We had a client come in recently whose estate was the exact opposite of liquid. It was very valuable — but it wasn’t in cash. His estate’s value came from his real estate empire. It was extensive, and he wanted to keep it in his family, but he didn’t know how. He didn’t have cash on hand to simply buy a bunch of life insurance policies. All he had was property. He thought his hands were tied when really, he couldn’t have been more wrong.
We worked with our client to protect his real estate empire while also keeping him from having to liquidate anything. We used a common but lesser-known tactic that we find works best with clients with estates that aren’t liquid. It’s called premium financing.
The Paradox of Wealth Transfer
We’ve covered the transfer of wealth before in previous blogs, so I won’t reiterate how important it is for reducing estate taxes. Instead, we need to discuss the obvious problem. How can you transfer the value of something out of your estate without selling it? For example, say I have a $7 million ranch in Texas. I have $7 million in property that I don’t want to sell. The whole reason I’m trying to reduce my estate is so my heirs won’t have to sell it when estate tax comes due, so I don’t have the money on hand needed to finance the premium of a $7 million policy.
This is where premium financing comes in. Premium financing is a common tactic among our higher net worth clients who want to use their money to build wealth, while at the same time, keep assets in their family and protect their heirs from high property taxes. By using leverage, these clients can create a pool of funding with no immediate out-of-pocket costs, while at the same time reduce their overall estate tax burden.
How Premium Financing Works
Premium financing works by using financing to pay the premium of an insurance policy, obviously. You use collateral you have to get financing from a company, and then that financing is used to cover a premium of a policy that your heirs would then use to pay off the loan you took out.
The bank lends the money to the irrevocable life insurance trust that has been established and the trust buys the policy. The loan may be personally guaranteed by the individual who pledges collateral of the life insurance policy plus investment assets for the life of the loan.
The collateral amount is the cash surrender value of the policy plus the difference between the total financed premiums and the cash surrender value reviewed annually. In the event the collateral falls below the minimum requirement, the borrower must provide more collateral.
Should the insured die prior to the repayment of the loan, the outstanding loan balance is repaid from the policy proceeds. The loan interest is generally paid by the borrower on an annual basis. In some cases, the loan interest is accrued and the loan principal and interest are repaid from the death benefit. The lender establishes the loan rate using LIBOR or the Prime Rate (adjusted annually) and a spread (the credit margin) of usually 100-300 basis points. The policy can be written on an individual basis or a last-to-die policy can be used depending on the circumstances.
Because premium financing uses leverage and your good credit history, the cost of funds and associated interest payments are typically much less than the cost of paying for a similar premium out of pocket. This allows those who qualify to purchase large amounts of insurance than they may otherwise feel comfortable purchasing given their current budget.
When you pass away, any outstanding loans or expenses you have are used to reduce your estate. So, if you have a $7 million mortgage on a $7 million property, your estate breaks even. Then, the trust pays out a massive insurance policy benefit that allows your heirs to pay off the loan and own the property outright. All of this happens outside of your estate, meaning that you eliminate the high cost of paying the premium outright and can even make money on the financing you take out.
Now, this isn’t right for everyone, and there are a few concerns that you’ll have to consider before taking the premium financing route. But for the most part, it can be a good option for clients who don’t have a lot of liquid assets but still need to create an estate plan because they have significant assets.
The Risks of Premium Financing
There are some risks to premium financing to consider. First and foremost is that the financing may cost more than the policy will earn. For example, if you’re a high-risk insured, that policy is going to cost a lot more upfront, which might mean that the margin between how much the financing will cost you and how much the policy returns will be slim. That could put you in a position in which financing the policy won’t make sense. You should only do this if you can get a policy that will return more than financing will cost you. In all cases, however, you need to be vigilant so that you manage your premium financing strategy closely.
Next, remember you’re dealing with collateral. If you fail to pay the premium, or if your heirs exercise Crummey powers and take money out of the trust, you could be in a situation in which the financing bill can’t be paid and could be in jeopardy of going into default. That means you should only use this tactic if your heirs understand your estate plan as much as you do.
Premium financing is a tactic we use when we have a high net worth client who doesn’t have a liquid estate. It can remove those high-value items from the estate while allowing the client to fund a policy that will allow heirs to take control of the asset when they’re gone. For more information on using premium financing as a tactic in protecting your estate, contact a Howard Kaye representative today at 800-DIE-RICH.
