Transcript
Stephan Shipe: Welcome back to the Scholar Wealth Podcast, where we tackle the real world financial questions that matter to high net worth families. Today we’re covering three very different situations, each with its own set of complexities. First, what should you consider before lending a large sum to a family member for a home purchase?
Then how do you evaluate whether a partnership buy-in is worth it? Next, we’ll break down a net unrealized depreciation or NUA strategy, and when it can help reduce taxes on company stock in your 401k. And finally, for our rotating special segment: this week in Advisor Red Flags, we’ll talk about why “exclusive” investment opportunities aren’t always as good as they sound.
So let’s get started.
Question 1 – Lending money to family for a downpayment
Listener: My brother is buying a new home, but they’re not going to close on their current home until after the purchase. They asked me to borrow the 20% down payment until they sell the house and then pay me back. He is financially stable and good with money, but they basically need a short term loan. I have the money, but am I crazy to say yes? And if I do, how do I protect myself?
Stephan Shipe: You are absolutely crazy to say yes if you haven’t taken some appropriate steps here. It’s a common situation that a lot of people get themselves into — not necessarily a bad thing, just you end up building up equity in a home, cash poor, you don’t have it. And then you know that as soon as your home sells, then you’ll have the cash available to pay down the note or have the money to actually have the mortgage on the second home.
So what we need to do on your end though is to start looking at what the risks of this are. The obvious risk is he doesn’t pay you, which is obviously a problem there. So we need to start considering what is that worst case scenario. In this case, good with money. He is good with his finances and everything, but what if there’s things outside of their control, right?
He has repayment delays, the market shifts, the economy runs into a problem, or who knows, right? The house that they’re currently in has some major issue that now they’re not able to sell it as fast as they want. So in any of these cases, we need to have some sort of formal agreement in place.
So if you are going to go down this route and loan money to any family, but especially in this case, it’s really easy to avoid the formal agreement step because it’s so short term. It’s, okay, I just need the money for a few weeks while we sell our house. It’s already on the market, there’s really good interest, so we’re gonna buy this one, and in a few weeks we’ll have the cash and we’ll pay you back. And that all could be legitimate.
In many cases it is. Nine times out of 10, you get into an agreement like this and this type of loan and you’re not gonna run into problems. But it’s that one time of 10 that you do and it’s gonna completely blow up a relationship. You want to run this as if you are making a loan to someone who is not family.
So you want to have the terms documented, have a really clear repayment schedule, what interest is being charged, what are the concerns where if you don’t get paid back, what recourse do you have? Is it secured by anything? This is where it gets a little tricky, but you could secure that loan with property or assets if possible.
Every complexity that you add to this will require some added complexity and attorney fees to set all this up. But in this case, when you’re talking about 20% of a home value, it’s worth spending a few grand to have an agreement written up so that way you have something clear and everyone’s on the same page.
If anything, you’re bringing in somebody, a third party, that takes away the awkwardness around you trying to talk about interest rates and what happens if they pay you, and all these types of things in these types of scenarios. So by bringing in a third party, having the attorney draft it, they’re gonna bring up all of the things that you’re probably not super excited to talk about.
Like, what happens if you default on this loan and I have to take the property? What do I get? So having that all in there. And the last thing to really consider is, do you really have to go down this route in the sense that, are there other options available for him to get the financing in the short term, as opposed to putting your relationship at risk?
You have security backed line of credits, some SBLOC stuff, you could go home equity line. He already has a current home. Could he open up an equity line or pull out equity on that house and use that for a down payment, even if it’s a smaller down payment on the second home?
Now there’s also the option of him opening up a home equity line on the second home as well at the same time, so sort of like a simultaneous close where he would buy the property and have an equity line open at the same time to get him to 20% that he’s shooting for and still only have to have 10% down.
There’s as much as I’d hate to say it, loans against retirement accounts and all of that. There’s a lot of ways that someone who’s in a good financial situation, which sounds like he is, to be able to access cash and liquidity, especially for a short amount of time, that doesn’t require getting into the risk of ruining family relationships.
So that’s always step one in this: is this truly the last option for him to get money? And then you need to ask yourself, if my brother has gone to all of these places and no professional lending organization, bank, is willing to give him any money, then why should you be so open to giving him any money in that scenario, and what risks are they seeing that you’re not?
So if you’re gonna go this way, there’s lots of ways to do it to protect yourself. But I think taking a step back and saying, has he exhausted all of the other possible sources of liquidity first? And then if that’s the case and he still can’t get a loan, then really think twice about whether or not the loan that you’re about to give is as secure as you think it is. And if it is, then time to bring an attorney, write everything up, and go from there.
