Should you own Zombie Apocalypse Insurance?

Financial Planning Dentist

Should you own Zombie Apocalypse Insurance?: Four risk mitigation disciplines to get familiar with

Zombie Insurance exists…yes really, if only as a marketing ploy for insurance shops. But it gives us a great reason to discuss the different types of risks, and the disciplines that exist to mitigate the given risk set. 

Zombie Apocalypse Risk is both an unmitigable risk, there is little if anything you can do to avoid an apocalypse. And it’s also not cost-effective, the replacement of anything lost in the apocalypse is unlikely – the insurer after all is very likely a zombie in this scenario. So it’s an easy “don’t buy it” recommendation. But how about others’ risks? Tax, fire, disability, market, etc. all exist daily, and all have nuanced methods for handling them. 

 Cost-EffectiveNot Cost-Effective
MitigableHomeowners Insurance (Buy it)Annual Downside Puts for Market Protection (likely don’t buy it)
UnmitigableLife Insurance (Buy it sometimes)Zombie Insurance (come on?!?!)

Effective risk mitigation requires understanding both the financial risk at play and the full length of consequences that result from the strategy a person or family chooses. Tax Risk is a great topic to think about. Most investors “Accept” Tax Risk and pay their taxes at the end of each year depending on their income and gains from the year before. You bought the stock, it went up 20% forgo 5% as a cost of doing business and pay your income and gains tax on it. 

Some Investors might “avoid” tax risk by using investment strategies, 401ks, IRA’s, or other legal means of tax avoidance. Further, still, some may limit their tax exposure by using several different investment strategies and holding strategies by spreading out the tax risk over time or using income streams that are taxed in different ways. Further still, some may use tax risk transference through trusts, gifting, and other asset location strategies to manage it.

Tax risk is just one flavor of risk, but almost every conceivable risk can be filtered through the strategies below to make the existence of risk far more tolerable.

Risk Acceptance

There are several risks you “accept” every day regardless of the calculus. The risk of an airplane part striking you at a wedding is really low, so you simply accept that risk and head outside.

The risk of a single down month in the stock market is high, and so is the cost to insure against it. Risk acceptance as a strategy is about balancing the likelihood of that risk happening, the financial impact it would have, and properly pricing the below strategies to handle the risk. Risk acceptance does not reduce any effects however it is still considered a strategy. 

The “acceptance” strategy is a common option when the cost of other risk management options such as avoidance or limitation may outweigh the cost of the risk itself. A company that doesn’t want to spend a lot of money on avoiding risks that do not have a high possibility of occurring will use the risk acceptance strategy.

Traditionally, risk acceptance can be the key to investment upside. The performance of the S&P 500 is a great example. If you simply accept the risk you will have more up years than down years, and the result will be net returns of about 9% year over year. If you used financial products to mitigate the financial consequence of a down year, it could cost you between 8-10% of the return to fully inoculate the risk. Leaving you with little to no return. So there are several times where risk acceptance is the more rewarding outcome. 

Risk Avoidance

The risk management effort is a process to target and control the damages and financial consequences of threatening events, risk avoidance seeks to avoid compromising events entirely. This is equally an activity you likely engage in regularly. You, like me, may not attempt amateur base jumping daily for a myriad of reasons. This simple act of not participating is a risk management strategy. 

When determining how you will approach risk, it’s important to not confuse the strategies of risk avoidance and risk acceptance with a very different concept “risk ignorance.” Risk ignorance stems from two very different but connected problems. The first is a knowledge gap, this is a problem with risk-takers’ understanding of a market, investment, process, etc. where they simply don’t have the skill set required to uncover and handicap all of the potential risks. When I don’t work on the inner workings of my vehicle it’s an acknowledgment of that knowledge gap.

The second gap, and likely harder to uncover, is a competency gap. This is the knowledge that the risk exists, but poor reconciliation of an investor or person’s skill to overcome the difficulties. Think about new building construction. The builder might know that the risk of financing can fall through, so they have crossed the knowledge gap, but if a project still falls through because of a lack of coordination, effort, or something else entirely it fell victim to mispricing of the competency gap. 

