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Articles in this Month's Issue
Living Trusts 101
A trust, like a corporation, is an entity that exists only on paper but is legally capable of owning property. However, a live person called the trustee must be in charge of the property. Further, you can actually be the trustee of your own living trust, keeping full control over all property legally owned by the trust.
Note: Property held in trust that is actually "owned" by the trustees of the trust, subject to the rights of the beneficiaries. The trust itself doesn't actually own anything.
There are many kinds of trusts. A living trust (also called an inter vivos trust) is simply a trust you create while you're alive, rather than one that is created upon your death under the terms of your will.
All living trusts are designed to avoid probate. Some also help you save on estate taxes, while others let you set up long-term property management.
Do I need a living trust?
Property you transfer into a living trust before your death doesn't go through probate. The successor trustee, the person you appointed to handle the trust after your death, simply transfers ownership to the beneficiaries you named in the trust.
In many cases, the whole process takes only a few weeks and there are no attorney or court fees to pay. When the property has all been transferred to the beneficiaries, the living trust ceases to exist.
Is it expensive to create a living trust?
The cost of creating a living trust depends on what you want to achieve. The more complicated a living trust is, the more expensive it will be. Also important to note is that while the fees associated with creating a living will are paid upfront a living trust actually saves you money and time by avoiding probate court.
Is a trust document ever made public, like a will?
A will becomes a matter of public record when it is submitted to a probate court, as do all the other documents associated with probate - inventories of the deceased person's assets and debts, for example. The terms of a living trust, however, need not be made public.
Does a trust protect property from creditors?
Holding assets in a revocable trust does not shelter those assets from creditors. A creditor who wins a lawsuit against you can go after the trust property just as if you still owned it in your own name.
After your death, however, property in a living trust can be quickly and quietly distributed to the beneficiaries (unlike property that must go through probate). That complicates matters for creditors; by the time they find out about your death, your property may already be dispersed, and the creditors have no way of knowing exactly what you owned (except for real estate, which is always a matter of public record). It may not be worth the creditor's time and effort to try to track down the property and demand that the new owners use it to pay your debts.
On the other hand, probate can offer a kind of protection from creditors. During probate, known creditors must be notified of the death and given a chance to file claims. If they miss the deadline to file, they're out of luck forever.
Do I need a trust if I'm young and healthy?
Probably not. At this stage in your life, your main estate planning goals are probably making sure that in the unlikely event of your premature death, your property is distributed how you want it to be and, if you have young children, that they are cared for. You don't need a trust to accomplish those ends; writing a will, and perhaps buying some life insurance is sufficient.
Can a living trust save taxes?
A simple probate-avoidance living trust has no effect on either income or estate taxes. More complicated living trusts, however, can greatly reduce your federal estate tax bill if you expect your estate to owe estate tax at your death.
If you're wondering whether you need a living trust give us a call and we'll help you figure out the answer.
Banks Have New Target for Fees: Debit Cards
A number of major financial institutions, including Wells Fargo and JP Morgan Chase, are testing or implementing new programs that will levy monthly fees on consumers who use their debit cards.
The banks are trying to recoup revenues lost when the Dodd-Frank Wall Street Reform and Consumer Protection Act took effect in 2010. The new regulation capped overdraft fees and charges banks could assess to credit card customers.
The new fees are assessed when consumers use their debit cards for purchases. They range from $3 to $5 per month, depending on the bank.
- Wells Fargo will begin testing its $3 monthly charge in October for customers in five states: Georgia, Nevada, New Mexico, Oregon, and Washington. Wells will also eliminate its debit card rewards program effective in October.
- Regions Bank will institute an across-the-board debit fee of $4 per month on certain accounts beginning in October.
- Earlier this summer, SunTrust started levying a whopping $5 per month fee to its Everyday Checking account holders.
Consumers Beware
Many industry experts expect more banks to launch fees on debit cards in the coming years. Pay attention to what your financial institution sends you in the mail -- both separately and with your statements. If you have questions, call your bank for an explanation.
If your bank has already sent you a communication signaling that changes are on the way, you do have one very valuable option: shop around. While many of larger banks may be tempted to charge a fee for debit card usage, many smaller banks and credit unions probably won't follow suit. You can always move your account to another institution that still offers free services. However, if you have multiple accounts with one institution or don't have any other banks near you, this may not be the most practical or convenient option.
Also, be sure to review your bank's new terms carefully. You may satisfy certain requirements to keep your services free or you may be able to switch to a different type of account to avoid any charges.
Because of the possibility of human or mechanical error by McGraw-Hill Financial Communications or its sources, neither McGraw-Hill Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall McGraw-Hill Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.
© 2011 McGraw-Hill Financial Communications. All rights reserved.
September 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Jim Oliver, a local member of FPA.
Hobby or Business? Why It Matters
Millions of Americans have hobbies such as sewing, woodworking, fishing, gardening, stamp and coin collecting, but when that hobby starts to turn a profit, it might just be considered a business by the IRS.
Definition of a Hobby vs a Business
The IRS defines a hobby as an activity that is not pursued for profit. A business, on the other hand, is an activity that is carried out with the reasonable expectation of earning a profit.
