Appendix A: Case Studies

The following are additional examples of building what I believe represents a strong financial table using my methodology of asset class diversification. Please note that these examples are based on the individual circumstances of each investor. They are not meant to be blanket recommendations and are for educational purposes only. Rates of return will vary and are not guaranteed, and the models used are hypothetical in nature. The math I use is simple, in an effort to help you understand the basics so that the door is open to learn more details as your interest in this methodology grows. Please consult with your financial advisor, or feel free to call us at 800-737-8552, or go to my web site, www.TheWealthCode.com, for more information.

Appendix B holds the detailed descriptions of each investment asset class. As you read through the case studies, I suggest you flip to the various investments in Appendix B as they are brought up and complete your education. I’ve always felt the best way to understand an investment is to see it in a real life example and then to read about the nitty gritty pros and cons. More glue for your Wealth Code table building adventure.

Mr. Johnson

Mr. Johnson is 78 years old and concerned about his income. He is living off his social security checks and doesn’t like to touch his stock portfolio because he never knows when it is a good time to sell. He would like more income without touching his principal, yet feels the dividends from most stocks are too low and will not keep up with rising costs.

At my request, Mr. Johnson invited his two daughters to be part of the portfolio discussions. He calls the shots but I always like to include the adult children/future beneficiaries in on any changes we might recommend for an older client. Though I feel I’ll get to bug him for another 20 years, you never know, and considering I would potentially be recommending some illiquid investments, it is always a good idea to let the future beneficiaries understand the choices being made and to have their say.

After analyzing his stocks and mutual funds, he realizes he hasn’t made a dime in the last 10 years. His portfolio has followed the markets up and down, like the majority of investors with similar portfolios. If he were to sell everything, there would only be a small amount of capital gains tax due on a few of his older stock positions and nothing on his mutual funds. Because the cost basis for mutual funds increases each year with each taxable dividend, his basis now exceeds the current market value of the funds and no taxes would be due.

When it came to the capital gains issue on the older stocks, he agreed with me that it was better to pay a little tax today and get the money working harder for him going forward, rather than sitting in an investment earning nothing year after year and continuing to defer the tax. By paying the tax, he was free to invest the proceeds into investments with a more reasonable probability of providing income and growth.

One point to remember: I believe that tax considerations should always be secondary to the right investment choice. Time and time again, I’ve seen clients hold on to poorly performing investments because they didn’t want to realize any taxable gains. Year after year they sat, making no further gains, but would not sell due to an embedded tax bill on the capital gains. There is an old saying, “You can’t go broke taking a profit.” Many times the best advice is to pay the tax bill and get the stagnant money potentially working harder for you in another investment.

A last consideration is he feels he might have some health issues and wants to keep a fair amount of his after-tax money liquid for emergencies.

A list of his assets includes:

Investable wealth:

Maximum per Real Asset financial investment:

As always, being more conservative in the amount per illiquid investment is being prudent. Using 5 percent as our target for these investments leaves us with around $20,000 per leg.

Designing Mr. Johnson’s plan was based on several criteria.

First, he is only state accredited, which means he is not allowed to invest in financial tools such as oil/gas programs, per SEC guidelines. Second, because of his age and always keeping in mind the uncertainty of sudden medical issues which was a concern to him, I kept a significant amount of his portfolio liquid.

If liquidity was one of the three attributes (High Return, Capital Preservation, Liquid) I had to use for a big piece of his money, I am left with choosing from the bank products (goal is Capital Preservation and Liquid) and the stock market (goal is High Return and Liquid).

Using the most conservative adaptive manager I have worked with who only trades fixed income, became a good place to start for a big chunk of his portfolio. In choosing this manager, the single biggest factor was looking at their performance in the bad years such as 2000 to 2002 and 2008 as well as the intermediate rough patches of time such as May through June 2010, August through September 2011 and May 2012.

I care much more about how a group has performed in the bad times than in the good. Everyone can thump their chests and say how great they are when times are good, I care far more about the performance when times are tough. How far did they drop? If and when did they move out to cash? This ability to move to 100 percent cash is the major advantage of adaptive managers.

KEY WEALTH CODE CONCEPT

To see how well a mutual fund, stock, or money manager will perform in the future, start with their performance during the rough times in the stock market.

