court looks at:
1. The debtor’s age and health.
2. Whether the debtor is employed and the amount of his take-home pay.
3. The debtor’s monthly expenses after dischargeable debts have been canceled.
4. The number of dependents in the debtor’s home.
5. The amount of the debtor’s assets and income from other sources, such as family trusts that are not part of his estate.
From these factors the bankruptcy court determines how much of the debtor’s pension payments are needed for his support. Even though the pension may be governed by ERISA, the court may decide it is not necessary for the debtor’s support. Thus it can be entirely lost in the bankruptcy.
*** END OF SAMPLE VIEW OF SECTION ***
2. EXEMPTIONS OF ERISA PLANS UNDER STATE LAW
Many states have specific exemptions for ERISA pensions. Some states exempt the entire plan while others exempt only those payments needed for support. Unfortunately, the United States Supreme Court in Mackey vs. Lanier Collections Agency & Service, Inc. ruled that a state could not grant an exemption for ERISA plans. In that case, Georgia had a law, as many states do, that prevented a creditor from attaching the ERISA plan of a debtor who did not file for bankruptcy relief. The Supreme Court held that the ERISA act superseded state law when is stated:
“We hold that ERISA does not forbid garnishment of an ERISA welfare benefit plan even where the purpose is to collect judgments against plan participants. Moreover, we agree with the Georgia Supreme Court that the anti-garnishment provisions found in Section 18-4-22.1 is pre-empted by ERISA, the judgment is affirmed.”
Since ERISA does not forbid creditors from attaching the ERISA plan, state law cannot prevent the attachment of such a plan for a debtor who does not file for bankruptcy protection.
Under the federal exemptions, by contrast, an ERISA plan is exempt from attachment to the extent needed for support. To illustrate, the Circuit Court of Appeals for the Tenth Circuit in the case Gladwell v. Harline 950 F2d 669 (1991) permitted a debtor to exempt his ERISA pension under the federal non-bankruptcy exemption. In addition, both the Fourth Circuit Court of Appeals in the case Anderson vs. Raine 907 F2d. 1476 and the Sixth Circuit in Forbes vs. Lucas 924 F2d. 597, held that ERISA pensions are not to be considered part of the debtor’s estate. As such, these courts reason, it is irrelevant whether they are exempt or not because a trustee cannot take them under any circumstance. These Courts of Appeals cover the following states: Fourth Circuit: Illinois, Indiana and Wisconsin; Seventh Circuit: Maryland, North Carolina, South Carolina, Virginia and West Virginia.
The recent Supreme Court case, Patterson vs. Shumate 504 U.S.-, 119 L.Ed2d 519 (1992) partially settled the matter, at least, as it applies to debtors filing for bankruptcy relief. The case dealt with the exclusion from a bankruptcy estate of an ERISA plan in Virginia, which does not permit the use of federal exemptions. The Supreme Court ruled that an ERISA pension plan having a transfer restriction (which means it could not be transferred or assigned) is not part of the bankruptcy estate, regardless of whether federal or state exemptions are used. Thus, an ERISA pension plan with a transfer restriction (all ERISA plans have a transfer restriction) is totally excluded from the bankruptcy estate and not just for the benefits needed for support. The United States Supreme Court held as follows:
“Having concluded that ‘applicable bankruptcy law’ is not limited to state law, we next determine whether the anti-alienation provision contained in the ERISA qualified plan at issue here satisfies the literal terms of Section 541(c)(2).
The anti-alienation provision required for ERISA qualification and contained in the plan at issue constitutes an enforceable transfer restriction for purposes of Section 541 (c)(2)’s exclusion of property from the bankruptcy estate.”
Taken together, the U.S. Supreme Court’s Mackey and Patterson decisions mean that an ERISA pension can be taken by creditors prior to a bankruptcy but is exempt after a bankruptcy petition is filed. If a large pension is involved, the debtor should consult a bankruptcy attorney for the most current law regarding pension exemptions.
