Since the time I was a small child, my parents preached what seems to be the declaration of their generation: study hard, go to college, get a good >job, pay off your home, and live happily ever after. Having worked as a financial planner I feel that this is a common philosophy from the “depression baby” generation. Now as I look at this plan after being not only a financial planner but also an insurance agent and long time realtor/real estate investor, I can sincerely see how short sighted this theory is especially today. First of all people are living much longer, yet the retirement age has hardly increased. The philosophy I mentioned above also makes no mention of investing (only working hard) and the nest egg that most of the people who believe in this ethic have is the equity in their house – and with a paid-off house this nest egg is relatively illiquid and has most likely never made a return the entire time they’ve owned it.
But it’s not just looking at the facts for me to come to this decision. I also can see this because I’m dealing with it first hand, assisting my 80 year-old mother with her estate planning and investment portfolio. Living by the mantra of her generation, almost 10 years ago when it came time to determine what to do about her living situation, my mother was at a standstill financially. She owned her house outright, was on social security, was fortunate enough to receive a small pension from when she worked full-time, and she still didn’t have enough money to stay in her home comfortably for the rest of her life. And to her and many other seniors, staying in your home was their original dream and primary goal. They didn’t plan to fail, they just failed to plan. In the case of many of these people, like my mother, many senior citizens are “equity rich and cash poor.” So around 2005, Mom was considering these three feasible options:
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Option One: Sell and Downsize
Mom could sell her home and either go into a retirement community, buy a smaller condo, or rent an apartment and pray she didn’t outlive her income.
Pros: In all three options she would obviously be downsizing so there’s little to no maintenance, cheaper utilities, and she would have neighbors (something she wasn’t used to in her 4 bedroom house).
Cons: Most retirement communities in our area are really expensive. If Mom did sell and decided to rent it would not only cost her to sell, but to buy a condo is pretty expensive not to mention you also have to pay the condo fees along with taxes and insurance. And with a condo or even an apartment she rented, Mom could definitely run the risk of outliving her income. But the biggest con to Mom was that she lived in and owned her home since 1964, moving in general would be a big unwanted change.
Option Two: Reverse Mortgage
The second choice was a reverse mortgage. A reverse mortgage is a loan available to homeowners or homebuyers, enabling them to access a portion of the subject home’s equity. The homeowners can draw the mortgage principal in a lump sum, by receiving monthly payments over a specified term or over their (joint) lifetimes, as a revolving line of credit, or some combination thereof.
Pros: Without heirs, this could be a good option because it’s basically income you could use to live or stay in your home.
Cons: The fees and points can be really high. This can also reduce most or wipe out most small estates. Also, many major banks aren’t writing this type of loan anymore because default rates are higher than for regular mortgages.
Option Three: Son to the Rescue
Third, the heir(s), which was me in this case, could purchase the home from Mom and invest the proceeds in a separate LLC.
Pros: You can invest and not only pay her expenses and debt, but also turn a profit by investing the remaining capital.
Cons: As the majority owner, I have to pay taxes on a large portion of what the entity makes after expenses. I’m responsible for how well the LLC performs and the biggest threat would be that if I became disabled how well could I continue to manage the LLC’s portfolio.
With mitigating some risk, we decided upon option three, utilizing an LLC to run a portfolio of property and mortgage notes because we could satisfy several issues at once. Mom could stay in her home, generate income for herself, limit taxes, and leave an estate where there usually wouldn’t be one (or much of one). This last one is key because Mom saw her own mother go into a nursing home for five years after a car accident and then proceeded to witness the nursing home fees wipe out the proceeds of her family’s estate (*note* Nursing home fees can deplete assets and income. Plus today they have a 5-year look back so even if she sold me her house a year before going into a home, they’re still going to charge my Mom like she still owned the asset).
Mom also couldn’t really benefit from her paid off primary very much because she was limited in write-offs and she didn’t really have much earned income. I on the other hand, with too much earned income, could always use the write-offs of another investment property (that in this case was rented to Mom). So, I decided to buy Mom’s house and put a $200K mortgage on this $250K house so Mom wouldn’t exceed the capital gains exemption. We cleaned up some credit card debt of Mom’s and then proceeded to fund our LLC.
Now here’s the cool part, Mom only owns a very small percentage of the LLC and I own the majority, but Mom is the manager and receives a monthly income. This is from three properties, private 1st mortgages, and performing 2nd mortgages. Our LLC’s investments have thrown off enough cash flow to pay the mortgage, taxes, insurance, maintenance, as well as mom’s draw. In fact, our little fund is growing quite nicely and our notes are starting to buy more notes!
Just in Case
One potential issue was if I were to pass away ahead of my mom, how would mom manage the LLC? So, I took out a life insurance policy on myself that was one and half times what Mom’s estate and assets were worth, plus she’d still control all the notes that would continue to generate income. The insurance is also paid for by the profits from the LLC. We also set up a trust for the proceeds of this insurance policy, so as to avoid the $350K estate that would be created from this policy. Now the beneficiary of this trust is my Mom of course and her friend is the trustee. After all, it’s best to control assets and not necessarily own them, as we get older.
As for the estate planning strategies that were accomplished, Mom pretty much has no real estate or taxable assets left to pass on, no significant assets that a nursing home could potentially seize in the future (especially since we did it over 5 years ago now) and Mom can now afford to stay in her house forever without depleting anything. This took a little work but it was a great way to keep Mom in her home, give her nice portfolio of assets, and hold onto my childhood home in the family. Now of course when all this was set up we incorporated these tax saving and estate planning strategies with an accountant and estate planning attorney all on board. So please do keep that in mind if you’re thinking about doing something similar. Everyone’s situation is different, but my point is to get you thinking.
As I quickly am approaching the time I’ll be receiving my senior citizen discounts, I too need to think more about controlling more of my assets without necessarily owning them all.
 Andrew, Douglas R. Missed Fortune 101: A Starter Kit to Becoming a Millionaire. New York: Warner Business, 2005. Print.
Photo: 401(K) 2013