Years like 2000 to 2002 (S&P 500 negative 52 percent) or 2008 (S&P 500 negative 38 percent).

Bad periods such as May through June 2010 (S&P 500 negative 15 percent), August through September 2011 (S&P 500 negative 20 percent) or May 2012 (S&P 500 negative 11 percent).

If the stock market drops 20 percent as it did in the 2011 rough patch and your particular investment choice also dropped 15 to 20 percent, should you expect a different result the next time the market swoons?

As Einstein was quoted saying; “The definition of insanity is doing the same thing over and over again and expecting a different result.”

---

The particular manager I selected for Mr. Johnson has a 10-year average return of more than 10 percent net of fees as of January 2012 with a beta of 0.18. If a money manager has been able to generate those types of returns in the same time period where the S&P 500 index has barely made over 2 percent, even though we have stated time and time again that past performance is no guarantee of future results, at least we have something to feel more confident about.

Beta is a volatility factor which essentially measures the amount of risk a manager is taking. With a beta of 1.00 being the S&P 500 benchmark, the lower the number the less volatile a particular group’s performance has been compared to the general stock market.

2008 was this manager’s worst year where they lost about 1 percent. A far better result than the negative 38 percent of the S&P 500, but a loss nonetheless. I know that investment results are going to vary, but again I look at how they’ve weathered (or not weathered) prior economic storms. After the appropriate manager was selected for this leg of Mr. Johnson’s new portfolio, we focused on the other legs for his Wealth Code table.

The other investments available to him include a fixed annuity, banking products, non-traded REITs, equipment leasing companies, various collateralized notes, and consumer grade real estate. Of course, I could add variable annuities and static stocks and bonds, but I tend to avoid these categories for most of our clients due to the current economic climate and outlook going forward. In addition, I make no claims to be a “stock picker” nor will I ever claim to be one.

Liquidity is important, and considering that he is 78 years old, I stuck to investments with durations of no more than five years. The equipment leasing category is excluded due to longer maturation dates of eight years or more and Mr. Johnson did not want to have a rental property where possible headaches are potentially part of the equation. The potential for this type of returns wouldn’t justify the nuisances for him personally. We choose to leave his CDs alone, sacrificing return for liquidity. The maturity dates for his CDs were generally laddered appropriately so that a number of them would mature over the years to provide liquidity if needed. All were of reasonably short duration as well.

Although fixed annuities do not normally play a part in plans I craft for clients, I added a small piece in a three-year non-MVA annuity, which could be annuitized in the future, adding another income stream for life. Due to his age, the payout for Mr. Johnson would be around 9 percent each year, lasting his remaining lifetime. If he waits to start the income stream, called annuitization, his payout percentage would increase due to a shorter life expectancy. For the meantime, the annuity will stay in deferral and pay out interest at a guaranteed 2.5 percent per year. Again, I am sacrificing return today to have the annuitization option in the future and liquidity at a small price in case he needs the money.

Within his $50,000 IRA, I used $20,000 of the money in an illiquid Business Development Corporation (BDC) and the other $30,000 in the liquid adaptive management account. Since he is required to pull out increasingly larger required minimum distributions (RMDs) each year from his IRA, we will use the managed account to satisfy the amount above the expected cash flow from both of the investments. He cannot take out more than the BDC earns so any additional amount required to satisfy the RMD will have to come from the liquid adaptive management account.

The goal of the IRS with RMDs from retirement accounts is to eventually drain out your account and force you to pay the deferred taxes. Eventually everyone will have to cut into principal each year as we get older unless you can earn more than the RMD. In Mr. Johnson’s case, at age 78 he only has to pull 4.9 percent, which the potential distributions from the two investments in his IRA will satisfy if they perform as expected.

My proposed plan for Mr. Johnson was as follows:

Summary of Recommendations for Mr. Johnson

Summary of Liquid to Illiquid investments

Mr. Johnson paid $45,000 for his house, 30 years ago, and likes the idea of real estate as a part of his plan, as it has earned him more money than any other investment he has ever owned. He believes rents will generally increase over time and will help offset his income needs with rising inflation. The two REITs chosen for him match his beliefs of what will hold its value over the coming years. The big-box REIT purchases single tenant real estate for stores he frequents a lot such as Wal-Mart, Walgreens, and Home Depot. He feels that no matter how bad the economy gets and even though their stock values might go down with a falling market, they should be able to stay in business and thus keep paying their rent on time.

