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  • Leverage, Arbitrage and Double Whammys

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    Introduction
    The concept of leverage and arbitrage is one of those ideas that everyone seems to understand, but few do in detail or well. My goal is to help make these ideas more clear and usable.

    Leverage
    Is the act of adding debt to increase return. This is why real estate tends to return so well, it has a global infrastructure to leverage it – and it is accepted practice to always have debt on real estate. This is not true of any other type of investments. You certainly can leverage a stock portfolio or a life insurance policy, but it is considered a riskier and “exotic” thing to do.

    Real estate example:
    If you have $25,000 and you invest it for a 10% return, you would end up with $27,500 at the end – a good return. But if you invest it in a $100,000 property and take a $75,000 loan your return would be higher. A 10% return on a $100,000 property is $10,000. If you then sold the property for $110,000 and paid off your $75,000 you would have $35,000. That’s a 40% return on your $25,000 of capital – an astronomical return. Leverage (the loan) is how you turned the same 10% return into a 40% return.

    This is common practice in real estate for a couple reasons:
    -Real estate tends to have both growth (the return you are going to get) and income (which is used to service the debt while we wait for the return). The income counteracts one of the negatives of debt service, which is that leverage (and the associated debt service) burns up cash in the short run.
    -Real estate has an active market which means if you need to deleverage (get rid of debt) you can normally find ready buyers to get you out of the market.
    -Real estate is a slower moving market. Unlike stocks where a downturn can happen, wiping out capital, inside of day – a tanking real estate market will still give you a month or more of lead time to sell.
    -Real estate tends to appreciate (grow) faster than the cost of debt (interest on the debt) on real estate. This is for two reasons primary reasons:
    -Especially in recent history, interest rates are incredibly low
    -Because of the other factors mentioned, real estate loans are viewed as “lower risk” (This view may not be correct – but it *is* the common view, for better or worse)

    Characteristics of good leverage scenarios:
    Fixed or steady returns
    Cash flow to service debt
    Ready market to provide liquidity
    Predictably higher returns than the cost of debt

    What people miss is that there are other things that can take on these characteristics. A steady business could take on debt (and if you look at bigger companies, they almost always do) because it has a higher IRR (Internal rate of return) than the cost of the debt. This means that the return on invested cash that a company is providing to shareholders is greater than the interest on the mortgage.

    Other Places to use Leverage
    -A liquidity event where a large tax amount is due. If you hold the money that would go out in taxes and have a relatively stable return a small amount of leverage might mean more wealth in the long run. Rather than giving money to the IRS, you can keep the money – eventually you have to pay the loan off, but you get to keep whatever earnings you had on that money while you held it.

    -A business with consistent cash flows – you can use the cash flow to service debt and use the lump sum of money to invest in something else – new assets, acquisition, expansion, etc. All of which should generate far more cash than you will eventually have to pay back.

    -As asset that is valuable, but not able to be sold (sentimental reasons?) could be leveraged to provide cash to buy producing assets.

    Arbitrage
    For leverage to work you have to have positive arbitrage. Arbitrage goes hand in hand with leverage – but is technically referring to something different. Arbitrage refers specifically to the difference (delta) between what you are buying and selling. In the case of leveraging of an investment you are collecting the delta between what you can and then subsequently sell capital for:
    -You are going to buy capital (by taking take a loan – the interest is your cost to buy it)
    -Then you will resell that capital (invest in something – the return is your sales price).
    As long as you can sell it for more than you can buy it for, you are making money. This is the essence of all investments (leveraged or not).
    The amount of the delta required varies based on the certainty of the returns. If I can take a loan at a fixed 5% and buy a life insurance policy that has an IRR (total return) of 7% (this is the return of premiums against the death benefit, not cash value) then I might accept a low arbitrage (2%) because the cost and return are relatively fixed.
    Conversely if I can take a loan at a fixed rate of 5%, but I invest in a business that has very volatile and unpredictable returns, a 2% arbitrage is likely not enough to make it worth the risk. I would demand a higher return (Maybe 15%?) so that my delta (10%) is worth the risk.
    You also need to consider the rate of leverage. In our real estate example you actually could lose more than you invested – because the loan is for multiple times what you put into the property. In the case of a stock portfolio loan you will never be allowed to leverage more than 70% of the asset value, which means you can repay the entire loan at almost any time – without being on the hook for more.