C. WHAT CAN BE DONE IF THE PENSION IS NOT EXEMPT
If the pension is not exempt under either state or federal law, the debtor has a couple of options available although somewhat extreme. The debtor could do the following:
*** END OF SAMPLE VIEW OF SECTION ***
The best chance a debtor has to keep IRA’s, SEP’s and Keogh plans are under the state exemptions. Many states specifically exempt such plans to the extent they are necessary for support. Example: New York does (In re Fill [1988] 84 BR 332), and California does (In re Dalaimo [1988] 88 BR 268). As with the Federal exemptions, however, there are some states which do not exempt IRAs, SEPs or Keogh Plans because of the substantial control the debtor has over the plan. Examples: Louisiana In re Talbot 15 BR 536, Oregon In re Mace (1978) 16 CBC 254, Nebraska Education Asst. Corp. vs. Zellner 827 F2d 1222.
State laws regarding exemptions are frequently being changed. The debtor should review the current status of the law before filing a petition for bankruptcy relief if such a pension plan, IRA, SEP or Keogh exists. Read the statutes and any amendments and consult a bankruptcy attorney.
VI. EXEMPTIONS AVAILABLE TO A DEBTOR
A. INTRODUCTION
The only property that a debtor can keep after a bankruptcy is that property that was exempt, redeemed or on which the debt was reaffirmed. A bankruptcy starts with the premise that all of the property belongs in the estate under the management of the trustee. Then that property the debtor claims is exempt is removed from the bankruptcy estate. The debtor keeps the exempt property irrespective of what happens to the rest of the estate.
The purpose of the bankruptcy code is to provide the means for a person to relieve some of the pressure of his debts and be able to start again. Bankruptcy is intended to provide a fresh start for the debtor. Since it would be difficult to start if totally broke, a debtor is allowed to keep some of his property so he can begin a new life.
*** END OF SAMPLE VIEW OF SECTION ***
In making the election as to which set of exemptions to use, the debtor should compare the sets and use the one that is most beneficial in the end. Example: The federal homestead exemption is $7,500 whereas the Wisconsin exemption is $40,000. As such, the Wisconsin state exemption is better. On the other hand, the Virginia homestead exemption is only $5,000, but when the other state exemptions which are not federal are figured, it might still be better to opt for the state set. To be better able to compare exemptions, they have been placed in groups throughout this volume and this chapter. Not only should a person compare both state and federal exemptions but also those of other states. It might be beneficial for a person to move to another state and live there for three or more months before filing for bankruptcy. In such an event, the person then utilize that state’s exemptions.
2. WHEN THE ELECTION TO USE FEDERAL EXEMPTION IS NOT MADE
If a person is not permitted to use the federal exemptions or does not wish to do so, there are several exemptions available under the general federal law to use along with the state exemptions. These particular nonbankruptcy exemptions cannot be taken if the debtor elects to use the federal set of bankruptcy exemptions. On the other hand, no state can prevent its citizens from taking these nonbankruptcy exemptions along with the state exemptions. These special nonbankruptcy exemptions do not derive from the Bankruptcy Code but, rather, they derive from statutes throughout the United States Code. When making an election between the federal and state exemptions a person should not forget to compare the federal bankruptcy and nonbankruptcy exemptions. It might prove to be more advantageous to use the state exemptions along with the federal nonbankruptcy exemptions instead of the federal exemptions alone.
C. STATE EXEMPTIONS
Every state has its own list of property that a citizen may claim as exempt from attachment. In a bankruptcy this list of exemptions determines what property a debtor is allowed to claim as exempt if the federal exemptions are not used. A person contemplating a bankruptcy filing should review the exemption schedule of his state of residence or the District of Columbia and the nonbankruptcy exemptions schedule. If the person lives in a state that permits its citizens to use the federal exemptions, he should compare the two schedules.