The mortgage pool represents a collection of 30-year fixed mortgages on residential real estate. The maximum loan to value (LTV) of these properties was 30 percent as an average per their prospectus as provided to the client before investing. That is, the real estate market across the country would have to fall a collective 70 percent from 2012 prices to jeopardize the principal in this investment. This is one of the more conservative investments he chooses. It will never pay an exorbitant amount, reasonably around 5 to 6 percent, but I feel the risk is commensurate with the return.

Though the annuity will probably not perform as well as the non-traded REITS or the collateralized notes, 2.5 percent is better than current CD interest rates in the low 1 percent range. More importantly, he can annuitize the contract to begin a much higher payout for the rest of his life, currently around 9 percent. This again is due to his life expectancy, when calculating the payment percentage. The older you are the higher the percentage and vice versa.

I chose a short-term annuity, which I can change in just three years if the economic environment warrants it. The surrender charges on this particular annuity were 4 percent, 3 percent, and 2 percent and 0 percent after year three and since this policy did not have a Market Value Adjustment (MVA) we did not have to be concerned with the negative effects on the surrender charge if interest rates rose. If necessary, he could surrender the policy at any time and, worst-case scenario, give back 4 percent. Again, this is a worst-case scenario. How many people would like to know their worst-case scenario with a stock or bond was only to lose 4 percent?

If interest rates rise dramatically within the next three years, he would be able to close the annuity penalty free after year three and move the money to a harder working financial vehicle.

Finally, I left the $50,000 CD alone because this is an account that provides him piece of mind. That is always worth more than gaining an extra couple of percentage points by moving the money. Always design a plan around your beliefs, not somebody else’s.

Using target dividend/distribution assumptions for the various investments, I was able to generate an approximation of his Cash Flow potential today.

Growth assumptions must be used to generate an expected total return for Mr. Johnson’s new Wealth Code portfolio. Nothing is ever guaranteed of course but having 10-, 20-, even 30-year histories of actual performance at least gives us warm fuzzy feelings about a particular group’s ability to generate returns.

In Mr. Johnsons plan, three of the four new investments have growth attributes: The non-traded REITs, BDC, and adaptive manager. The non-traded REITs and BDCs have generally tacked on another 2 percent for growth and the adaptive managers we currently work with have 10-year returns of more than 10 percent net of fees going back to 2001. Being conservative and cutting the adaptive manager’s historical performance down to 8 percent suggests we should see another 2 percent for growth on top of the 6 percent distributions we will take from that category.

The potential total return for Mr. Johnson’s plan equals income plus growth. In his case, $19,950 plus $5,100 for a total of $25,050.

$25,050 divided by his investment amount of $400,000 equals a total return goal of 6.26 percent.

My job for Mr. Johnson was not to light the world on fire but to provide an investment platform that I believe could potentially provide a consistent return that would be comparable to the real rate of inflation. He was more concerned with the return of his principal rather than the return on his principal. With the designed portfolio, I feel he’ll have a fighting chance to realize both.

Ms. Smith

Ms. Smith is 55 years old and single. She does not work and lives off an inheritance she received from her deceased parents. She loves to travel and maintains a condo in a downtown high rise. The condo works nicely with her lifestyle, as it allows her the flexibility to leave town on a moment’s notice.

A list of her assets includes:

Investable wealth:

Maximum per Real Asset financial investment:

KEY WEALTH CODE CONCEPT

Clients have muni bonds in their portfolio for the obvious benefit of being federal tax free and potentially state tax free. Even though their returns may be only three of four percent with realistically no upside potential due to probable rising interest rates, the justification for accepting the low yields is the net tax benefit.

As previously mentioned, in order to get higher yields on a muni bond, you have to extend out the term of the bond. A 20-year muni bond will most likely pay more interest than a 10 year bond. Whatever the term of the bond, if interest rates happen to rise quickly, an investor will most likely be stuck in the bond until its maturity date, ten, twenty, or more years into the future, all the time losing purchasing power due to the effects of inflation.

What if there was an alternative investment which, after tax, yielded more than a particular muni bond and was far shorter in expected duration?