Risk avoidance is one of the least understood methods used by investors and as a result drives two negative behaviors. Rationalization or compartmentalization. In this first, investors fall in love with an idea, stated returns, or a story and begin down a path they believe is “risk avoidance” but is actually rationalizing them into risk ignorance. The second “compartmentalization” is a form of risk avoidance but for the wrong reasons. An investor may not understand a product or service and as a result, shut down a whole category of strategies. A great example is in derivatives, many people attribute the financial crises to derivative products and thus write off the whole group regardless of other tactics that might support their goals. 

A lack of sophistication and understanding of risk is a common source of aversion, failure to change advisors, or even seek investment advice in the first place. 

Risk Limitation

Risk limitation is the most common strategy. It is actually the core of the diversification concept and controlled usually through your investment policies. Limiting the total damage a single risk might have on a portfolio. A fantastic example would be a neighborhood a builder might see new potential in. While a single project might fit the companies needs for return and the risk might be reasonable for the reward, owning an entire investment portfolio in that neighborhood might represent compounding risks.

Within the idea of risk limitation, it is important to remember that some risks have a linear impact on the negative consequences of a portfolio. Let’s use the above neighborhood builder as an example. If there is a 1% chance that a fire wipes out a city block that you have 3 buildings on, there is then a 1% chance that the entire portfolio will be impaired as the result of a single catastrophe. By limiting the total exposure to say 1 building per city block that builder has all but guaranteed that the whole portfolio cannot be impaired simultaneously.

Neighborhood Fire RiskIRR

If through policy or practices you limit exposures along the geographic, market, and stylistic categories that exist in investments to mitigate some of your exposure to an investment. Sometimes this comes at the cost of total return, but most investors find that acceptable returns with lower catastrophic risk exposure are with the trade-off. In the above example, building across the 3 neighborhoods lowers the portfolio return from 10% (had you only built in the most lucrative) to 9% but lowers the fire risk wiping out the portfolio from 1:100 to 1:100,000,000.

Risk Transference

Risk transference is done through changes in people, policy, the process to a willing or unwilling third party. Usually done in the financial world through insurance. But in some companies, it looks like outsourcing certain operations such as investment selection, customer service, payroll services, etc. This can be beneficial for an investor if a transferred risk is not a core competency of that investor. It can also be used so a person might focus their energy and time on more lucrative endeavors. A real estate agent might find that they can routinely guide investors and families through the process for real estate prospecting, but might inherit a Honus Wagner rookie card and find that the marketplace is different enough that the pricing expertise cannot possibly translate. 

Risk transference is most commonly in the form of insurance. Buying a year of home insurance for the replacement of your house is less costly than keeping the replacement value in cash for the year. So because investors have a risk they chose not to accept (or are required by law or lender) they place the risk with the insurer, and this frees up the capital to find more lucrative returns elsewhere. And in many cases, a person doesn’t have the replacement cost on hand. 

Risk transference requires balancing the financial risk at stake, and the cost of the transfer (i.e. the price of insurance). This is often done by amateur risk managers by simply “Buying” the insurance policy they are sold. This process usually doesn’t bother handicapping the other options available, nor does that effectively manage the changes to the risk and cost after the policy is signed. 

Two easy way to see this failure in risk management is in insurance. A homeowners policy can lose effectiveness over time as the underlying assets and their replacement value change. This can be as simple as the rising costs of rebuilding a home. Traditionally, a homeowner’s policy declines in its efficiency as a risk mitigator with every dollar the house appreciates.

Inversely, a life insurance policy becomes overpriced with every day that goes by. If a worker is trying to inoculate against the loss of 10 years of $100k income it might be a $1 million policy on day one, and let’s say carries a premium of $1000. Giving it a risk efficiency ratio of 1:1000. But at the end of year 1 if the policy stays the same the worker only needs to inoculate 9 years of risk of no income. The worker is still paying for $1 million in coverage but only needs $900,000. In this case, they are still paying for the insurance that covered year 1, but that income was realized. Their risk has diminished, but the price they are paying has stayed the same. 

