Relying on the Rental Real Estate QBI Safe Harbor

In response to a recent question we wrote this article to clarify some elements relevant to many of our clients who have rental real estate in their investment and business portfolios.

2017’s Tax Cuts and Jobs Act amended the Internal Revenue Code in many ways, including a provision for a “qualified business income” (QBI) deduction.  This article discusses the availability of this deduction.

Applying this deduction to the case of taxpayers with personally-owned rental property was challenging and the IRS created a “safe harbor” allowing taxpayers to have a tool upon which they can rely in making claim to this deduction.  The safe harbor applies to “rental real estate enterprises” which are discussed below.  In order to rely on it, the response to all of the following questions must be “yes.”

  • Is the property held in a “rental real estate enterprise?”
    • Is the property “held to generate rental or lease income?”
    • Is the property an “interest in a single property or interests in multiple properties?”
    • Does the taxpayer personally own or own the property(ies) in question through a disregarded entity (Example:  A single member LLC)?
  • Does the taxpayer keep separate accounting books and records that reflect income and expenses for each rental real estate enterprise? Note that we assist clients with these requirements.
  • 250 Hours:  For rental real estate enterprises that have been in existence less than four years, did the taxpayer spend 250 or more hours performing rental services in the year of the deduction?  Note that an IRS auditor will request records of this time spent in the event of an audit.  For other properties (beyond the four years), was 250 hours documented in at least three of the past five years?
  • Does the taxpayer maintain contemporaneous (not created after the fact) records, including time reports, logs, or similar documents, regarding the following:  Hours of all services performed; description of all services performed; dates on which such services were performed; and who performed the services?  Note that we recommend our clients use a mobile app to document these requirements.
  • Is the taxpayer willing to attach a statement to the taxpayer’s return filed for the tax year in question that the taxpayer is relying on the safe harbor?

If the responses to the preceding questions are all “yes,” an interest in a rental or rentals can be treated as a single trade or business for purposes of this deduction.  We want to note that even if the safe harbor does not apply because one of the questions above has a “no” response, the QBI deduction may still be available through the 199A provisions themselves.  Using this approach may increase audit risk and involve additional documentation burdens.  The preceding link provides a wealth of information on QBI in general.

This information is provided for discussion purposes only and does not constitute tax advice.  Readers should discuss their specific situations with us or another qualified tax professional.

Moving to the DC/MD/VA (DMV) Area

Mainly for Foreign Service clients:  When being reassigned to the “mother ship” (aka “Main State” for the State Department FSOs), don’t forget to get a local driver license, to reregister your vehicles, and to submit local withholding forms.

Using a Virginia residency as an example, Virginia requires you to obtain a Virginia driver license when you are going to be present in the state for extended “TDY” or “PCS.”  The Virginia DMV website states:  “Within 60 days of moving here, you must obtain a Virginia driver’s license.”  This is not optional and should not be confused with uniformed service member exemptions of the “SCRA.”  We’ve heard of several examples when the “lesser included offenses” of not having taken care of these details exploded a small fine into a large one.

Here are the vehicle-related requirements starting with the 30 day requirement to have it titled in Virginia: Vehicle Titling and Registration.

The District of Columbia and Maryland have similar (but not exactly the same so consult with their sites here – DC and here – MD) provisions so you’ll want to check your understanding.

Don’t forget to submit an updated withholding form for local taxation.  It’s likely you’ll file part year resident in the year of arrival and year of departure though for some the requirement for filing nonresident is triggered by circumstances instead.  Virginia’s form is located here.  You can fill it out and scan/email it to the Charleston pay office.  DC’s form is here while MD’s form is here.

If you prepare your own taxes, make sure to only include state “source income” as your W2 amounts may or may not be correct depending on when the change went into effect.

We have other articles covering some of the details of taxation including residency versus domicile issues.

These comments do not constitute tax advice and are offered for discussion only. Consult with a us or other qualified tax professionals to discuss your specific situation.

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State Tax Residency and Filing Requirements

Summary:  State level filing requirements can be tricky for those who move around during their careers with the same employer. It’s important to maintain correct witholding certificates with the states in question and to file timely using the correct status. It’s easier to have a filing requirement you don’t know about than you think.