A difference between the stock market-traded REITs and the non-traded REITs is the pass through of tax advantages to the end investor. The non-traded REITs use 1099 reporting of their income each year. On the 1099, an investor will see their total distributions or reinvestments broken into two pieces. Taxable distributions and non-taxable distributions.

For instance, let’s say an investor receives 7 percent or $7,000 of income from a $100,000 non-traded REIT in a given year. Their 1099 might report the taxable distributions as being $3,000 and the non-taxable distributions as being $4,000.

$7,000 total distributions = $3,000 taxable distributions + $4,000 non-taxable distributions

The non-taxable distributions result from items such as depreciation, mortgage interest, and other real estate tax advantages being passed through to the investor’s tax return.

Ultimately, you are lowering the cost basis of your investment until the eventual sale of the properties where you will recapture the off-set income.

The investor will have to pay tax on the $3,000 and not on the $4,000 until much later and at potentially more favorable tax rates.

Assuming the investor is in the 35 percent effective tax bracket today, they would pay $1,050 in income tax. Subtracting this from their total distribution of $7,000 results in net income of $5,950 in their pocket.

$7,000 (distributions received) − $1,050 ($3,000 taxable income × 35 percent) = $5,950 net or 5.95 percent

Compare the example non-traded REITs 5.95 percent after tax return to the longer-term muni bond maybe only yielding 4 or 5 percent.

There are two major differences between a non-traded REIT and a longer-term muni bond:

1. Length of investment is generally much shorter, generally in the four to eight year range;

2. Principal growth potential.

Most will agree real estate, if held long enough, will appreciate in value. The goal of the non-traded REITs is to sell the underlying properties for a potential profit and return more than the contributed capital to the investors on top of the received distributions. The goal is to have appreciation of the principal, something muni bonds today, in today’s potentially rising interest environment, will most likely not experience.

The bottom line question for an investment is, whether it is tax free or taxable, what’s in your pocket after Uncle Sam has taken his piece of the pie? If a muni bond is paying 5 percent and another taxable investment, after taxes have been paid, is earning more, isn’t it better to have the higher paying investment if the risks and rewards are suitable?

---

Though I am not a fan of muni bonds in a probable rising interest rate environment, Ms. Smith’ bonds were appropriate for her. Her current advisor had chosen an ultra-short duration portfolio of individual bonds, with the longest maturation date a mere two years out. She had more income than she knew what to do with and was comfortable with the portfolio.

Going back to Ms. Smith, I recommended doing nothing with the short-term muni bonds and instead focused our attention on her property.

Discussing her rental property, she said it was the one nuisance in her life. The terrible Ts (tenants, toilets, and trash) were driving her crazy. She felt tied to the property due to the capital gains she would owe when selling it. If she sold, she would realize $500,000 in capital gains, and with the recapture of depreciation, her tax bill would be more than $125,000. The taxes paid would represent a huge leak in her financial bucket of lost opportunity.

We taught her about 1031 exchanges, (discussed in detail in Appendix B and Appendix D) and showed her options using co-ownership real estate via Delaware Statutory Trusts (DST). These securities allow her to sell the property and do a 1031 exchange, deferring all the taxes, into multiple co-ownership real estate properties for investment diversification.

Our recommendations for Ms. Smith were as follows:

Using target distribution assumptions for the various investments, we are able to generate an approximation of her cash flow potential.

The average target yield for the properties selected was around 6.9 percent. By exchanging the equity in one property into four distinctly different properties, she was able to diversify her holdings and raise her net cash flow from $18,000 to around $48,000.

The part that surprised her was how large commercial properties can accelerate depreciation via a cost segregation study.

This study effectively identifies and reclassifies real estate assets into four categories: personal property, land improvements, building components, and land. The first three have accelerated depreciation deductions and easier write-offs when an asset becomes obsolete, broken, or destroyed. The net effect of using a cost segregation study for DSTs in general is that, for Ms. Smith’ income of $48,000, she may only have net taxable income of $15,000 to $20,000. Basically, the same situation she was in before the 1031 exchange.

The other headache she was relieved of was that of tax reporting, which is essentially prepared by the sponsor of the DST and mailed to the owners. The owners just hand the forms to their accountants and they are done.

