July 1981
Vol 3 No 10
In a recent issue of a widely read tax newsletter, the writer tells a tale of a couple who attend a well known investment seminar, and then make every mistake in the book. Reading this fictitious account of rampant buying, selling, and refinancing, reassured me that our program was sound from a tax standpoint.
While rereading the letter, I wondered how many amateur investors were out there in the real world doing all of the horrible things the story portrayed. As we can all learn from the scenario that was analyzed from a tax standpoint, it is worth retelling.
Our couple begins with the premise that in the event that they can acquire many houses with low down payments, they will soon stop paying taxes on the income they derive from other sources, and will become very rich in short order due to the effect of inflation. They acquire the houses by moving into them and obtaining ninety-five percent conventional loans, at prevailing interest rates.
Next they move on to another house and repeat the pattern over and again, always renting the house that they leave at a negative cash flow. As soon as any of the houses generate any borrowable equity, they immediately borrow against it using a second and acquire yet another house. These houses also had negative cash flows.
As they were so eager to acquire dozens of houses, they often bought properties at retain prices or higher because of the good terms offered by the sellers. Later they sold several of these houses when the negative cash flows became uncomfortable, or they became nervous about the appreciation potential of the neighborhood. Usually, but not always, they were able to sell these houses at a profit.
As time passed, they sold a number of the houses on wraps, to generate cash flow, and after about six years still owned twenty nine out of a total of fifty seven they had acquired over the years. Now for the fun part, they get audited.
Before we examine their tax problems, let’s analyze the errors in their overall game plan. First, they used institutional financing to acquire many of the properties. This naturally led to large negative cash flows. Unless you acquire property at a price well below the fair market value, it will not have a positive cash flow when financed with a ninety-five percent amortizing loan.
The key to successful single family investing is using private financing, structured so that you have a positive cash flow from the beginning. With an owner financing the sale you can arrange for your payments on his equity to begin only after the property will generate enough cash flow to cover them.
Next, because they acted quickly, and then planned later, they bought many properties which they had to resell because of bad cash flows or poor locations. In the event that they had a grand design, in which they would only acquire properties in certain price ranges, in specific neighborhoods, and with favorable financing, they could have avoided the wasted time and effort of selling their mistakes. In addition, one who buys only cash flow houses, and never sells, would have much less to discuss in the event that our friends from the Government decided to pay a visit.
Enter the taxman.
When most of us picture having an audit, we imagine some accountant type asking us to substantiate income and expenses of our business or rental properties. Some auditors may be much more subtle, by instead of asking for numbers, asking questions regarding your intent in acquiring your properties. How would you answer the following questions?
1. Do you regard your houses as a good business investment, or did you buy them only for the tax write-off?
2. When you sell, is the selling price, plus the total rents received, greater than the total of the purchase price you paid plus all of the operating expenses and interest?
3. When you buy are the prices you pay equal to fair market value, or are they distorted to give someone a tax benefit?
4. Do you ever take title with a deed which provides for the retransfer of the property to the original owner?
5. Do the cash flows on your property equal the going rate of return on comparable investments, or did you buy them solely with the intent of reselling at a profit?
6. Have you ever received any interest in a property in return for services, without declaring the fair market value of those services and paying taxes on that amount?
7. Is the total interest you pay on the properties in excess of $10,000 over total rents?
In the event that the taxpayer who is being questioned has followed the same pattern as our friends in the previous example, they should be sweating profusely during this interview. They now see the error of their ways in acquiring property, which has no redeeming virtues other than sheltering current income, unless inflation is kind enough to carry its value beyond the price they paid originally, plus the holding costs.
Should they confess this revelation to the interrogator, he will certainly ask, “Then the only reason, besides sheltering current income that you bought the property was to resell at a profit at a later date?” an affirmative answer would have them well on their way to “dealer status”, in which event they would not be allowed to depreciate their properties, and would have to declare all profits at ordinary income rates.
As should be apparent, the moral of this grizzly tale, is that keeping an excellent set of books will not save you, in the event that you consistently buy the wrong property. “BUY AT A PROFIT” and you will not have to worry about defending the position that is pictured above.
The above questions were paraphrased from the tax newsletter “The Inside Story about Taxes” authored by Charles Ray Considine, and published by the Academy Network Corporation, 46 North Washington Blvd., Sarasota, FL 33577. Subscription $84 Annually.
Although rent control statutes are spreading, we have yet to hear from a single family house investor who could not either avoid it, or outsmart it. The low profile of owning one house with one tenant, as opposed to a multiple unit building, is a tremendous advantage. This coupled with strategies of selling all or part interest to your tenants, using a contract for deed, or a lease option, will allow you to continue to increase your cash flow, without giving up all of the appreciation.
It is interesting to note the similarities between the document used to either rent on a lease option situation, or sell on a contract for deed. The lease option document states that the “buyer/tenant” will have the right to occupy the property in return for paying a specified amount each month, and at some point in time, can acquire fee title to the property in the event that he pays a certain sum, either over a period of time or in a lump sum. It typically states that in the event that the “buyer/tenant” decides not to complete the purchase that he will relinquish all rights he may have in the property.
It may state or imply that the owner/landlord has title to the property now, or is in acquisition, and that he will provide a deed to the buyer/tenant, in the event that they fulfill all the obligations of the lease option agreement. Subject to negotiation is who would maintain the property, and be responsible for the taxes and insurance.
Take a moment to review the above clauses. Are they not the same as those you would find in a contract for deed (agreement for sale)? In both cases the owner remains in title to the property, while the lessee or purchaser, contracts to occupy the property and for the right to purchase in the event that he lives up to the terms of the agreement.