Our Example

Taking a break from tax return prep for this post based on a discussion in a group on Facebook.  Many of our clients work overseas and move around quite a bit, several with nexus in the DC/MD/VA (DMV) region while wanting to maintain residency in their “home of record” or “home leave” states, the place they started from. I’ve adapted this blog post from a contribution I made there. While this is specific to clients covered by the Foreign Service Act of 1980, in general, the framework applies to anyone working overseas. I’ve used New York as an example but the general outline, with specific modifications for each state, territory, or district, applies.

Assume you are a resident of New York when you join the Foreign Service (or other agency — these comments do not apply to those covered by the SCRA). You will remain a resident of New York until either you or circumstances force a change. At the time of entry, you filled out a federal witholding certificate and a New York one. You then continue filing a resident state return until circumstances change that.

For many U.S. government employees, but this applies to any large corporation for which you may be moved around, the circumstance that changes the situation is an assignment (TDY or PCS does not matter) to the DMV region (or wherever your headquarters is located out of state) during which you exceed one of the DC/MD/VA (DMV) tests for residency. Note that the DMV authorities tax all income regardless of residency status after one of the test thresholds is passed (resident, part-year resident, or nonresident return required).  The tests Virginia applies, for example, can be found here: Virginia has an income threshold requiring one to file even if still a resident of another state, in that case filing a non-resident return.

State level witholding certificates should be regularly adjusted for those who anticipate having to file a state-level return whether it is resident, part-year resident, or nonresident, to match where tax is going to be paid. A few years ago, some employers in the DMV, including government agencies, began automatically changing witholding for permanent moves into the DMV but those working even temporarily (TDY in government terms) need to be careful to avoid having underwitholding penalties.

Once you have become a resident of a DMV jurisdiction, you will remain there even if you depart on an overseas assignment unless you take steps to return your tax domicile to your original state or another one in which you can establish residency.

Using New York as an example, we have this hypothetical. Individual with New York residency joins the U.S. Foreign Service (State Department). Remains a New York resident and files a New York resident return to reconcile New York witholding with New York tax due. If in the DMV for training and does not cross a DMV threshold, files a DMV nonresident return for years in which this is required by a DMV test, whether the physical presence test or the income test. Continues filing NY resident and getting credit for tax paid on a DMV return. Goes overseas and continues filing NY resident until crossing the NY Group B criteria found at the link below. Files nonresident NY from that point on until back in the DMV or NY and the cycle continues.

This is all so much easier for those covered by the SCRA, generally uniformed military.

New York has its own witholding certificate which does not allow those with New York residency to be exempt from witholding even if the taxpayer will have no tax due or meets the test for filing a nonresident return due to the nonpresence test. The federal W-4 is not an allowable substitute though we’ve seen situations in which an employer erroneously accepts it as such and will modify state witholding anyway. To be exempt from New York witholding, a New York resident must be young, or old or in the military and assigned out of state. Note all the “ands” in the conditions to qualify for exemption:

Most state level tax authorities have a definition of “source income” that looks to where the business or service the worker is performing is taking place. It does not consider where the employing entity is located (the corporate headquarters or government agency headquarters), but rather where the worker is located and working. For example, if I work in Virginia, as a U.S. State Department employee, I have Virginia sourced income regardless of the State Department headquarters officially being in the District of Columbia. If I were assigned to United States Mission to the United Nations, I would have New York sourced income according to New York.

Have fun playing with the endless combinations and permutations of this framework throughout your careers!  Be careful though with the statute of limitations built into most state level jurisdictions’ tax laws. Generally, if no return is filed, no clock has started on the time limitation. These issues could pile up into quite a disaster over many years. Some states (and the District) can be quite aggressive once they detect a revenue opportunity.

These comments do not constitute tax advice and are offered for discussion only. Consult with a qualified tax professional to discuss your specific situation.

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Robo Advisor versus Full Service Live Advisor

I started an experiment a year ago or so to compare a Robo-Advisor  with traditional brokered investment accounts I’ve had for years and an initial verdict is in: The RA beat the traditional approach including a fund we have that only uses Vanguard ETFs. So, even if you “like” the broker you’ve been dealing with, a person who may have a conflict of interest with you (the better things work for him/her, the worse they work out for you in terms of transaction fees, 12(b)1 kickbacks, risk, and the like), you may want to consider transitioning to a RA.