There are trade-offs for DSTs, the biggest one being a very limited ability to sell one’s ownership share during the duration of the investment, typically between four to eight years or longer. This wasn’t a concern for Ms. Smith, considering she had owned her previous property for more than 20 years and understands real estate is a long-term investment.

DSTs require a lot of education concerning the pros and cons and should only be considered after careful due diligence and working with a financial advisor experienced in DST investments.

Other negative attributes are the same negative attributes that affect all real estate investments. Income can be suspended if the property loses tenants, additional cash requirements may be needed if significant issues arise with the property, and real estate values go both ways, up and down.

Though Ms. Smith didn’t really care about the increase in income, she was thrilled to no longer have to deal with the terrible Ts. The DSTs she purchased all came with professional management. Now, she is truly free to leave town without any of the headaches of managing a property and being on call to deal with them.

Mr. and Mrs. Jaspar

Mr. Jaspar is 38 years old, a graphic artist with income around $45,000 per year. He is married and has a 4-year-old son. His wife, Mrs. Jaspar, is 35 years old and works as a nurse part-time earning $36,000 per year. The family rents a two-bedroom apartment for $1,500 per month.

Many times when younger clients come into my firm, my first goal with them is to look at the basics, things like estate planning and insurance planning. Being in California a basic revocable trust is a good starting point. In other states a simple living will is most likely sufficient. I strongly urge you to consult with your own estate planning attorney in your own home state.

It is important to remember that more than just the living trust or will you get the other vital documents which come with it such as a medical power of attorney and durable power of attorney. Both cover the situation if one of the spouses is incapacitated and the other needs the authority to make medical and financial decisions on their behalf.

You might question why, since the Jaspars are so young, we start with things like estate planning. Bottom line, not having your estate in order is a train wreck waiting to happen for any age group. It is never too early to start. As we are not attorneys, we referred the Jaspars to a number of competent, yet very reasonably priced small law firms and let them choose who they worked with.

Because the Jaspars have significant family liabilities, we also recommended term life policies for both spouses, due to their having similar incomes. Because of their ages, both applied for 25-year term policies for $1M each, with a cost at the time the policies were put into place of around $600 for him and $400 for her. Anytime a family has young children at homes, life insurance, in my opinion, becomes a necessity.

Does an additional cost of $1,000 per year or $83 per month cut into the amount they could be saving? Of course it does, but it is an inexpensive hedge against either or both of them being killed and leaving the other or their son facing financial hardship. It is important to consider the loss of future income and costs associated with college or other typical expenses of raising a child.

I recommended the 25-year term policies to cover them to around age 60 and past the college years for their son. At that point, family liabilities generally tend to ease as does the need for life insurance. If there are still other liabilities remaining, such as mortgage, job, estate, and so forth, this may deem a continued need for insurance or changing the coverage to a permanent policy.

A list of their assets includes:

With a combined income of $81,000 per year and net worth of $55,000, the Jaspars are considered non-accredited investors. They wish to start building wealth and feel they are going nowhere at this moment with their current investments.

Because of the security laws for accreditation, they do not have access to most investments that are part of the Wealth Code table. Again many of the illiquid investments have rules of net worth and income requirements. Typically the state of domicile minimum is $70,000 income and $70,000 net worth or $250,000 net worth to have access to the non-traded REITs, BDCs, note programs, and so forth. The higher accreditation standards of $1M net worth apply to most of the partnership deals.

That being said, one of my favorite categories for an investor is consumer-grade real estate, real estate valued at less than $5M. In this case we are looking for single family rentals in the range of $60,000 to $80,000.

Since the real estate bubble peaked in 2006, many areas of the country have now fallen more than 30 percent in value. In several areas of the country, houses which used to be $100,000 plus are now in the $60,000 to $80,000 range. As the values continue to fall, the gross rents as a percentage of the value of the homes continue to rise.

For instance, a house which rents for $8,000 per year and used to be worth $100,000 had at that time a gross rent of 8 percent. That house, having fallen in value to $70,000, now has a gross rent of 11.4 percent assuming the rent stays the same.

$8,000 Rent/$100,000 Previous Home Value = 8 percent Gross Rent

$8,000 Rent/$70,000 Reduced Home Value = 11.4 percent Gross Rent

Historically, when gross rents approach 15 percent, you are getting very close to the bottom of a local real estate markets cycle. Local can literally mean a particular zip code.