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boulder investment management, tax planning, k-1, real estate
Kevin Taylor

How to read a K-1?

Welcome to the exciting world of K-1 forms! Okay, let’s be honest, K-1 forms may not be the most thrilling topic, but understanding them can save you some serious tax headaches. In this blog post, we’ll break down everything you need to know to read your K-1 form like a pro. Whether you’re a seasoned investor or a first-time partner, we’ve got you covered. So, put on your reading glasses, and let’s get started! Reading a K-1 form can be complicated, but here are some steps to help you understand the information provided: Understand the entity type: The K-1 form will indicate whether the entity is a partnership, S-corporation, or LLC. Each entity type has different rules for tax reporting, so it’s important to know what type of entity you are dealing with. Identify your personal information: The K-1 form will include your personal information, such as your name, address, and identification numbers. Make sure this information is correct. Review the income section: The K-1 form will report your share of the entity’s income. Look for the “Income” section of the form and review the amounts in each box. These amounts will need to be reported on your tax return. Review the deductions section: The K-1 form will report your share of the entity’s deductions. Look for the “Deductions” section of the form and review the amounts in each box. These amounts will also need to be reported on your tax return. Review the credits section: The K-1 form may report any credits you are entitled to, such as foreign tax credits or energy credits. Look for the “Credits” section of the form and review the amounts in each box. These amounts will be used to reduce your tax liability. Look for any other information: The K-1 form may include other information, such as capital account balances, distributions, or other items. Make sure you review all sections of the form to ensure you are reporting all necessary information on your tax return. Seek professional help if necessary: If you are unsure about how to read or use the information on the K-1 form, seek help from a tax professional. They can help you understand the information and ensure you are reporting everything correctly on your tax return. In summary, to read a K-1 form, you should identify the entity type, review your personal information, and review the income, deductions, and credits sections. Look for any other important information and seek professional help if necessary.

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1031 Exchange Alternative
Peter Locke