I shopped around between several offering, including Wealthfront, Betterment, Wealthsimple, and others and settled on Wealthfront based on its balance of assets under management (the viability of this niche industry depends on low client acquisition costs and scale) and its ease of account establishment and low costs for initially small accounts.

All of these firms are built on the theory of modern portfolio theory which is only modern if one thinks of the 1950s as being “modern.” In any case, this approach to investing beats 94% of actively managed approaches and it’s not likely that our “normal folk” clients have access to those insider approaches.

An interesting angle for taxable investments is the tax loss harvesting feature that approaches, but doesn’t technically cross,  the legal proscription against wash sale tax deductions. Wealthsimple’s algorithm (and those of several other RAs) places a buy order for a near peer security (in the age of ETFs, this isn’t hard) whenever it looks like there is a loss that isn’t going to recover timely. You’ll get to deduct the loss without actually leaving the market since the sale and buy take place in accordance with Internal Revenue Code provisions. Neat, huh?

Another feature we really liked was the up-front discussion of risk. These discussions take place in a RA environment with little of the hedging of a live investment manager who may be tempted to steer you toward investments that exceed your risk tolerance. The computer doesn’t have a personal stake in your game.

We’ll keep an eye on the phenomenon so you don’t have to. We intend to grow our personal Robo-Advisor holdings at the expense of traditional, actively managed holdings. At this point, it looks like the best aspects of several strategies and tools, combining the buy and hold strategy of MPF and dollar-cost averaging, with portfolio rebalancing to manage risk and tax-loss harvesting only a computer can achieve at the lowest cost.

We aren’t investment advisors and don’t want to be. That said, part of our game is helping clients to invest the money we save them on their taxes through our low fees and tax code expertise and the RA milieu looks like a winner to us.

Obamacare (AKA, the PPACA) and Shared Responsibility Payments

The ever-politicized Patient Protection and Affordable Care Act (PPACA) branded “Obamacare” by those who never liked it was modified under Congressional budget rules in the Tax Cuts and Jobs Act the president signed into law last week. While actually modifying the provisions of the PPACA wasn’t possible in the parliamentary chicanery of the budget law, Congress did provide for changing the penalty calculations as they do have revenue effects. The two ways to calculate the penalty, which remains a “greater of the two” penalty, had their rates changed from 2.5 percent to zero percent of “household income in excess of the return filing threshold,” with a minimum that changed from $695 to $0. A creative approach, no? Leave the penalty in place, but reduce it to $0.

An aspect that may take some by surprise, however, is that the rate reduction does not take place until after 12/31/2018. So, dear clients, please make sure you have some kind of coverage to avoid what will be a painful fine for those without coverage.

Contact us through our contact form if you’d like to discuss options.

Tax Changes

Well, the president signed the tax bill so it is now law starting after December 31, 2017. We’ve gotten a lot of inquiries from clients about what this means so we’ll start unbundling the law as it applies to our client base over the next couple of weeks.

The first point that applies to all of our clients is that the new law doesn’t apply to the year that is about to end (Tax Year 2017). So, you’ll still be able to itemize just like always. That means:

  • getting all those charitable contributions made before the 31st

In addition, since this is the last time that many will be able to itemize (or, frankly, need to do so), take a look at these options:

  • Prepay property taxes due in 2018
  • Re-register personal property like vehicles in advance if there is a tax involved
  • Prepay items like alimony
  • Pile on medical expenses especially if you’ve hit your deductible — probably too late for most of us since our providers are on holiday vacations!
  • Prepay professional memberships like unions, chambers of commerce, the AICPA (in my case!), and the like
  • Make purchases that qualify as unreimbursed employee expenses this year rather than waiting till 2018
  • Pay your January mortgage payment in December (pay for two months in December)

What’s the common thread on all of these? They are items that you can deduct now but not next year and if you pay them in advance, you’ll be able to take the deduction on your tax return that you file before April 17, 2018. Scan your 2016 Schedule A for items you may be able to pay in advance since they won’t be deductible when you file your tax return in 2019 (for tax year 2018).

Note that in the fine print for this provision, the TCJA law’s implementation is going to require property owners to have a tax levy notice in hand in at the time of payment in order to take a deduction for prepayment of property taxes. Check with your county assessor or equivalent before attempting prepayment. Additional details are available at this IRS page but we read this stuff so you don’t have to.