This is not speaking for the country as a whole being at the bottom of its real estate cycle, just the particular area where the gross rents are now approaching 15 percent.

Why 15 percent? Maybe it is a psychological number where investors will start to buy. Can the rest of the country continue to fall? Absolutely! Places which still have large numbers of foreclosed properties waiting to hit the market as well as gross rents that are in the single digit percentages have a ways to fall in my opinion. California, Las Vegas, Arizona, and Florida come to mind that match this criteria.

The opportunity lies in the fact that today loans are extremely difficult to get. You need solid income, high credit scores, and low debt to qualify for even the smallest loans.

The biggest barrier to entry is the required down payment. Many of the potential buyers, families with local jobs and kids in the nearby schools, have some money saved, but not $20,000 to $30,000, so are forced to keep renting. They do not wish to be in apartments and would rather raise their kids in a single-family residence. The unfortunate aspect is the rents in these homes are rather high, again, roughly 15 percent of the value. Not having the down payment forces them to pay rent, and this is the opportunity for investors with sufficient cash whether in a self-directed IRA or after-tax dollars, to purchase these investment homes.

The Jaspars’ were straddling both sides of this fence. They did not have sufficient down payment to purchase a home in Los Angeles, due to the relatively high home values, but had enough saved and the credit to buy a rental in one of the more reasonably priced rental markets.

Mr. Jaspar was also rather nervous of taking on a multi-thousand dollar mortgage and property taxes that would be associated with buying a primary residence in Los Angeles. Though they would like to buy a house, they know it is out of their reach at this moment and are content in their current living arrangement.

After teaching them the difference between a liability and an asset, which is something that has a net negative cash flow versus something that puts money in your pocket each month respectively, the Jaspars were very interested in purchasing their first rental property and beginning to build real wealth and positive cash flow.

We referred the Jaspars to a few different real estate management groups in the mid-west. Why the mid-west? Because the overall cost of homes there was substantially less than the local Los Angeles market. In other words, similar sized homes (3-bedroom, 2-bath, for example) were hundreds of thousands of dollars cheaper in other metropolitan markets. At one of the real estate management groups, they were able to find a newly rehabbed three bedroom single family home with a long-term tenant in place renting for $825 per month.

At a purchase price of around $80,000 and a required down payment typically of 25 percent for investment properties, they would only need $20,000 for their down payment. The only debt they had was a revolving credit card which they paid off each month. With their good credit and low debt payments, the Jaspars could qualify for the loan of $60,000. The monthly payment for a 30-year fixed mortgage, with current interest rates for investment properties around 4.65 percent, would be around $308.

Why this number is important is because it is roughly the same amount Mr. Jaspar is contributing to his 401(k). That makes him feel financially comfortable because he knows, even if there is a vacancy at the rental property, he could divert their 401(k) contributions ($300+$200) to pay the home’s mortgage and property taxes, and his overall cash flow as well as tax situation would stay exactly the same. That is, their living needs would be covered by the same effective take home income since they were not using the amount contributed in their 401(k)s anyways. Their tax situation stays the same because even though they are taking more home in their paycheck, paying the mortgage and property taxes neutralizes the increased income.

The summary of the property is as follows:

The summary of the estimated potential cash flow is as follows:

Looking at the net cash flow and dividing by the investment made gives the Jaspars’ a healthy net return of 15 percent.

$3,313 net cash flow ÷ $22,000 initial investment ($20,000 Down Payment + $2,000 closing costs) = 15 percent

Here’s the icing on the cake. If the property over the next 10 years averages three percent compounded appreciation, their total return will equal more than 27 percent per year.

3 percent compounded appreciation × $80,000 (Initial FMV) = $2,751 average per year growth

$3,313 net cash flow + $2,751 average per year growth = $6,064 per year total return

$6,064 ÷ $22,000(Initial Investment) = 27.56 percent annual return

I ask you, as the reader, to tell me that their own 401(k) has matched that performance over the last five years or longer.