*** END OF SAMPLE VIEW OF CHAPTER ***
INDEX
Accounting Methods ……………………………………………………………………12
Alimony ……………………………………………………………………………………… 16
Alternative Minimum Tax……………………………………………………………….. 19
Annuities ………………………………………………………………………………….. 183
Converting ordinary insurance………………………………………………. 189
Fixed versus variable rates…………………………………………………… 184
Operation …………………………………………………………………185
Payment options ………………………………………………………..187
Installment payment …………………………………………………………….188
Interest only ………………………………………………………………………188
Life income ……………………………………………………………………….188
Lump sum………………………………………………………………………… 187
Taxes ……………………………………………………………………………… 186
Arbitrage Bonds ………………………………………………………………………….168
Bankruptcy ………………………………………………………………………………. 267
Automatic stay…………………………………………………………………………… 284
Converting Chapter 7 to Chapter 13………………………………………………. 285
Emergency filings …………………………………………………………………………269
Exemptions, federal……………………………………………………………….. 295,296
Exemptions, state ……………………………………………………………………294,297
Home ………………………………………………………………………………………….251
Foreclosure …………………………………………………………………………….276,282
Homestead exemption……………………………………………………………………. 279
Judicial lien ……………………………………………………………………………..276,282
Tenancy by the entirety…………………………………………………………………… 280
Meeting of creditors ………………………………………………………………………..270
Motion to redeem secured property ……………………………………………………272
Motion to set aside a lien …………………………………………………………………..273
Motion to set aside the automatic stay…………………………………………………. 273
Pension …………………………………………………………………………………………..285
Exemption under federal law ………… ………………………………………………….. 286
Exemption under state law …………………………………………………………………..289
ERISA plans under state law ………………………………………………………………. 290
IRA’s and SEP’s ……………………………………………………………………………….. 293
Non-exempt pensions ………………………………………………………………………… 292
Preparing and filing the petition …………………………………………………………….. 270
Ratification agreement and discharge hearing …………………………………………… 274
Reopening the estate …………………………………………………………………………… 275
Selecting the proper court ………………………………………………………………………268
Trustee’s management ………………………………………………………………………….. 272
Bartering ……………………………………………………………………………………………… 39
Bonds ………………………………………………………………………………….. ………….. 178
Bond Insurance …………………………………………………………………………………. .. 176
Call back feature ……………………………………………………………………………………164
Capital gains treatment……………………………………………………………………………. 164
Corporate bonds ……………………………………………………………………………………177
Federal bonds ……………………………………………………………………………………….165
Treasury bonds ……………………………………………………………………………..165
Bearer ………………………………………………………………………………………………….166
Call back feature …………………………………………………………………………………….164
Interest …………………………………………………………………………………………………166
Registered …………………………………………………………………………………………….166
Savings bonds ……………………………………………………………………………………….167
Municipal bonds ………………………………………………………………………………..14,168
Alternative minimum tax ………………………………………………………………….169
Private activity bonds ……………………………………………………………………..169
Yield comparison…………………………………………………………………… 169, 175
Open End Funds …………………………………………………………………………………….172
Single State Funds …………………………………………………………………………………..172
Unit Investment Funds ………………………………………………………………………………173
Commodities ……………………………………………………………………………………………………190
Financial futures ………………………………………………………………………………………………..196
Gold ……………………………………………………………………………………………………………….190
Leveraged accounts …………………………………………………..197
Perishable commodities 195
Platinum 193
Silver 192
Commuting Deductions 20
Corporations 26
Debts 243
Advice 264
Exemptions 246
Family exemptions 247
Head of household 247
Exempt property 248
Homestead 251
Personal property 248
Property used in trade and business 249
Tenancy-by-the-entirety property 250
Wages and earning 249
Secured versus unsecured 244
Dependency Exemption 10
Disaster Loss 20
Earned Income Credit 18
Federal Employees Compensation Act 37
Gasoline Tax Credit 18
Home Purchase
Adverse possession 57
