December 24, 2024

Linking Northern and Central NJ, Bronx, Manhattan, Westchester and CT

On a trip to Europe, John bought a painting. He really didn’t know much about art, but he shelled out $25,000 because one of his trusted friends told him it was a good buy. “Hold on to it for 10 years or so, and it will probably triple in value,” the friend said.

It seemed like his friend was right. A few years later, John saw reports of similar paintings selling for $50,000 or $60,000. Out of curiosity, John had a gallery owner assess his painting. The appraiser’s estimate: $65,000. “Imagine that,” said John, “I’ve got $65,000 hanging on my wall. That’s cool!”

As John considered the painting—and his good eye for investment—another thought occurred: Why not buy a few more? After all, he’d made a nice profit when he didn’t know a thing about collecting art. Now that he sort of understood the market, he might do even better. Over the next few years, John dipped into his savings and bought several works from up-and-coming artists.

Pretty soon John’s home had become a small art gallery. Not that he was bragging, but his art collection was valued at over a million dollars! “Wow. Collecting has really goosed my net worth and retirement plans. And the prices just keep going up. Imagine what my collection will be worth 10 years from now!”

But while John had paintings worth one million dollars, he didn’t have a million dollars. And there was a difference.

The next summer, John had an opportunity to buy a small lake cottage for $250,000. It was a great deal. But John didn’t want to crimp his cash flow with a second mortgage.

“Hey,” he thought, “One of my paintings is valued at a little over $250,000. Maybe the seller would consider a trade—I’ll give him my painting for the cottage.”

He was slightly surprised when the cottage owner declined his offer. “I want my settlement in cash. A painting hanging in my living room can’t pay for groceries or my kids’ college tuition.”

John really wanted the cottage, so he decided to sell the painting. He called an art gallery and made arrangements for a sale. The gallery owner agreed that John’s asking price was reasonable and began soliciting some of his patrons.

A month went by. John didn’t receive a single offer. “What’s the story?” he asked the gallery owner. “Why isn’t it selling? Is it overpriced?”

“The price isn’t the problem,” said the gallery owner. “I’ve had several people say the price was fair. It’s just that they weren’t interested in buying right now. You have to remember, buyers of high-end art represent a very small percentage of the populace. Just because something is worth the price doesn’t mean there’s a buyer who will pay it.”

John considered his options. Even if he cut the price, there was no guarantee he would find a buyer. So, if the painting was really worth $250,000, it wouldn’t make sense to sell it at a discount. He told the gallery owner to continue listing the painting but stay firm on the price. John also told the owner of the lake cottage he would have to pass.

Not being able to buy the cottage bothered John, and made him a little disillusioned about art as an investment. He contacted the gallery owner and arranged to auction his entire collection. Unfortunately, the market for art had turned. Even though the long-term forecast for collectors remained bullish, right now was a terrible time to sell. The night before the auction, the gallery owner called to say there simply wasn’t enough interest to justify having it.

John faced a sobering reality: The canvasses on his walls held a million dollars, but he couldn’t get that money when he needed it.

Until It Sells, You Don’t Know What It’s Worth.

This fictitious example may seem a bit over the top, but it’s not much different from the thinking and behavior of many people in regard to their homes or businesses.

Like John’s paintings, these homes and businesses are certainly worth something. There may be recent sales of comparable properties or companies to justify the values given to them. And standard accounting practices would certainly include these assets in a statement of net worth.

These assessments can encourage unrealistic expectations. You may have heard a homeowner say “This place is my greatest

asset. When I retire, I’ll make a killing on the sale. That money will really boost my retirement income.” Small business owners seem particularly susceptible to this thinking. In a 2017 study of small business owners, 18 percent said they had no retirement programs because… “They’re planning on selling their business to fund their retirement.”

Maybe these plans will work. Some people do sell homes or businesses for a tidy profit. But just like John and his paintings, until you find a buyer, the value is trapped in the assets. Illiquidity makes these assets useless in emergencies and unreliable for any plans that require income, like retirement or college funding.

Until the Taxes Are Paid, You Don’t Know the Real Value.

Beside valuing illiquid assets as if they were already sold, individuals are prone to over-estimating the values of assets that have yet to be taxed.

When a participant in a qualified retirement plan funded with pre-tax dollars says, “I have a million dollars in my 401(k),” what’s the true value of that account? Because every withdrawal will be treated as taxable income, the net account value is something less than $1 million. How much less is speculation; no one knows what tax rates will be in the future. Until distributions begin, the real value of the retirement account is uncertain.

The same uncertainty applies to assets whose sales result in capital gains taxes; the tax due will depend on the values and tax rates at liquidation. And both factors will almost certainly fluctuate several times before the liquidation occurs.

To circle back to John and his paintings…

Trompe l’oeil is a French phrase for a painting that creates a visual illusion, “one used to trick the eye into perceiving a painted detail as a three-dimensional object.” The literal interpretation is “deceives the eye.”

A parallel phrase might be trompe le grand livre—a deception of the ledger. Illiquid and untaxed assets in net worth statements or account balances can produce a distorted picture of one’s wealth.

A prudent planning approach would under-value illiquid assets and over-estimate taxes. Which would undoubtedly lead to a prescription of increased saving today, or a lower assessment of how much these assets might be worth in income-generating scenarios.

One of the best uses of newer personal finance software is to calculate a range of possible outcomes based on different assumptions. Working with a financial professional, you may be able to get a clearer vision of how you might effectively integrate these assets in your financial future.

This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.

Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products/services and advisory services offered through PAS, a registered broker/dealer and investment adviser. Financial Representative, The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian.

PAS is a member FINRA, SIPC.

Neither Guardian, PAS, Wealth Advisory Group, their affiliates/subsidiaries, nor their representatives render tax or legal advice. Please consult your own independent CPA/accountant/tax adviser and/or your attorney for advice concerning your particular circumstances.

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Submitted by Elozor Preil

 

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