Author Topic: Is this the best strategy? Any way to avoid capital gains?  (Read 1057 times)

handsnhearts

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Is this the best strategy? Any way to avoid capital gains?
« on: February 14, 2017, 03:13:40 PM »
DH has an investment account that came to him in an inheritance. 

He has primarily used it for rental property investment, prior to our marriage (and prior to my basic financial literacy/competency). 

His account is approximately $400k.  He has it in 4 funds at Fidelity, a growth fund, a value fund, a low cost fund, and something else I am forgetting.  When he purchased 2 separate rental properties about 10+ years ago, he went on margin to leverage the account.  He currently owes about $220k. 

He is very concerned about a market correction imminently, and would like to get out of margin, as his funds are at a 52 week high.  It would involve between 50-60k in capital gains. 

The reason this is coming up is that he recouped some of this in 12/2015, without discussion, and caused us to have a 10k, unanticipated by me, capital gains bill at tax time.  This was in addition to us not with-holding enough (our income went up dramatically that year), and a penalty as we didn't complete taxes until Oct 2016, and missed the payment deadlines.  Ouch!!!

So the up-side of that last paragraph is some financial stuff that I previously considered to be in "his" realm, I am now seeing can seriously affect my budgeting and planning.  Also, he has promised to never again sell something like that without a discussion.  We are now starting to approach our finances in more a of a team based approach than before, which is really important.  We have even refinanced one of the rental properties together, which is a relief to me to know when and how much to anticipate paying for the year. 

Yesterday, he told me about the desire to sell more shares, and get out from under margin (which I wasn't aware of, last time he just told me he had to sell because it was a good time and I was too pre-occupied with the tax bill to ask more questions).  I now understand the desire to sell.  I think this may be a good idea.  But I am nervous about that Capital gains bill.  It will be charged at the 15% rate, and will be about $9000 (or less I hope). 

We also have ~200k in Student Loan debt, but no other debt.  Income will be going up a bit this year, and will likely put us over the MAGI for Roth IRA for 2017. 

I was basically financially illiterate prior to 2 years ago, when I found this website.  I was also in a low pain training position, and a student prior to that, so my financial needs were less then. 

We have a lot of Health Care expenses this year, and that is where all our cash is going at the moment, but we are hopeful that this will only continue for about 1 more year.  We have about $45k in emergency fund, much of which is earmarked for this year, and which is basically our networth, excluding rentals.  I need to dig into the rental numbers some more.  Neither are upside down, and both are mostly paying for themselves (PII, we paid T on one last year). 

I am wondering if there is any better way to come out of margin and avoid that big capital gains bill?

PS I have SO permission to discuss this and he will also review this.  Let me know if I need to clarify something, or if it sounds like I don't understand something I should. 

Thanks Moustachians!  I feel like this is the smartest, best group of people and I am looking forward to continuing my education, even if it sometimes is the School of Hard Knocks! 

MDM

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #1 on: February 14, 2017, 09:14:34 PM »
Consider putting things in the "Case Study" format.

Using combined numbers (other than where the spreadsheet template has room for 2 salaries, if needed) will facilitate the best responses.

ChpBstrd

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #2 on: February 15, 2017, 12:18:37 PM »
The implied concern is that a market correction would decrease the value of the collateral and lead to a margin call, right? And the margin call could force you to sell shares in a downturn or sell the properties, rather than riding out a dip, right? (Just ensuring my assumptions are clear).

What was the original rationale for using margin to buy real estate, instead of a mortgage? Were margin rates lower than mortgage rates 10 years ago? Did you lack credit in the past?

If those assumptions no longer hold, just refinance the properties to pay off your original loan. If Fidelity charges less than prevailing mortgage rates of about 4%, let me know and I'll leverage to the hilt!

mrspendy

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #3 on: February 15, 2017, 12:33:14 PM »
Unless you negotiated a special deal with Fido (which is possible) you are likely paying 6-8% / year in margin interest on that $220K ($15K / year!!!). Now if the market makes more than that, you come out ahead on the borrowed $'s. But just because the market has made more than that in the recent past does not mean it will do so in the future (long term returns typically mean revert via corrections, the market won't keep going up 15% a year forever)

Without a more in depth knowledge of your situation other than the facts presented, I would suggests immediately selling. You could lose a big chunk of your  equity in a correction. Let's say stocks go down 30%, so your $400K is now $280K, and fido makes you sell, boom, your $180K of equity is now worth $60K and you realize that entire loss; leverage works both ways. Don't be afraid to pay the tax man his due and move on.

https://www.fidelity.com/trading/commissions-margin-rates

If you must keep this levered trade on, at the very least call fidelity, threaten to transfer all your business to interactive brokers if they don't cut your rate substantially.

But I really suggest you sell. It is a very difficult argument to make that you should be levered with recourse mark to market leverage paying 7-8% margin interest 7 years into a bull market. The base case is the market makes equal to or less than your financing cost, the downside case is you lose all of which you own.