If any of this is confusing, contact us for a one on one follow up.

Year-End Tax Review

As we come to the end of 2017, there’s a final chance to take advantage of remaining 2017 opportunities and to begin positioning for 2018. If the House and Senate agree on and pass a tax code revision this year (and the President signs it), we’ll publish our take on what that means for the various components of our clientele. This article focuses on remaining 2017 opportunities.

Fund Your IRA

Even if you participate in your employer’s 401(k) plan, consider setting up (if you don’t already have one) and funding an IRA this year (or making a contribution if you have one). For many of our clients, your IRA contribution won’t be tax deductible and they won’t qualify for a Roth IRA. But, in 2017, the opportunity to make a non-deductible contribution remains open for everyone and clients have the right to change their minds later on and recharacterize that contribution to a Roth.

We’ve written previously about the wonder of self-directed IRAs for opening up the investment horizon to rental real estate, tax liens, promissory notes, and other options not available through brokerage-administered IRAs. All that remains true and we’re working on an update.

For clients who are hitting their maximum deferred compensation limits of $18,000 for 2017, reducing any unmatched amounts to allow for an IRA contribution makes sense since clients then have more control of their investment options. This is even true for those who have access to the Federal government’s Thrift Savings Program — we recommend that any amounts saved for retirement beyond 5% of pay be contributed to an IRA rather than the TSP (yes, we’ve taken the ultra-low-cost TSP administration fees into account in making the recommendation). The same logic applies to 401(k) plans in general. Clients should plan on making an IRA contribution in 2018 and adjust their payroll withholdings accordingly.

Charitable Contributions

Charitable contributions remain deductible for 2017 so we recommend clients take a few minutes to review their charity list from previous years and to take a look at funding some new ones. Many states have a “double dipping” list of charities and even tax credits that make giving to specific types of charities a dollar-for-dollar reduction up to the taxpayer’s state liability. In Arizona, for example, donations to charities that qualify as “Qualifying Charitable Organizations” that support foster care or the working poor reduce taxpayer liability in the amount of the contribution up to $400. Arizona allows these contributions to made up to the return due date of April 17, 2018.

We hope folks don’t forget local schools contributions as an option either especially if there is a local tax credit available in their states.

Tax-Free Medical Funds

Many clients set aside pre-tax funds in the various options (MSAs, HSAs, FSAs). Review those if yours has a “use-it-or-lose-it” component and get to the dentist or whatever. If an individual or family has met their health plan’s deductible, getting elective procedures or tests done this year will save, especially if meeting the deductible next year isn’t likely. Think about how much to set aside for 2018 and remember that FSAs now have the ability to roll over limited amounts rather than simply losing them.

Tax Loss Harvesting

If clients have had a windfall sale during the year, now’s the time to sell portfolio holdings at a loss, especially if a similar (but not identical) asset (not the same one) is available for immediate purchase with the freed up funds. Clients should avoid triggering the IRS’s wash sale rules by repurchasing the exact same asset just sold.

Prepaying Tuition

This may be the last time this one works. The Hope or Lifetime Learning credits are still available for 2017.

Small Business Deductions

This is the true engine of wealth generation — investing in productive assets. Major asset acquisitions that can still be deferred to 2018 may get a better treatment by doing so. For most filers, though, this won’t make a difference and we recommend taking the deduction in 2017.

Summary List

This list summarizes the article’s points and adds items to consider for your upcoming filing.

  • Penalties for early withdrawal of savings
  • Alimony paid
  • Student loan interest
  • Prescription eyeglasses, contacts, and hearing aids
  • Crutches, canes, and orthopedic shoes
  • Medical transportation costs
  • Cost of alcohol or drug abuse treatments
  • Charitable contributions
  • Local and state income taxes
  • Personal property taxes or real estate taxes
  • Points paid for a mortgage or refinancing a home
  • Unreimbursed employee business expenses
  • Mileage and other expenses associated with volunteer work
  • Casualty and theft losses
  • Tax preparation software and tax-preparation fees

As always, our articles are not intended to be specific advice. We publish them to stimulate discussions with each client so please contact us with your thoughts and questions regarding the points you found interesting or relevant to your situation. We’re awaiting your email or message.