Considerations 42
Contract for sale 64
Co-operatives and condominiums 72
Co-purchasers 52
Joint tenancy 53
Tenancy by the entirety 54
Tenancy in common 54
Deed
Grant deed 66
Quit-claim deed 66
Reconveyance deed 69
Easements and servitudes 55
Covenants 59
Financing 67
Installment sales contract 70
Mortgage 67
Deed of trust 67
Deficiency judgment 71
Due on sale 70
Finding a home 46
Life estate 51
Mineral and water rights 76
Recording a deed 61
Notice recording act 62
Race recording act 63
Race notice recording act 63
Title to a home 50
Warranty of fitness for use 74
Zoning 75
Homestead 73, 253
Installment Sales 40
Interest Deduction 21
Investment Tax Credit 23
Limited Partnerships 130
Acts requiring consent of limited partners 137
Definition 131
Differences from S corporation 145
Fiduciary duties of partners 139
General partner 135
Limited partners 143
Partnership property 134
Powers of general partner 135
Powers of limited partners 138
Taxation 144
Registration statement 141
Security laws 146
Termination 140
Uniform Limited Partnership Act 131
Medical Bills 15
Money Market Vehicles 222
Money market account 228
Insured 228
Interest 228
Money market certificate 229
Comparison to T-Bills 230
Taxation 230
Money market fund 223
Comparison to T-Bills 226
Mutual Funds 200
B shares 210
Fund closure 212
Investing into 202
Load versus no-load funds 210
Open end versus closed end funds 205
Ratings 215
Bank funds 217
Bond funds 219
Income funds 216
Growth funds 216
Recommendations 219
Taxation 214
Parents
College education through title guaranty program 22
Gifts to reduce income taxes 21
Employing children 21
Pension Plans
401(k) plans 29
Individual Retirement Account (IRA) 29
Simplified Employee Pension (SEP) 33
Real Estate Investment Trust (REIT) 232
General requirements 233
Election 232
Income source requirements 232
Investing into an REIT 237
Investment diversification requirements 232
Taxation 234
Investor 236
Trust 234
Real Property Rental 79
Considerations 80 Fixtures 102
Statutory lien 103
Leasing the property 85
Periodic tenancy 85
Tenancy at will 86
Landlord’s obligations 87
Implied warranty of Habitability 89
Quiet enjoyment and constructive eviction 90
Maintenance of common areas 90
Rent controlled property 84
Retaliatory eviction 99
Right of entry 87
Security deposits 102
Sublease or assignment 93
Tenant’s abandonment of the lease 96
Tenant’s hold over 96
Tenant’s obligations 92
Unlawful detainer 97
Defenses 100
Self-help 100
Writ of possession 101
S Corporations 27
Scholarship and Grants 37
Small Claims Court 105
Attorneys 105, 108
Defendant 107
Cross-claim against the plaintiff 116
Failure to appear at trial 115
Definition 106
Filing suit 117
Monetary limits 112
Judge or jury 117, 118
Judgment
Appealing the judgment 119
Collection 120
Attachment of wages 121
Judicial lien on real property 123
Seizure of real property 122
Effect of bankruptcy 124
Examination of debtor 125
Satisfaction of judgment 125
Suit for bad checks 126
Validity 126
Presenting the case 117
Recovery of court costs 113
Service of the complaint on the defendant 114
Statute of limitations 109
Witnesses 113
Sole-Proprietorships 25
Stocks 150
Common stock 155
Investment advice 154
Margin trading 159
Options 156
Put 157
Call 157
Strike price 157
Preferred stock 155
Short selling 161
Stock Brokers 152
Stock Exchanges 151
American Stock Exchange 151
New York Stock Exchange 151
NASDAQ . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Tax Exempt Bonds 14
Tax Filing Status 9
Tax Shelters . . . . . . . . . . . . . . . . . . . . . . . . . 27
Equipment leasing 36
Oil and gas 35
Real estate 34
Treasury Bills (T-Bills) 179
Auction 179
Comparison to money market certificate 229
Comparison to money market funds 226
Noncompetitive bid 180
Tender for Treasury Bills 180
Treasury Notes (T-Notes) 181
Worker’s Compensation . . . . . . . . . . . . . . . . . . . . 38