« Last Edit: February 15, 2017, 12:40:10 PM by mrspendy »

powskier

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #4 on: February 16, 2017, 01:52:00 AM »
Margin calls are brutal. Avoid margin.
Sell, take your profit, pay your taxes. Learn from the past .

handsnhearts

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #5 on: February 16, 2017, 02:59:10 PM »
Thank you all! 

To respond, I have no idea if there is a margin interest rate, but you can better believe I am about to find out! 

The rental properties are both mortgaged already, and are barely afloat as far as I can see. Definitely a speculation, not good cap rate if you include all expenses. Rents pay the mortgage and interest, not taxes, upkeep, property management, or vacancies. Luckily vacancies are rare as they are in a desirable area and we have lots of friends in the area to spread the word. Also a college town.

I think the properties are a reasonable speculation. But that is neither here nor there right now.

I am now suggesting that we do more that meet the margin, but also sell enough to recoup the taxes, as this is an unexpected tax bill, at the same time as or normal taxes are due.

We already refi one of the properties this year, to get out of an ARM with balloon, so at least that is now fixed 30 year. I can't remember the interest rate, but I know it was reasonable. (Less than 5, I think low 4).

I think the leverage in the past was before the 2008 debacle. He had a cap gains from a flip, and flipped it into 2 properties at the high end and stretched to make it happen. Then the market crashed.

One of the properties is still a good value, double lot and making plans to build the second house, or sell with plans and city approval in place (restrictive city so hard to do).

I should have asked for more info before. Like I said, I was financially illiterate basically until 2 years ago, and I still have a long way to go. At least I know I don't know, I don't think DH understands that about himself.




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handsnhearts

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #6 on: February 16, 2017, 09:27:12 PM »
Margin rate 6.825% or ~$13,000 per year!  What!!!


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ChpBstrd

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #7 on: February 17, 2017, 08:57:05 AM »
Do I understand correctly that the margin loan @ 6.825% was used to originally purchase the properties, and then a mortgage was taken out on at least one of them a few years later? Where did the proceeds from the mortgage go? To pay off part of the margin loan or to cover the properties' negative cash flow?

It goes without saying, but here it is: Borrowing with interest to own negative-cash-flow assets is a double bad situation. Your situation is basically like owning a fleet of cars. The right thing to do is put them up for sale and hire a CPA to do your taxes this year.

The silver lining is that the negative cash flows and interest payments may have saved you more in taxes than you'll pay in capital gains when you sell. You'll want to go through your tax records to ensure these losses were properly recorded - better yet, let your accountant do that. Yes, this service will cost $100's but it will probably save thousands, especially if you need to do amended returns for previous years.

1) Hire accountant & organize records meticulously
2) Put properties up for sale for a full value price
3) Look through your bookshelf for anything written by Ray Kiosaki in the mid to late 2000's. Place these in the trash or burn them ceremoniously.

Also, I'm a bit concerned about your (or your husband's) desire to sell shares and real estate based on the expectation of a future price decline. That's market timing, an investment strategy that loses money 99% of the time. If he sold in late 2015, he already missed out on more gains than a major correction would have wiped out.

Oops. Lesson learned. Move on. But first, clarify your thinking right now:
1) You have zero -zero- reliable information that could predict an imminent market crash. Nobody does. Definitely not the press or bloggers.
2) You are selling the real estate because it has negative current cash flow and is too speculative. You will redeploy any proceeds by first paying down debt and then investing in appropriate investments for your risk tolerance.

yachi

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #8 on: February 17, 2017, 10:09:42 AM »
I think most posters missed the 45k safety fund.  You said it's earmarked for something this year, so maybe this won't apply to you, but here is my apprach:
I rely on my taxable investment account as my safety fund.  It's a margin account, currently without a margin loan.
If I need something I can't just pay from normal cash flow, I'll withdrawal from the account, and the money withdrawn becomes a margin loan backed by the investments in the account.  I'll then deposit into it until the loan goes away.  It doesn't make much sense to have a 6%+ loan while also having 45K you could throw at it. 

Also, rental properties can be wonderful if they cash flow, but these don't.
You make money on rental properties in three ways:
1. Cash flow above costs
2. Mortgage paydown
3. Property appreciation

I chose my rental house so it would provide cash flow above its costs.  I wouldn't own it otherwise.  I find mortgage paydown too slow and property appreciation too speculative to be worth the headache.


ChpBstrd

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #9 on: February 17, 2017, 11:11:37 AM »
I think most posters missed the 45k safety fund.  You said it's earmarked for something this year, so maybe this won't apply to you, but here is my apprach:
I rely on my taxable investment account as my safety fund.  It's a margin account, currently without a margin loan.
If I need something I can't just pay from normal cash flow, I'll withdrawal from the account, and the money withdrawn becomes a margin loan backed by the investments in the account.  I'll then deposit into it until the loan goes away.  It doesn't make much sense to have a 6%+ loan while also having 45K you could throw at it. 

I noticed it, but considered the bleeding from the real estate wound to probably be more serious in the short run. Probably the 45k is sidelined to guard against a margin call.

There are many other posts on the subject, but I think 2-5k in cash is reasonable. Then have about 10-20k in credit card open credit that will tide you over a few days in an emergency until the lower-interest loan can be lined up from a brokerage, HELOC, bank, or P2P site. Or by selling something.