Question 2 – Law firm partnership buy-in
Listener: I’m on track to make partner at my law firm next year, and they’ve told me the buy-in will be around $500,000. Right now as a senior associate, I make about 400 grand a year and equity partners here average closer to 750. How should I think about whether this buy-in is worth it, the risks involved, and the best way to finance it?
Stephan Shipe: Yeah, great question and great opportunity for you. In many cases, these are slam dunk decisions. You’re making partner, you’re gonna go through with the buy-in and everything’s gonna be great. Your income’s gonna jump, you’re gonna have those equity distributions, so it’s rare that these are not good scenarios.
But that doesn’t mean you shouldn’t do your due diligence on the whole relationship. And frankly, I think your partners would probably be disappointed if you didn’t do any type of due diligence on the entire relationship there. And a lot of that has to do with understanding what that change is going to look like as you go from associate to partner.
So out of that average, you’re talking about that increase in compensation. Assuming that that is all the partnership distribution, that’s your share of being an equity owner in the company. How much of that is reliant upon you generating revenue for the firm? Is it all your revenue generation?
Is there a ramp up to when you’re gonna have that type of compensation, or is it: you start off today with your $400,000 salary and it’s gonna jump hundreds of thousands of dollars in the next year, and that’s what’s expected? Maybe that’s the case after the buy-in, or maybe there is more that you’re expected to do and the people you’re talking to on the partner side have already ramped up to that area.
I think that’s gonna be the first. You also need to start thinking about this as a business owner instead of just an employee looking at compensation differences, which is something that I see as really common — that shift in mindset that’s needed to go from associate to partner and really start thinking about this from an ownership perspective.
What is your responsibility going to be after this time? What does revenue look like? What does revenue stability look like? Looking at financial statements over the past few years, really digging into what the future path and trajectory is for the firm.
And then thinking about what does it look like. Is your equity locked up? Do you only get out if somebody else buys in? What is that whole mix around the buyout process, right? The buy-in process, your relationship with other partners from a distribution perspective. Are there times when revenue stability may be good, but then you’re cutting back distributions because of growth opportunities?
What does that look like? How are those decisions made? And then thinking too about what is the mix of partners right now that you have, and how many of them are staying in for how long? How risky is it for one of them to retire or multiple of them to retire? Now, this may not be a concern. Maybe there are 50, 100 partners in your firm and one partner leaving is not a big deal.
But if you have a smaller firm that you’re in and one or two partners leave or retire, you want to be careful that you’re not just the retirement plan where your ability to buy in is actually cashing somebody else out and you’re stuck holding the bag type scenario. We want to be careful of that.
So really thinking about valuation, the buyout process, and time to hire your own attorney in these types of situations to review the documents, make sure all the questions that you’d expect to ask are asked, and look at how your role is going to be and what limitations are you giving up and what opportunities are opening up for you during this time.
But it sounds like a good opportunity. In many cases, we don’t see this being too bad. The increase in income that you’re gonna have will likely pay back your partnership buy-in over that three to five years, which is expected. So you’re gonna have a few hundred thousand dollars increase, you’re gonna pay back the $500,000 for the buy-in, and that buy-in is gonna be after-tax money.
So you’ll need to earn a little bit more on that one. But it sounds like three to four years would be enough income from the profit side to pay for the buy-in. Which is exactly what you’d expect. So that gives you a multiple, roughly of three times or so, three or four times on the profits. If — and this is the big if — if the earnings that you’re seeing from other partners or what you’re told to be expected is something that you’re almost guaranteed, as opposed to it solely being your ability to generate equity.
And your ability to generate income on your share of equity, that’s the big question. And that’s gonna be expected that you’re gonna have to do something. You can’t just hop into a partnership role and you’re not expected to generate any revenue for the firm. But you want to know how much of that revenue is still you generating that revenue, and how much is the benefit from you being an owner of the firm.
Question 3 – Using NUA
Listener: I’m retiring next year and have $3 million in my 401k, including $800,000 in company stock with a cost basis of about $250,000. I’ve been reading about NUA strategies. Could I use this to help me pay less in taxes when I sell the stock?
Stephan Shipe: This is a super cool situation. The NUA is something that a lot of people don’t understand, and the fact that you’re looking at it already is massive because it is one of those really obscure things around the tax code and understanding what you own in a portfolio that is really unique to make sure that you’re on the same page on the strategy idea.
The idea here, for anyone listening who does not understand: the NUA idea is that you are stuck now. You have your 401k, you have the $800,000 in company stock, and it’s grown a ton. You have $550,000 of gains. So your portfolio, $3 million in 401k, everything looks good there.