Spring Review


Spring Review

Summary: Spring is an excellent time to review the details of your existing financial plan components. Updates can avoid problems down the road as the specifics of our lives change over time.

Spring is in the Air

Before we get caught up in the hustle of the summer season, late spring is often a good time to “take a knee” (as we used to say in the military) and evaluate where we are. Here are some example questions you should ponder and then contact us for a link to our interview tool if you have questions or would like to discuss your situation. In general terms, you can also join our forums to review the threads there or post your own questions (and we’ll respond within a work-day).  So ask yourself:

  • Do I have the correct beneficiary elections (HSA, life insurance — don’t forget all those little policies at places like credit unions or membership organizations, IRAs, 401(k)/TSP/457(b)/403(b))?
  • Do I have property ownership the way I want it?
  • Do I have bank and other accounts correctly titled?
  • For items in my estate (none of the above are in your estate), is it time to revise my estate plan (will or trust)?
  • Are my investments optimized?
  • What to do with tax withholdings?

A close friend recently passed away. As I was helping his widow close out the estate, we found that he’d never updated the life insurance. The insurance company paid the policy out to his previous spouse, something I’m sure my friend wouldn’t have wanted, but he never got around to changing that beneficiary or lost track of that policy. It’s a lesson in keeping beneficiaries up to date and to not forget all those little policies that are out there, such as those issued by membership organizations and credit unions. We recommend keeping a spreadsheet with all this information. See our article on online security for related information on how to keep this type of personal information secure.

The same logic applies to so-called “real property.” Make sure that you have it titled properly in such a way that ownership passes directly to who you want. This is called, in some states, joint tenancy with right of survivorship, but consult with an expert in your state. Vehicles and anything else that has a written title to it can be treated this way and kept outside either an estate or a trust.

Bank accounts are frequently overlooked. Failure to have them properly titled can result in all the cash in your estate being locked up until a court can act. That makes it critical that at least an operating, or survival cash, account be shared with someone who can care for you if you become unable to care for yourself, or who can care for your loved ones who are unable to care for themselves.

If you have significant collections of art or other collectibles or real property that wasn’t titled as we’ve previously discussed in this article, does your will or trust, i.e., your estate plan, or provide, for the disposition of those things? If not, now is a great time to think through this and develop a plan and mechanisms, in conjunction with your trusted advisor, to address this.

You should be reviewing your investments regularly. This process, though, may give you new insights into your needs. If it does, you’ll need to get in touch with your investments advisor to discuss near-term, mid-term, and retirement needs.

If you received a tax refund, this is also a good time to go to the IRS Withholding Calculator and update your W-4. Your employer’s HR department will know what to do with the IRS Form W-4 that results.  If your take home pay will increase as a result of this, consider seriously opening up a savings account to receive the difference each month, so you never see it.  It is a great way to increase your savings.

Making this an annual ritual (we plan on updating and rerunning this article yearly), will keep the fundamentals of your “financial house” in order, and fits neatly with the urge to spring clean other aspects of life.


Tax Simplification

Once again, the politicians in Washington have chosen to attack the straw man of the tax code. They love to portray the IRS as somehow (they never state this but artfully imply it) creating the tax code. The truth is quite the opposite: Whenever a constituent darkens a member of Congress’s doorway asking for something in return for a campaign contribution, the result is frequently a new provision in the tax code if the contribution or contribution bundle was big enough. Every few years, we go through a purging of the code in the interest of “lowering your taxes” or “making it simpler” but the net result is just a reset in this interaction between Congress and constituents.

This year, part of simplification in legislation that would affect your taxes in 2018 is decreasing the number of tax rate brackets from seven to three. At the same time, various deductions would be eliminated such as the homeowner’s (a special interest group if there ever was one!) mortgage interest deduction and caps on charitable contributions (charities are another “special interest” — a term we’ve all been trained to hate — with powerful lobbies in Washington). The minimum rates commonly discussed would be an increase from 10% to 12% at the bottom.

Another aspect of the so-called simplification is the sought-after decrease in statuses from four to two: Head of Household and Widow/Widower would be eliminated. The following chart shows the current state of complexity.

