Copyright 2007, The WPI

Before I get into the mind-blowing material for today’s newsletter, I wanted to comment on last week’s newsletter.  Last week’s newsletter was on how the Alternative Minimum Tax (AMT) negatively affects the concept of Equity Harvesting (herein after “EH”).

My point with last week’s newsletter was to illustrate that advisors are not receiving full disclosure from books such as Missed Fortune 101 or sale’s programs revolving around the EH concept.

I received much feedback asking me if I had changed my mind on the concept of EH as a viable planning tool.  That was a surprise to me.  For the record, and as I’ve laid out in great detail in the new education module I created for the Master Mortgage Broker course, EH  is a very powerful wealth-building tool whether you are able to write off the interest or not and whether the client has to pay an AMT or not.

Equity Harvesting

I am not going to re-explain the concept of EH.  For a multi-page summary on the topic, please Email Us “>e-mail here.   In short, EH is a tax-favorable, wealth-building concept where a client removes equity from a personal residence through a refinance and invests the borrowed funds into cash value life insurance. Life insurance is the investment of choice because cash in the policy grows tax-free and can be accessed tax-free in retirement through policy loans.

The topic is usually sold on the assumption that interest on the debt is deductible.  As you read in last week’s newsletter, Home Equity Debt (which includes a refinance with removal of equity) is deductible up to a $100,000 of new debt and limited by the FMV of the home. Having said that, if the borrowed funds go into a cash value life insurance policy where the client funds it with contemplation of borrowing from the policy, the interest is NOT deductible (which is this week’s subject matter).

Title 26 – IRC, Section 246(a)

Question

If a client has a home worth $500,000 and current debt of $200,000, can that client refinance the home and remove $100,000 of equity? YES

Can that same client use the borrowed funds to invest in life insurance?  YES (this is the EH concept).

If a client uses borrowed funds from Home Equity Debt (HED) and invests the money into cash value life insurance where the client contemplates borrowing from the life policy, is the interest on the HED deductible?  NO

The previous paragraph will be like a lightening bolt hitting thousands of insurance agents who have been selling the EH concept and telling clients to write off the interest on the new debt.

Most advisors who pitch EH have read the books or been to the sale’s seminars which tout how powerful this concept is as a sale’s tool (which is true).  Life insurance agents use EH to sell large amounts of life insurance and mortgage brokers use EH to sell mortgages (and a few really bright advisors sell both the life insurance and the mortgages).

If you are one of those advisors, have you heard about Section 264(a)?

If not, why not?  I believe the answer is simple─it is not in the best interest of the firms marketing to advisors to make them aware of this Code Section because it takes some of the sizzle out of the topic and the sale’s pitch to clients.

You say you don’t believe that Section 264(a) prohibits the deduction? You can read the Code Section for yourself

264(a) General rule

No deduction shall be allowed for—

(2) Any amount paid or accrued on indebtedness incurred or continued to purchase or carry a single premium life insurance, endowment, or annuity contract.

(3) Except as provided in subsection (d), any amount paid or accrued on indebtedness incurred or continued to purchase or carry a life insurance, endowment, or annuity contract (other than a single premium contract or a contract treated as a single premium contract) pursuant to a plan of purchase which contemplates the systematic direct or indirect borrowing of part or all of the increases in the cash value of such contract (either from the insurer or otherwise).

What does Section 264(a) mean to those of you selling the EH concept?

It means the people you look to for sale’s support are doing you a disservice and could potentially have set you up to be sued for giving incorrect advice on the interest deduction.

Does Section 264(a) kill the concept of EH?

Absolutely not.  Why not?

1) There are two viable and simple ways to posture a client so the interest on Home Equity Debt (which includes refinanced debt with equity removal) is deductible under 264(a).

For a more detailed discussion on the two ways to posture a client so that the interest is deductible when EH, you should sign up for next week’s FREE webinar.  If you are a CWPP™, CAPP™ or MMB™ or if you are a member of the Asset Protection Society, please e-mail me; and I will forward you specific information on the two ways to posture a client.

2) EH works even if a client does not write off the interest.  I have to admit, I’d never sat down to really run the numbers; but now that I have, I can tell advisors who are interested in EH that it does work even if the interest is not deductible.

For a look at the numbers I put together to demonstrate that EH works as a viable planning tool even if the interest is not deductible, please click here.

Side note:

EH using the personal residence when NOT writing off the interest is viable because residential lending rates are reasonable.  For those of you who have looked at or have used the A/R financing plan to help doctors build wealth and protect their A/R (which also falls under Section 264(a)), it is very difficult to make the numbers work because commercial lending rates on the programs are prohibitively high.

Summary

Equity Harvesting is a terrific topic for the “right” client. The concept can work well even if a client does not write off the interest; and the concept is nearly a no brainer from a financial standpoint if the client can write off the interest.

Unfortunately, many of those who are selling books and sale’s systems to advisors revolving around this concept choose not to give full disclosure, which has put many clients at risk for negative audits and advisors at risk of being sued.

Section 264(a) is not the end of the world when it comes to Equity Harvesting because there are two simple and viable ways to help posture clients so they can write off the interest on the Home Equity Debt.

Roccy DeFrancesco, JD, CWPP™, CAPP™, CMP™