The default decision is you’re gonna take that money in the 401k and you’re gonna roll all of that over into an IRA. That’s what the normal, no-NUA type of scenario looks like. So you roll that $3 million over into an IRA, and now every dollar you pull out of that IRA is gonna be taxed as income.
Now, normally that’s fine. We have other concerns down the road related to RMDs and Roth conversions and all of that. But where it becomes important in your situation is the change in value of the company stock going from 250 up to $800,000. So that big jump, that $550,000 worth of gains is great. Now you have $550,000 in your IRA, but what if you could only pay capital gains tax on that $550,000 worth of gains as opposed to ordinary income tax, which is gonna be the default with the IRA?
That’s where the net unrealized appreciation situation comes in. And this all has to be done as a lump sum distribution, and you have to be careful of that, because some people look at that and say, it’s a lump sum distribution, so I have to take everything out of the 401k at once.
That is not true. You need to have the IRA portion that is not the company stock go to an IRA, the tax-deferred portion. The amount of company stock that you have, that $800,000, will transfer to a taxable brokerage account. And once in that taxable brokerage account, you will pay ordinary income tax, but only on the basis.
So you’ll only pay ordinary income on $250,000 of the $800,000 that just hit your taxable brokerage account. Now, your taxable brokerage account is $550,000 worth of long-term capital gains that you can take whenever you want.
So when does this make sense? It’s gonna make sense in your scenario if you believe that your tax rate in retirement, or especially over the next few years, is going to be so high that it makes more sense for you to take ordinary income only on the cost basis and capital gains on the actual appreciation of stock.
So if you’re in a 12% bracket or so, maybe there’s some opportunity there, but you’d likely be at zero capital gains. The fact that you have the $3 million in the 401k, the odds of you being down below 22% tax bracket is likely not going to happen.
So that means that that benefit of the NUA really is going to pay off because what’s gonna happen: take the 800, all of that ends up in the taxable brokerage account. The other $2.2 million of the 401k is now in an IRA. So if we’re following the money, around 2.2 million is in an IRA, $800,000 is in the brokerage account.
Of that, you have long-term capital gains of $550,000 in there. If you sold all that, you’d only pay capital gains. You wouldn’t have to pay ordinary income on that amount.
Now, where people get messed up in this situation is not understanding that while this sounds great — you’re gonna have $550,000 of long-term capital gains that you’re not going to have to pay ordinary income tax on — you will have to pay ordinary income tax on that cost basis, and immediately. Which means the year you transfer this over, you are going to increase your ordinary income by $250,000.
So best time to do this is going to be a time where you expect income to drop significantly. Fortunately, you can only do this during major events: so retirement, 59 and a half, all of these different things, changing jobs.
So wait until your income drops. Be careful on that year. It’s a good year to make sure you delay any Roth conversions. You want to do this ideally before Social Security. There are a lot of ways to plan for this so that way you have a year that has very low income. Take the NUA. You’re gonna pay ordinary income tax on $250,000. Everything else is gonna roll to your IRA.
And then you’re gonna be sitting with a brokerage account of $800,000, $550,000 as long-term capital gains, and then you can make the decision to sell all that and pay the long-term capital gains.
Now, the risk that you’re gonna have — because it all sounds so good that there’s gotta be a catch in the scenario — the catch in the scenario is if you were to go sell that $800,000 of company stock today in your 401k or in your IRA once it all rolls over, you’re not gonna have to worry about any immediate tax.
So you’re not gonna have to worry about any immediate tax and you’re gonna diversify $800,000 of your portfolio that right now is concentrated in a single stock. So of the $3 million in your 401k — not sure how much you have in the other accounts — but if the 401k is a large portion of your net worth, you have $3 million there, $800,000 is in one stock, which is way too much.
If you keep it in the IRA you can sell all of that today. You can clean it all up, get rid of that concentration risk, and immediately be in a diversified portfolio. The downside there being that you’re gonna pay ordinary income tax on every dollar you take out.
On the other end, if you go the NUA decision, you’re gonna get more favorable tax treatment from long-term capital gains. But you’re gonna have to hold that stock. You’re still gonna hold $800,000 of that stock until you divest. And if you divest it all at once, then you’re gonna end up taking this very large tax bill. You’re gonna pay $120,000 plus of taxes just in long-term capital gains, plus the tax you paid on the ordinary income tax and the cost basis all in the same year.
So definitely something to weigh out. I’m glad you’re looking into it. It is a really important factor to look into. Generally it is better when you have larger capital gains, like in this scenario for the company stock. But as soon as you have those large capital gains and it starts looking good, the risk you face is that now you’re stuck with a very concentrated position in your taxable brokerage account.