An Alternative or Back-up for the 1031 Exchange

The Delaware Statutory Trust (DST) is a trust that is structured as a pass-through entity and can hold passive Real Estate. It can function as a 1031 Exchange Alternative. All of the debt is nonrecourse and the income, net of expenses, is distributed to the investor.  What are the advantages?   1031 Exchange compatibility Passive investment with no management responsibility Estate planning tool – pass DST on to your heirs, tax deferred Who benefits from them? Investors no longer wanting to manage real estate Retiring real estate investors Backup/ alternative option for 1031 exchanges Investors looking to diversify into properties typically unavailable to them A Delaware Statutory Trust is a legal entity used to arrange for the co-ownership of property. DST’s are a great vehicle when constructing real estate offerings as co-owners are entitled to profits earned from the property, like rent, without the management responsibilities. For many it can be a 1031 Exchange Alternative. So why do people use DST’s? Let’s say you have an investment property that you’ve held for a long time and because you’ve depreciated the property for a number of years your basis is very low and the property has grown considerably simultaneously. Well you’d have a large capital gain on your hands if you sell it. You could do a 1031 exchange (1031 Exchange)  but that means getting another investment property, following a number of rules, and doing it in a short amount of time. Although very doable, looking at a more passive strategy may benefit you.  If you want your capital to be invested from your home without losing a majority of it to capital gain taxes and are accustomed to cash flow from your rentals then deferring your gains and reinvesting your capital into like-kids real estate can be done through a 1031 exchange. You may also decide to hire a third party management company to take the day-to-day responsibilities away as well which although cuts into your income, saves you from the downside of being a landlord. If you’re the one being a landlord, want to expand your investment portfolio, and want cash flow then the DST is the best of both worlds alternative where you don’t have to choose between paying taxes now or being a landlord. With the DST, you get passive income, capital grows free of capital gains tax, you avoid being a landlord, and you get diversification. Let’s walk through how you’d do this. First, you’d make use of the 1031 exchange by swapping the proceeds from your real estate sale of your investment property for interest in a DST. By doing this, you become co-owners/investors in a diversified portfolio of properties and pass the management responsibilities on to the sponsor who acts as the trustee for the DST. This satisfies your IRS responsibility of finding a “like kind” property and enabling you to defer capital gains.  DSTs provide you limited liability protection, regular (at least quarterly but often monthly) cash flow income, high-quality assets, and 1031-compatibility. Since with any trust there is a trustee (takes legal title for purposes of management) and a beneficiary (takes equitable title). DSTs are pass through entities, so as a beneficiary, this structure entitles you to a fractional share of income, appreciation, and tax benefits from the properties.  This structure is key for 1031 eligibility as the acquiring property must be “like kind” to your sold real estate and even though you don’t hold legal title, for tax purposes, you’re treated as owning that property. Since the DST is a separate legal entity, beneficiaries have limited liability and therefore any debts incurred by the DST won’t put the investors personal assets in harm’s way. It also protects personal assets from the liabilities of other owners and the DST itself.  DSTs are the only statutory trusts to be explicitly recognized by the IRS as legal entities that can facilitate a 1031 exchange.  What are the risks of DST’s? Macroeconomic risks Economic downturn can mean lower returns and income Liquidity risks Most DST’s have an investment period of 7 to 15 years Although you get cash distributions your principal is off limits during this time Management risks A bad sponsor may pick overvalued properties when compared to peers  A low yield while the investor is still collecting fees for management and organizing the investment Do your due diligence to check the sponsors history, background, and how similar deals have done in the past to see if projected return rates were met and problems due to bad management didn’t occur High vacancy rates and unforeseen costs hurt cash flow Financing Risk DSTs are managed differently but if the trustee uses high loan to value offerings there is a higher risk of foreclosure Fully amortized loans need to be paid by the end of the loan agreement so that could affect your cash distributions Eligibility The DST needs to be structured to facilitate your 1031 Exchange Alternative In conclusion, DST’s when done properly, are a great way of getting away from being a landlord or paying a large sum of capital gains taxes while simultaneously giving you the passive income, limited liability, 1031 compatibility, and high quality asset diversification. However, just because it does all these things doesn’t make it a great investment. They require proper due diligence to review the sponsors reports, loan documents, appraisals, underwriting data, etc prior to investing.

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Account Types: SIMPLE IRA

Simple without being simplistic Annual Contribution Max: $13,500 Why we like SIMPLE IRA’s: They are easy to set up and require little to no fiduciary oversight Employee’s can direct the assets with total control Low contribution limits {Total elective contribution = $13,500 (2020)} Works well at a startup, or low revenue business The commitment is predetermined (Employer contracts with employee to have salary reduction) Earnings grow tax deferred on all contributions Not required to meet all of the nondiscrimination rules applicable to qualified plans and don’t have the burden of annual filing requirements Employer deposits match on regular basis tax deferred without payroll tax Employee elective deferrals are not subject to income tax but are subject to payroll tax Why we don’t like SIMPLE IRA’s: They have low contribution limits They match a small percent of the income Employer cannot have more than 100 employees Employees who earned $5,000 during any two preceding years OR are expected to earn $5,000 during the current calendar year qualify 100% vesting in all contributions and earnings Employer is required to make either matching contributions to those employees who make elective deferrals or, alternatively, to make non-elective contributions to all eligible employees Simple IRA’s are available for employees who want to be very hands off but still provide a benefit to employees.  The employer has two options, match contributions or make non-elective contributions to employees. If matching is selected, the employer is generally required to match the employee’s deferral contributions on a dollar-for-dollar matching basis up to three percent of the compensation of the employee (without regard to covered compensation limit) for the entire calendar year.  Alternatively, instead of matching the employees contributions, the employer can make non-elective contributions of at least 2% of each eligible employee’s compensation (up to the covered compensation limit of $280,000 for 2019) . The employee can then choose to make additional contributions as well. If the employer makes the contribution, it must make non-elective contributions whether or not the employee chooses to make salary reduction contributions. If the employer chooses a 2% contribution, it must notify the employees within a reasonable period before the 60-day election period for the calendar year. These plans are generally simple to set up, but the larger the company grows and the more the company wants to raise the contribution amounts these plans become less effective. 

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