Another question they had was funding future college costs. I have always been an advocate of the philosophy that a client should build their personal cash flow as much as possible by passive means. By using that cash flow to continue to build additional income streams, the day college rolls around, you may be able to divert some of that income to help pay the costs. Once college is over, you still have the potential for income streams for yourself in your retirement. This is the same strategy as paying for a car, buying assets to pay for liabilities, except college is not a depreciating liability but rather a long-term asset for your children. Thus you get the best of all worlds. You bought assets to pay for another asset.

My personal problem with typical college accounts such as 529s is that the principal is spent and gone forever. The asset value gets drawn down to zero as college is paid for. Yes, you hopefully have a college grad, but you do not have the principal to provide future cash flow. If an asset such as a rental property helps pay the tuition, the property is hopefully still there after the child graduates. Using the checks in the mail approach provides for both the higher education expenses and personal retirement needs.

In summary, the most important education I provided to the Jaspars was to teach them to shift their focus from making only 401(k) contributions as their primary means of building wealth to buying a real asset which would produce its own paycheck for them today and not only after age 59½. This extra paycheck comes to the door whether they get out of bed or not. Generating additional passive cash flow is a tried and true wealth building principle.

Many people might argue that we should have guided them into purchasing a home for themselves first. While this is desirable for many, I teach my clients to buy assets first, liabilities second. If successful, the Jaspars may eventually have enough cash flow coming from various rental properties (assets) to equal a mortgage payment on their own house (a liability). Then they would be effectively mortgage-free!

Mr. Warbucks

Mr. Warbucks is 67 years old, married, with lots of grandkids. He recently sold a patent to a big turbine manufacturer for $50M. He had excellent tax and estate planning already in place and was looking for a financial advisor to help guide him in investing the money. Needless to say, this client was shopping all the big names, and they all were putting on their best dog and pony shows for him.

This client came to me after seeing the proposals from the major wire houses and most of the boutique firms in the area. His comment to me was that the plans from everyone so far were pretty much the same: stocks and muni bonds. They all discussed the need for lower taxes and over emphasized muni bonds.

His concerns about the proposals presented:

• Interest rates were at the bottom and would put downside pressure on stocks and bonds when they eventually rise.
• Income needs for himself and his family would always be going up with inflation, and he wanted a better hedge for the future.
• He wanted a lot of flexibility for the majority of his money within five years, due to the unpredictability of the economy.

Here is the plan proposed to Mr. Warbucks:

Alternate Idea: Replace some real estate with money management to provide more liquidity.

Hypothetical Income Analysis:

When looking through my plan, the first thing he noticed was the smiley face and fun money category. My comment to him was, “Congratulations, you just won a very well-deserved spending spree. Spend all the money in this category within a year. Blow it on every frivolous idea you can imagine, spend it on your kids, grandkids, the neighbors’ grandkids, your favorite charity. Enjoy it. You worked very hard for this accomplishment.” With a smile on his face, considering the spending possibilities, we got down to business.

After describing to him my philosophy on wealth and the use of numerous legs on one’s financial table to potentially provide stability and income, I broke down the individual pieces and how they related to the overall plan.

Starting with the real estate portion, we decided on a combination of single-owner DSTs, and non-traded REITS. The single owner DSTs were meant for him to have total control over the buildings and the final say. There would be no other owners to cloud discussions about management, possible sell dates, and so on. The money that went into these properties would potentially grow effectively capital gains tax-free over many years due to the planned use of 1031 exchanges whenever a building would be sold. Remember, using DSTs for 1031 exchanges has risk, and the PPM must be read thoroughly before investing.

As previously mentioned and further explained in Appendix D, when Mr. Warbucks passes away, those buildings will receive a step-up in cost basis per current tax law, and the next generation will inherit them without any capital gain tax burden. Both the DSTs and the non-traded REITs provide a high degree of current income tax sheltering via depreciation and other pass through tax advantages.

We used the non-traded REITs for a smaller but significant chunk of his money for the shear diversification among hundreds of institutional grade real estate properties across the country, and in various categories from multifamily, storage, big box retail, student housing, to office and data centers.

The plan consisted of two types of energy DPPs I commonly use for clients. The oil/gas royalties would generally provide for inflation-adjusted income streams we could plan around and the energy drilling was used for two purposes. The first being the possibility of higher income distributions, the second being the favorable income deductions available from intangible and tangible drilling costs associated with these programs. Per current tax law, one option someone has when investing in an energy drilling program is to amortize the purchase amount over five years and receive 100 percent income deductions without concern for Alternative Minimum Tax (AMT) holdbacks. By placing $4M into various energy drilling programs and amortizing the intangible and tangible drilling costs over five years, Mr. Warbucks will receive $800,000 of income deductions each year until they are exhausted.