The tax considerations are different for each activity so it's important for taxpayers to determine whether an activity is engaged in for profit as a business or is just a hobby for personal enjoyment.
Of course, you must report and pay tax on income from almost all sources, including hobbies. But when it comes to deductions such as expenses and losses, the two activities differ in their tax implications.
Is Your Hobby Actually a Business?
If you're not sure whether you're running a business or simply enjoying a hobby, here are some of the factors you should consider: - Does the time and effort put into the activity indicate an intention to make a profit?
- Do you depend on income from the activity?
- If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
- Have you changed methods of operation to improve profitability?
- Do you have the knowledge needed to carry on the activity as a successful business?
- Have you made a profit in similar activities in the past?
- Does the activity make a profit in some years?
- Do you expect to make a profit in the future from the appreciation of assets used in the activity?
An activity is presumed to be for profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training, or racing horses).
The IRS says that it looks at all facts when determining whether a hobby is for pleasure or business, but the profit test is the primary one. If the activity earned income in three out of the last five years, it is for profit. If the activity does not meet the profit test, the IRS will take an individualized look at the facts of your activity using the list of questions above to determine whether it's a business or a hobby. (It should be noted that this list is not all-inclusive.)
Business Activity: If the activity is determined to be a business, you can deduct ordinary and necessary expenses for the operation of the business on a Schedule C or C-EZ on your Form 1040 without considerations for percentage limitations. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is appropriate for your business.
Hobby: If an activity is a hobby, not for profit, losses from that activity may not be used to offset other income. You can only deduct expenses up to the amount of income earned from the hobby. These expenses, with other miscellaneous expenses, are itemized on Schedule A and must also meet the 2 percent limitation of your adjusted gross income in order to be deducted.
What Are Allowable Hobby Deductions?
If your activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity.
Note: Internal Revenue Code Section 183 (Activities Not Engaged in for Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the "hobby loss rule."
Deductions for hobby activities are claimed as itemized deductions on Schedule A, Form 1040. These deductions must be taken in the following order and only to the extent stated in each of three categories: - Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
- Deductions that don't result in an adjustment to the basis of property, such as advertising, insurance premiums, and wages, may be taken next, to the extent gross income for the activity is more than the deductions from the first category.
- Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent gross income for the activity is more than the deductions taken in the first two categories.
If your hobby is regularly generating income, it could make tax sense for you to consider it a business because you might be able to lower your taxes and take certain deductions.
Give us a call if you're not sure whether your hobby is actually a business and we'll help you figure it out.
ETFs for the Active Trader
For the active individual investor, exchange-traded funds (ETFs) are multifaceted tools that offer opportunities to execute sophisticated investment strategies, such as hedging through options, short-selling, and temporarily equitizing a cash position. 1
What Is an ETF?
An ETF is similar to a mutual fund in that it offers investors the opportunity to own shares in a broad portfolio of securities. But unlike mutual funds, ETFs are traded throughout the day on exchanges such as the New York Stock Exchange.
Generally, ETFs are managed to mirror the performance of a particular index, such as the S&P 500 or the Dow Jones Industrial Average. In many cases, an ETF manager may choose a selection of representative securities rather than the entire spectrum of securities in the model index. Investors can find ETFs that track not only the broader U.S. market, but also specific sectors, geographic regions, and investment styles as well.
Shifting Focus
For investors who prefer active trading to buy and hold, ETFs may be an appropriate alternative to individual securities because they offer targeted yet diversified exposure. Sector rotators, for example, can find ETFs in financial services, technology, utilities, and consumer staples. Investors shifting focus among management style and market capitalization will find offerings in growth, value, small-cap, mid-cap, and large-cap stocks. Tactical asset allocators can choose among ETFs focusing in different asset classes, including equity, fixed income, and real estate.
Hedging With Options
Option contracts on ETFs offer investors a variety of opportunities to potentially enhance portfolio returns. A call option gives the purchaser the right to buy ETF shares at a stated price -- known as the exercise or strike price -- at any time before the option's expiration date. By contrast, a put option gives the purchaser the right to sell shares of an ETF at the strike price. In each case, the option seller has an obligation to either sell (in the case of a call) or buy (in the case of a put) shares of the ETF.
Option investors may experience a range of potential outcomes, depending on how they expect the price of the ETF to move. By combining an option contract with an existing position in the underlying ETF, an investor can help hedge a portfolio against loss while maximizing return potential. Following are some examples.
Covered Call Writing: With this strategy, the investor owns shares of an ETF and wants to hold on to them, but also wants to use them to generate some immediate income. She sells a call on the ETF for which she receives cash (or a "premium"). In return, she promises to sell her shares if the strike price is reached on or before the expiration date. Her belief, however, is that the price will remain unchanged during the time frame. If this is true, the call will expire unexercised and the investor will walk away with the premium. A variant of this strategy is to write a slightly "out-of-the-money" call. This is one in which the strike price is only slightly higher than the current price. An investor selling this type of call is sacrificing future upside potential in return for current income.