What then is the major difference in benefits to the parties? Taxes of course. With the lease option, the owner of record may continue to depreciate the property until the tenant exercises his option to purchase. There are no tax benefits to the tenant, as he cannot deduct his rent. With a contract for deed, the owner of record cannot depreciate the house, as he has “sold” it to a buyer, who can deduct the interest.
A successful tax attorney friend of mine once quipped, “Don’t argue taxes with the IRS, argue real estate”. When structuring an agreement between an owner of a house and a party who would like to occupy the house and have the right to purchase it at a later date, at a fixed price and with periodic payments in the interim, title it “Agreement”. Now who is to say whether or not we have a lease, where the owner must depreciate, or maybe a contract to sell the property, where he cannot depreciate. Certainly both are contracts, and because of their remarkable similarity, you have an arguable point, both when discussing taxes, and when discussing rent controls. Rent controls, and tenant and landlord statutes, do not affect parties to a contract of sale.
We are continually brainwashed by titles on instruments. Many amateurs have learned the hard way that just because an instrument is titled one way, for example “Second Mortgage” does not necessarily mean that that is indeed what it says it is. Structure your agreements to do the job you want done, considering taxes, control over the appreciation and occupancy, and potential liability. You may own properties with large encumbrances which you can “sell” and clean up your statement. (For additional information on rent control strategies refer to the July, 1979 CWL in which we enumerated several tested and proven strategies.)
In spite of Reagan’s austerity plan, there are several programs in the mill to help the poor folks. Many of you may remember the FHA 235 program, where “poor folks”, that is those whose income was no more than 95% of the median income for that area, received a government subsidy to help them with their payments. Many of those houses were subsequently abandoned and picked up by investors for back payments. A new program will apply the same guidelines, but has redefined who may qualify, to those with incomes up to 130% of the median income in any given area (averaging around $26,000 for a family of four).
As these houses are exactly the ones we want to own, watch for new neighborhoods catering to this clientele. For more information on this new program, and all new developments in Federally regulated government programs, send for your free subscription to the “Seller/Servicer”, a publication of the Federal National Mortgage Association, 3900 Wisconsin Avenue, N.W., Washington, D.C. 20016. In the last issue I received they had a lengthy discussion of the due on sale clauses, how and when they expected to win, and in which states. It is a publication intended for their primary lenders, but available to all.
I have just received the statistics for the median sales prices of existing single family houses in California for the last five years. You guessed it, they went up. Five years ago the median price of a house in California, (that is the one we recommend you buy) was $44,800. Today that same house sells for $103,285. That is a 131% increase during the five year period, but it is interesting to note that no two years were alike. Here is the breakdown year by year: 1976-26%; 1977-14%; 1979-29%; 1980-6%. 1979 was the hands down winner for dollar increase of nearly $22,000 on a $75,000 house.
In the event that you would chart these prices you would notice a stair-step effect. During some years the prices really jumped, while during others they remain relatively level.
As you can see by studying the trends, the best time to buy would be during a period just before the rapid appreciation. Interestingly enough, those are the periods of little appreciation, typically high interest rates, and slow home sales markets. Now is one of those times. We are in a flat place in the appreciation in nearly every state. There are reports of people selling for less than what the property was worth a year ago, but quite often, the year ago value was placed on the property by a real estate salesman trying for a listing. I have yet to hear from someone who sold their house for less than they paid for it, although there must be many doing so right now.
Real estate is, and always has been a long term investment. Those speculators who think they can outsmart the market and sell for a short term profit, sometimes win big, but mostly lose. (How is it we always hear about the winners?)
This month’s “Dear John” letter asks “What should I watch out for when purchasing discounted trust deeds?” for the past three years I have been actively buying existing mortgages and trust deeds, for long term investment. This is contrary to many investment advisors’ theories, however I feel that everyone should have liquidity in their portfolio, and I can demand and get a higher yield from well secured trust deeds than any other type of liquid investment.
I now spend nearly two hours in the three day seminar describing where to locate the owners of these notes who would be willing to sell at discounts to yield 35%+, and how to negotiate the purchase of these notes. Here I will try to point out several of the many pitfalls, in which an unwary investor may be trapped in the event that he does not do the proper homework before buying.
First you should examine the collateral for the note, paying special attention to the existing encumbrances. Although the equity behind the note you are buying is important, the encumbrances, (other trust deeds, liens, unpaid property taxes, etc.) which have a prior claim to the property, define your risk. In the event that the owner would default on any of the underlying encumbrances, you must be in a position to step in and make that payment, or you may lose your position. For example, a fifty thousand dollar second behind a two hundred thousand dollar first, both secured by a five hundred thousand dollar parcel of land, would seem to be well secured. However, should the first have a balloon payment due for the entire balance in sixty days, the owner of the second may be in jeopardy. Notice not only the amount of the underlying loans, but their terms. Balloon payments, variable interest rates, and acceleration clauses could all cause you to lose your cash.
Secondly, check with the person who owes the money. You need to ascertain that they do indeed owe the amount of money that the holder of the note claims they do, and that they intend to pay it. Notes are often created as a result of the sale of an asset or business, and many times there may be a dispute as to the amount owed. A holder in due course, that is a person who purchases the note in an arm’s length transaction will normally be protected by the courts, however, you should always have an estoppels letter signed by the signer of the note, stating that the money is still owed and that he acknowledges that you are acquiring the note and all further payments should be made to you, and not the previous holder.
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