    Tax Leverage
    We have two ways in which we use the IRS code to accomplish this: one old and one new.
    The new way is the C-Corp versus the S-Corp. We used to use S-Corps to only pay a single tax – it avoided the double tax issue of a C-Corp. Double tax of corporate profits, of course refers to the fact that corporate profits are taxed when earned and then again when you take the cash out, in the form of a dividend, which is taxable to the person.
    Right now, the highest individual rate is 37%. The corporate rate is 21% and the dividend rate is 20%. This means that having an S-Corp or other pass thru pays a net 4% lower tax than the double tax of the C-Corp. But the trick with the C-Corp is the timing – you don’t have to pay the 20% dividend rate up front. Which means that you have use of that money during a time period – and the earnings on that chunk of money might end up being more than 4% of the initial profit, ending you up in a scenario with a greater net worth at the end.

    The old one is the “Double Whammys” is an informal tactic referring to charitable entities in the tax code that can provide us with a form of leverage unique to the tax code.

    When we donate an asset to charity, we get a tax deduction. So if I donate $100,000 asset to charity, I lose $100,000 – but I get a $40,000 refund. Which means the gift of $100,000 only actually cost me $60,000. This is a form leverage. Think of it as cost leverage – rather than increasing my return (like in the case of real estate or investment) I am lowering a cost (my taxes).

    We also use trusts (CRTs, Foundations, PIFs, etc) to create a form of leverage/arbitrage as well. Assume I have an investment that makes me 5%. If I put money into a CRT I lose that money (again, say $100,000). But I get a deduction for it (assume I get $20,000 back in taxes). But I also get to the 5% return on the entire $100,000 I put into the CRT. So, in this case my return is actually 6.25% ($5,000 / $80,000 (my net capital outlay $100k - $20k). I, in effect, leveraged my return from 5% to 6.25%.

    The double whammy assumes that the $100,000 asset was going to generate a taxable sale. Assume I had to sell an asset for $100,000, which had $60,000 of gain. I would pay taxes on the gain, so I would not net $100,000. Assuming $15,000 of taxes, I would get $85,000 of net cash. So I would only earn 5% on the $85,000 which is $4,250. This means that on my $100,000 investment, because of taxes, I LOST return because I am only getting 4.25% (4,250 / $100,000 of capital).
    But if we contribute the asset to the CRT, we don’t pay taxes on the gain – so I earn my 5% on the entire $100,000. But if I get a $20,000 refund, then my net capital is down to $80,000. Which means my return is back up to 6.25%. Using the double whammy, I used charitable leverage to gather a 2% arbitrage on my asset – from 4.25% to 6.25%. 2% increase doesn’t sound like much, that is a 47% increase in return.

    Assets are not single purpose
    “Leverage for deduction”
    If you look at a company/owner that is paying high taxes, there is likely a desire for something that can offset taxes, like a defined benefit pension plan. But a DB plan requires around $200k a year in cash flow to be committed. That might be more than the owner wants to commit.
    But if they have an investment account with a chunk of money, we can “leverage” that into the DB plan. Set up the DB plan, loan that money to the corporation, and use the excess cash to fund the DB plan. At a 40% tax rate you get an immediate, one-time initial return of 40% on that money. It almost doesn’t matter what asset you had to sell to accomplish this - there is nothing that returns that high – which is why tax leverage is almost always a good idea.

    Alternatively, cut down the owner salary, have him/her/they live on the savings and use the increased cash to fund the DB plan. In both these cases you are using and combing assets. People tend to think of assets as having a single purpose. But when you look at the owner and the owner’s business together you can leverage one against the other to create more return.

    So use these strategies when you see:
    Assets with lots of gain, but that are underperforming
    Assets with a large value that are illiquid

    And when the subsequent investment has:
    Fixed or steady returns
    Cash flow to service debt
    Ready market to provide liquidity
    Predictably higher returns than the cost of debt

    Balance Sheet Inflation - Disclaimers
    Leverage is, by definition, a balance sheet activity – you increase the total size of the balance sheet by adding assets and liabilities. It is critical to note that increasing assets and increasing liabilities
    Does not increase wealth!
    The going back to what we said about arbitrage – leverage creates the opportunity for arbitrage. Increasing assets and liabilities has zero effect on equity/net worth. The actual wealth creation doesn’t happen until you earn money on the increased asset base, more than the carrying cost of the debt.
    We have the ability to “create money” and that is a power that needs to be wielded wisely.