Bull Call Spread: In this case, an investor expects an increase in the price of ETF shares he is holding and wants to try to generate extra return while limiting risk. This investor would purchase a call at a stated price, paying the premium, while selling another call option at a higher strike price, receiving a smaller premium amount. If the price of the ETF shares doesn't reach the lower strike price on the exercise date, the investor's loss is limited to the difference between the two premiums. If his expectations come to fruition, then he can purchase the additional shares when the price rises and sell them when the price rises higher, generating additional return.
Bear Put Spread: On the other hand, if the investor expects the price of his existing ETF holding to decline, a bear put holding can help protect the value of the portfolio while reducing the cost of hedging. Here, the investor purchases a put option and then sells another put with a lower exercise price. As with the bull call spread, the maximum loss on the option position is the difference in the premiums paid, if the ETF price does not fall as expected. The maximum potential gain is the difference in the strike prices. Investors may use bear put spreads to temporarily hedge against a modest price decline; however, keep in mind that if the ETF price falls below the lower exercise price, the gain on the option position will not fully offset the loss on the underlying share price.
Note that many niche ETFs may not have options linked to them, or in cases where they do, the options may be thinly traded. Investors will want to carefully consider whether ETF option-trading tactics are right for their needs.
Other ETF Strategies
Following are some other investment strategies active traders may employ to make the most of ETFs.
Short-selling and margin trading: Both professionals and individual investors use ETFs to help take advantage of short-term changes in the overall markets. For example, if an investor expects that a particular sector of the stock market will dip due to increasing interest rates, he or she may short-sell ETF shares that represent that market. Selling short is when an investor borrows shares to sell, then buys them back later at a lower price, resulting in a profit. In addition, unlike traditional mutual funds, investors who expect ETF shares to experience an imminent rise can purchase ETF shares on margin.
Precious metals, 2 commodities, 3 and currency 4: Investors can gain exposure to commodity sector stocks, such as materials and energy companies with ETFs focused on these specific areas. Today, there are even ETFs that track the prices of gold, silver and commodities such as oil (rather than company stocks), as well as currencies.
Equitize a cash position: Individual investors also use ETFs as a place to park cash while they make longer-term decisions. ETFs track all kinds of indexes, from low-risk government bonds to sector stocks, so investors looking for a temporary holding place for cash should be able to find one that suits all levels of risk and return requirements.
Capture losses for tax purposes: Another common strategy for ETFs is that they may allow investors to capture losses to help defray income tax obligations without running afoul of IRS rules. (The IRS wash rule states that investors can't cash out of a holding and then buy back in within 30 days.) Investors who want to cash out mutual fund shares for a loss for write-off purposes may do so, while maintaining a similar position in the market by simultaneously investing in a comparable ETF. (The rules governing wash sales are complicated, so before employing this strategy, investors should consult a tax professional.)
Considerations
Investors exploring some of these strategies (particularly those involving short-selling) will want to consider the liquidity of the underlying securities in the portfolio, as well as trading volumes on the ETF. In addition, although ETFs are marketed as a cost-effective alternative to mutual funds, active traders must pay commissions on each of their transactions. Frequent trades, therefore, may negate the overall cost advantage of ETFs over traditional funds. Despite this risk, however, ETFs provide a multipurpose tool for an active trader's toolbox.
Points to Remember
- For the active individual investor, exchange-traded funds (ETFs) are multifaceted tools that offer opportunities to execute sophisticated investment strategies.
- For investors who prefer active trading to buy and hold, ETFs may be an appropriate alternative to individual securities because they offer targeted yet diversified exposure.
- Investors may consider trading options on ETFs to generate immediate income and try to take advantage of anticipated swings in market prices.
- Other active trader strategies with ETFs include short-selling and margin trading; investing in precious metals and commodities; equitizing a cash position; and facilitating the capture of tax losses.
- Investors may want to consult a financial or tax professional before employing sophisticated strategies with ETFs.
Source/Disclaimer:
1"Short selling" is a strategy that involves selling something that you do not already own. Short selling is extremely risky. Be cautious of claims of large profits from short selling. Short selling requires knowledge of securities markets; requires knowledge of a firm's operations; and may result in your paying larger commissions. Short selling on margin may result in losses beyond your initial investment.
2Investing in the precious metals sector involves special risks, including those related to fluctuations in the price of precious metals and increased susceptibility to adverse economic and regulatory developments affecting the sector. It may also be subject to the risks of currency fluctuation and political uncertainty associated with foreign investing.
3Exposure to the commodities market may subject investors to greater volatility as commodity-linked investments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity.
4Changes in foreign currency exchange rates will affect the value of currency investments. Foreign investments may entail greater risks than domestic investments due to currency exchange rates; political, diplomatic, or economic conditions; and regulatory requirements in other countries. Financial reporting standards in foreign countries typically are not as strict as in the United States, and there may be less public information available about foreign companies. These risks can increase the potential for losses.
Because of the possibility of human or mechanical error by McGraw-Hill Financial Communications or its sources, neither McGraw-Hill Financial Communications nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall McGraw-Hill Financial Communications be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.© 2011 McGraw-Hill Financial Communications. All rights reserved.
September 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Jim Oliver, a local member of FPA.
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