$4,000,000 Oil/Gas Drilling investment amortized ÷ 5 years = $800,000 per year

Given that the price per barrel of oil has a strong correlation with inflation both royalty and drilling oil/gas programs should potentially provide a high degree of inflationary income protection. If inflation moves up quickly, oil prices tend to follow fairly closely, which would correlate into higher distributions from his oil/gas programs.

The collateralized note investments (a combination of BDCs, mortgage and life notes) are designed to be shorter term in duration and have a higher sensitivity to rising interest rates. Considering many of these programs are short-term loans to corporations, as the money comes back in and if interest rates have risen, these investments will lend out the capital at higher rates and potentially pass the higher earnings on via distributions. The shortest investment was a six-month life note and the longest a BDC with an expected duration of five years. The biggest problem with the collateralized note programs is they do not have any tax advantages. Any earnings they have are passed through to the investors as pure interest reportable either on a 1099 or K-1 tax filing. What we gain in terms of shorter term investments we have to sacrifice a bit in tax planning. Of course, if someone used these in a retirement account, that would neutralize the tax issue, but in the case of Mr. Warbucks, he only had after-tax cash to work with.

Mr. Warbucks lives very modestly for someone who is worth so much. He agreed that he does not have liquidity needs he could possibly foresee beyond a million or so. I placed $5M into muni bonds and $3M in gold/silver bullion for the just-in-case needs he might encounter immediately. Better safe than sorry. Who knows, he might on a whim want to purchase a house for each of his grandkids.

The target projections were discussed in detail and he felt they were reasonable but understood that nothing was guaranteed.

When adding all the projected dividends/distributions along with the tax benefits, Mr. Warbucks was looking at cash flow approaching more than $233,000 dollars per month, $2.8M annually.

Most of the investments have depreciation or mineral depletion deductions, so of the $2.8M, only around $1.765M is taxable based on current tax laws.

From $1.765M we subtract the annual $800,000 oil/gas drilling IDC leaving just $965,000 exposed to a combined effective Federal and State income tax bracket of 31.32 percent. This results in income tax of $302,725 due.

Netting everything out leaves Mr. Warbucks with annual after tax income of around $2,497,275.

$2,800,000 gross income − $302,725 Federal/State income tax = $2,497,275 after tax income

Even though muni bonds only represented 11 percent of my Wealth Code portfolio for him, dividing $2.497M by the starting principal ($45M) results in an after-tax distribution of approximately 5.55 percent.

This is an income higher than most muni bond portfolios will pay, with one added advantage. There is the potential for growth of his principal in the rising interest rate and inflationary environment he expects, something the bonds will not likely achieve given the current economic policy of the Fed as of late 2012.

Also, consider he is using such a small portion of his after tax income. At the end of the fifth year when our oil/gas drilling deductions ($800,000) go away, it is very likely Mr. Warbucks will invest in other oil/gas developmental drilling programs to keep the oil and tax benefits flowing.

Lastly, the plan for Mr. Warbucks included a significant amount of advanced estate planning and asset protection, charitable gifting, and life insurance. Though he had done a significant amount of the above planning, I still managed to find several holes in his plans. For the scope of this book we are just focusing on the diversification of the assets and generation of cash flow.

Summary of Recommendations for Mr. Warbucks

Summary of Liquid to Illiquid Investments

Please note that when we were dealing with larger amounts like this and with someone who lives on only a very small portion of the cash flow generated, it can be suitable to invest a substantial amount of the principal in illiquid investments, as in Mr. Warbucks’ case, only needing about $400,000 per year. The client was looking for stability and income, the primary goal of the High Return–Capital Preservation category. The tradeoff again was limited liquidity and long-term commitments to the investment programs.

As we finished up our meeting, the most gratifying thing Mr. Warbucks said about the plan was the use of the fun money category. “Astonishing,” he said, “you were the first advisor who looked beyond the money and thought of me and my family and how we could improve our lives.”

I believe many of the grandkids now have new homes.