Advisor Red Flags
Stephan Shipe: Now for today’s rotating segment Advisor Red Flags, we’re calling out practices and promises that should make you hit pause.
The claim that we regularly hear — hear this from clients all the time — saying, Stephan, I had somebody call, they gave me an exclusive opportunity to invest in this amazing real estate fund that they have. And they’re revolutionizing the world of real estate and their condos are unlike anyone else’s condos. Whatever the sales pitch is, right? It’s a private equity fund, it’s some sort of hedge fund that has some proprietary strategy, it’s a solar farm in the middle of the desert. I’ve heard ’em all. I’ve seen ’em all.
And the things you have to watch out for in these scenarios is this large promise of the future. Now, there are many legitimate private investments that exist. It’s not that I’m saying that any private investment is bad. I’m saying that you have to really be careful because private investments have an entirely different level of information asymmetry — both on the investment side, which is generally where the pitch is, in that we can buy things that public companies can’t buy.
But they also have a lot of opaque information related to how much they make and what their returns are. One of the big things that I see are any past returns, you really have to watch how they’re marked to market, who did the evaluation.
So I can say that I have a portfolio of companies in a private equity fund. And I bought them for a hundred million dollars, and then next year, I tell you I think they’re worth $200 million. Well, who said? Right? I said. Which is convenient for me to show you a 100% return by saying that the investments I bought went from 100 million to 200 million. And that’s worrisome.
What you really want to focus on are distributions, how much cash is actually coming out in these scenarios, and what is the experience of the people running it?
The problem that we end up seeing is that for these types of private investments, they have to look for accredited investors. So there are all these rules about having a certain net worth or having a certain amount of income to be an accredited investor that the government says: these are sophisticated investors, they already have enough money, so we don’t have to worry about what they invest in as much anymore. If you lose your money, that’s your problem. That’s the accredited investor idea.
But what that ends up meaning though, is you end up having a lot of high net worth individuals that get targeted for these types of exclusive or invitation-only type of scenarios, where it makes it seem a lot harder to get into than it actually is. Especially with these investments. And the reality is, what’s funny about that is they’re looking for investors.
So if anyone has more opportunity to negotiate in these situations, it’s the person with the money. And in this case, it would be you with the money investing in these funds. So looking for information is going to be key, right? Really digging into what the past finances are of these investments, how long has it been going on, what are the actual distributions of cash, who do they work with, and why is it so exclusive?
And if these are so great, why are they cutting back on all of these? So you want audited financial statements. You want to make sure that when you’re looking at a financial statement for any private investment, you want to know what’s concrete, what’s actually happened, and what is just someone’s projection of what they think was gonna happen.
And we saw a ton of this with the real estate syndication issues of the past few years. I remember looking at one where they had this condo or this apartment building that they were gonna buy. And none of the people on the management team had ever done this before. There were typos all along the PowerPoint slides, which is always my number one red flag.
If you can’t figure out how to spell correctly in a PowerPoint, then you don’t deserve anybody’s money. And especially when that is your job — to go collect money.
So looking for those types of red flags, talking to these people, and then looking at scenarios where they’re always gonna run projections. The projections are always gonna look great. No one goes and asks other people for money when they’re showing losses in the future.
But look at what projections those are and say: are these realistic? What is required for them to hit these goals? And some of the ones that were kind of egregious were the fact that they were financing all the debt now at 7 or 8%. And the only way they were profitable is within 12 months they were able to refinance back down to 2.5% or 3%, which is a huge red flag.
So really look at these, and that’s a thing we do. Bring in an advisor, look at ’em, talk to someone who’s in the area who can look at this stuff and say: it looks good at it, I’ve talked to some people, I pulled some information, I think it sounds great. The story sounds great. But now it’s time to dig in, do a little bit more vetting of these opportunities before you’re sending over money to anyone.
When the money’s still in your account, you have complete control over that situation. As soon as that money goes over there, you’re locking it up for who knows how long. And remember that those goal lockup periods and goal returns and everything that they have are only goals.
We all know people in this world who thought they were putting money in and they were gonna be guaranteed to get that out in three to five years — and 20 years down the road, they’re still holding some of these investments on their balance sheet.
So be careful of those and watch out for those exclusive opportunities.
So that’s our show. Thanks for listening, and we’ll see you next week.
Disclosure
Scholar Advising is an independent, fee-only financial advisory firm focused on providing hourly financial advice. The information provided in this podcast is for general informational and educational purposes only, and is not intended to constitute financial, investment, or other professional advice.
The opinions expressed are those of the hosts and guests and do not necessarily reflect the views of any affiliated organizations. Investing in financial markets involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, consult with a qualified financial advisor who can assess your situation, objectives, and risk tolerance. Thanks for listening!