 What this dialogue ignores is that the complexity of the tax code is in two areas that precede or follow the determination of this rather mechanical and simple process: What is the income amount to be taxed and what credits are available to lower the amount of tax once it has been calculated. The former we call determining adjusted gross income (or AGI) while the latter consists of subtracting various calculated amounts from what would otherwise have been the tax to be paid. In many cases, for those able to take advantage of the nuances of the tax code, they can lower their tax due to zero (especially corporations)!

If the only complexity in Title 26 of the United States Code (the formal name for the tax code) were just what politicians are trying to con us with, their proposal would be relevant. But, I’ll bet that most readers, once they know their AGI, can place themselves in the chart in less than 15 seconds. Are you married or single? Is your spouse dead or alive?  If you are single, do you have dependents? Then, how much is your AGI?  Voila!  Read to the left on the chart above, and that’s the rate by which to multiply your AGI.

As always with tax policy changes, there are winners and losers.  Early betting on potential losers is on single mothers who will lose the benefit of preferential treatment.  Congressional staffers though have been quick to point out that more generous child care deductions will more than offset the double whammy that some have identified — an increase in tax rates, remember the increase from 10% to 12% at the bottom, and the loss of the household deduction built into their status (income not taxable until  $13,250).  We’ll keep an eye on the childcare deduction as will Forbes and others.

If you work with us, however, your taxes will, in each succeeding year, be increasingly lowered by credits as much as your circumstances will allow — we seek to structure your financial life to gain access to credits or to shield income, legally, from taxation. And that’s not simple, nor is it going to be, at least not for long. Why? Well, that’s where we started. Remember that person darkening the Congress member’s doorway?


Groundbreaking: McFarland-CPA’s new Tax Organizer—Coming Soon!


Tax Organizer Coming Soon!

We are working feverishly on the Tax Organizer!

Like our attempt at a clickbait-style headline?

As part of McFarland-CPA’s ongoing commitment to delivering the best value, in the quickest way, at a cutting edge price, we are putting the finishing touches on our online tax organizer.  Most tax pros employ only one of the few options available for working with clients and price their services accordingly. We have striven to take the best aspects of each of these and synthesize them into a new way of doing business.

What are the options:

  • An in-office, face-to-face interview
  • An online file upload with follow up interactions via voice, email, or, rarely, online chat
  • Email a form (most common) and hope clients will fill it out prior to an appointment to drop off the resulting packet

Each of these alone has pros and cons and we’ll touch on the major points of each. For the first option, the most expensive one, this is like getting your hair done. It’s a custom job and takes up a lot of the pros time. You should expect to pay a lot for this approach if you are dealing with a trained professional. H&R Block and many other store-front franchise operations drop you in a cubicle to be interviewed by an entry-level staffer following a set script. That approach saves on costs but obviously you’ll lose the benefit of years of experience and training. Also, you should expect a lot of back and forth, which many people find frustrating, in order to develop a complete set of information for your return.

In the second option, the one followed by the early adventurers wandering out into the wilds of the internet, you could expect, and should still expect, a lot of back and forth. There was, and is, almost no way to make that work without the structure of the third option.

The tax organizer questionnaire is the solution to the unstructured problem of option two and is really the script for the entry level folks in some implementations of option one (remember H&R Block?). This option forces you to look through a sixteen page questionnaire (yep, we printed out the one the AICPA provides tax practitioners and it was 16 pages long) selecting what applies and what doesn’t. It’s a one-size-fits-all tool.

Our approach, which keeps costs to a minimum while providing a full CPA review of your situation, is a hybrid of all of these that allows us to start together on your adventure with tax-advantaged wealth accumulation and financial independence. We use an online tax organizer engineered to guide you through only the relevant parts of the organizer. In this way, we are similar to tax software. The information you provide through the organizer will be evaluated for reasonableness and probable completeness and then we’ll prepare the correct forms for you. Some items have multiple options and we have the experience to think through those and come up with the best solution for you. Software just doesn’t do that (unless you believe that Watson is actually evaluating your tax return using fuzzy logic).

We anticipate sending you the link to the online organizer later this week which will put us all in an excellent position in the countdown to April 17 (that’s the filing deadline for this year without an extension). If you want your return prepared and submitted later in the year, the organizer will provide you that option.

As always, we, the members of McFarland-CPA, want to express our gratitude for your patronage and can’t wait to get started on this journey with you! We think you will be much better off for having known us as the years go by and are thankful for the opportunity of serving your financial needs.