Your plan is good, although I like adding a few fallback options. In an economic emergency, for example, credit is often withdrawn by some but not all sources.

In the end, one's "safety fund" is the size of one's liquid wealth. Eliminating cash drains reduces the need for safety funds.

mrspendy

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #10 on: February 17, 2017, 12:07:38 PM »

Also, I'm a bit concerned about your (or your husband's) desire to sell shares and real estate based on the expectation of a future price decline. That's market timing, an investment strategy that loses money 99% of the time. If he sold in late 2015, he already missed out on more gains than a major correction would have wiped out.

I agree but isn't holding levered unhedged stocks with a decently high interest rate also market timing? You are making a prediction that a 20 or 30% drawdown and forced margin call  won't happen. You are also making a prediction the market will return higher than your financing rate. nether of those seem like wise bets.

I do to think selling down the stocks to pay off e margin loan is market timing. It's reversing a mistake (holding unhedged stocks on margin with high interest rate) that thankfully didn't cost much (because the market has been more than cooperative the past few years). I say this as someone who uses margin so I'm a hypocrite but I have hedges in place and employ a much lower leverage and my margin debt costs 1.8%.

ChpBstrd

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #11 on: February 17, 2017, 03:00:15 PM »

Also, I'm a bit concerned about your (or your husband's) desire to sell shares and real estate based on the expectation of a future price decline. That's market timing, an investment strategy that loses money 99% of the time. If he sold in late 2015, he already missed out on more gains than a major correction would have wiped out.

I agree but isn't holding levered unhedged stocks with a decently high interest rate also market timing? You are making a prediction that a 20 or 30% drawdown and forced margin call  won't happen. You are also making a prediction the market will return higher than your financing rate. nether of those seem like wise bets.

I do to think selling down the stocks to pay off e margin loan is market timing. It's reversing a mistake (holding unhedged stocks on margin with high interest rate) that thankfully didn't cost much (because the market has been more than cooperative the past few years). I say this as someone who uses margin so I'm a hypocrite but I have hedges in place and employ a much lower leverage and my margin debt costs 1.8%.

Good point. Perhaps the definition of market timing is the expectation that an event will happen soon, and the definition of investing is the expectation that business fundamentals will continue to create value over long periods of time.

More importantly, where do you get 1.8% margin? In a fund?

handsnhearts

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #12 on: February 17, 2017, 11:01:25 PM »

Also, I'm a bit concerned about your (or your husband's) desire to sell shares and real estate based on the expectation of a future price decline. That's market timing, an investment strategy that loses money 99% of the time. If he sold in late 2015, he already missed out on more gains than a major correction would have wiped out.

I agree but isn't holding levered unhedged stocks with a decently high interest rate also market timing? You are making a prediction that a 20 or 30% drawdown and forced margin call  won't happen. You are also making a prediction the market will return higher than your financing rate. nether of those seem like wise bets.

I do to think selling down the stocks to pay off e margin loan is market timing. It's reversing a mistake (holding unhedged stocks on margin with high interest rate) that thankfully didn't cost much (because the market has been more than cooperative the past few years). I say this as someone who uses margin so I'm a hypocrite but I have hedges in place and employ a much lower leverage and my margin debt costs 1.8%.

That is it exactly!  We are already in this situation and it is working out pretty well, thankfully!  It could have gone another direction, and it still could.  I am not the greatest gambler, and that is essentially what we are doing with this margin loan.  We have come out ahead and I am ready to take my winnings and leave the table, despite the fact that I may be walking away from better wins.  I am happy that my room and meals and trip were paid for, and would like to go home with some profit in my pocket. 

I also feel like I would like to be involved in this decision if there is another margin loan.  The 43K is earmarked right now for anticipated medical expenses.  We may not need it all, but we might and then some.  We'll see in the next 1-2 years. 

We do have a CPA, and this interest has helped to offset gains in previous years.  We are waiting for a response from our CPA now. 

The loan went towards down payments, along with long term capital gains from another property that was flipped.  The mortgage still exists, and both properties are having negative cash flow.  This is definitely speculation, purchased at a market high in 2005. 

We are a high income earners and I agree that these are good speculations.  We lived in one of the properties for several years, and we lived in the city for 10+ years.  This is a safe long term investment.  Of course, opportunity cost may need to be looked at. 

We just need to agree if we are going to flow more cash into these properties, and plan appropriately for it. 

I don't want to get involved in other speculations, but we are in this one, and it is winnable. 

Thanks for all the input.  I have learned a lot in the last few days about margin accounts, and cash flow positive rental properties.  The financial education continues...

mrspendy

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Re: Is this the best strategy? Any way to avoid capital gains?
« Reply #13 on: February 17, 2017, 11:27:16 PM »
More importantly, where do you get 1.8% margin? In a fund?

With the gigantic caveat that they show no mercy if your account falls below what they deem to be an acceptable level of equity/ above what they deem to be an acceptable degree of leverage, Interactive Brokers has the best margin rates in the business. But even if it were no cost, margin doesn't make sense for the vast majority of people because it can force one to sell at the bottom.