January 1987
Vol 10 No 3
When George Orwell wrote '1984' he missed by 3 years. Even he couldn't guess the degree to which government in the United States is going to control the lives of its FREE citizenry. 1986 is going to be a landmark year from which individual liberty's decline will be measured in much the same way that 1967 is the year that the decline in the purchasing power of the American dollar is measured. Consider these tidbits:
Starting in 1987, all real estate closings will include a special form which the closing agent, attorney, seller, buyer or other will have the legal responsibility for filling out. Failure to complete it will result in penalties. It will contain the social security numbers of the participants together with the financial summary of the purchase or sale. It will enable government at all levels to trace ownership of private property and commercial transactions of private citizens.
From now on, government is going to track all citizens over the age of 5. If you have small children, you're going to effectively register them with the government. In future years, all their activities will be monitored by computers. They've already begun talking of a national I.D. card each of us will be required to carry. This is supposedly a defense against illegal immigrants, but it reminds me of all those old Nazi movies in which everyone had to show their 'papers'. Of course, one of the really thriving business opportunities in Mexican border towns today is the manufacture of false I.D.'s. That will be the difference between American citizens and illegals. Our government won't be able to track those with the false I.D.s. Only true citizens will suffer any loss of freedom.
Moving right along, the 'smart' computer card is on the way. It will be a self clearing credit card. When you use it, the card reader will inmediately transfer funds from your bank account at point of purchase. As we move more and more into a cashless society, we'll train ourselves to accept automatic removals by computers. Now enter the IRS with 20,000 or so agents each carrying a hand-held computer terminal which can be plugged into the telephone line at your home or office. By using the master data base that each credit card transaction helps to build, the friendly agent can reconstruct all your transactions for the year, bring up all your prior tax returns, do statistical analysis of your spending habits and earnings patterns over the past years, then decide how much you owe. That sounds interesting, but consider this:
The IRS has already proposed to start automatic tax collections. They'll consult their computer banks, decide what you owe, remove it from your account balances and send you a statement of your tax payment. If you don't agree, you can sue to get your money back. Who needs audits with this neat system? Of course, you'll have to have a bank account from which to withdraw funds, so enter the 'cashless' society. We're already half way there, aren't we? In a few years, most of us will have little choice at all.
Did you ever try to rent an automobile from a national agency, register at one of the larger hotels, buy an airline ticket, get a check cashed without having a major card? Combine the a credit card with the new HOME EQUITY CREDIT CARDS and voila: you've registered the equity in your home with the computer, just in case you need a little extra in your account to pay your taxes. It's going to be a great year! Hopefully, I'll be able to provide some strategies to help cope with the new challenges.
Copyright Sunjon Trust All Rights Reserved
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THE BASICS ARE CHANGING . . .
Commencing in March of 1985 I began offering a short seminar to subscribers at low rates which focused on the fundamentals. I did this because it seemed to me that there was lots of information on ways to make fortunes in real estate, but very little hard data on the actual details. In 1986 this information was updated to conform to the requirements imposed by the new tax act. Without repeating the information in prior letters too much, let's explore some of these new basics to see if we can't define the ways we should be doing business over the coming year.
The whole key to real estate tax shelter is in generating cash flow from rental activity in which the owner takes an active managerial interest. Then this cash flow can be used to make the payments of principal, interest, taxes and insurance (PITI) each month as well as pay for maintenance and management. Assuming that these all equal each other and there's no cash left over nor additional cash required, for houses bought after 10/22/86, the depreciation allowed under the IRC can be used to offset active income from wages/salary or portfolio income or business profits up to $25,000. This deduction is rapidly reduced as one's adjusted gross income exceeds $100,000. per year.
If you want to use more of the depreciation, then your houses need to throw off more cash flow from rents. In the above example, suppose your houses generated $50,000 in depreciation, that you were an active manager, and that your. AGI (adjusted gross income) was less than $100,000. That means that you'd need at least $25,000 EXCESS RENTAL INCOME after expenses in order to use up all the depreciation. Of course, if you had a larger personal income and more depreciation, you'd need MORE RENTAL INCOME to use up the tax shelter generated by your rental activity each year. This is for houses you acquire from now on. Your current rentals will enjoy a phase-in period through 1990.
Your strategy is to buy properties at prices and with terms which enable rents to pay for expenses with enough left over to be sheltered by depreciation. This sheltered cash flow remains a key benefit to the investor comparable to the income that might come from municipal bonds, but with a significant difference. In the event of future inflation or a rapid rise in interest, tax free income from rental activity would rise, while bond interest would remain the same, thus house prices would increase and bond prices drop.
In terms of rental cash flow, when you buy a house, PRICE IS LESS IMPORTANT THAN TERMS! To illustrate: suppose a house were worth $75,000 and the owner would agree to carry back the mortgage at 9%, 30 years based upon 10% down payment. Look at the variables.
LOANS INTEREST TERM P.I. PMT RENTS REPAIRS MNGMT CASHFLOW
|
*$67,500.00 |
9% |
30 yrs |
$6517.44. |
$7,800. |
$750. |
$750. |
$(217.44) |
|
75,000.00 |
6% |
30 |
$5395,95 |
7,800. |
750. |
750. |
+ 904.05 |
|
90,000.00 |
0% |
18 |
$5000.00 |
7,800. |
750. |
750. |
1300.00 |
|
90,000.00 |
0% |
18 |
$5000.00 |
7,800. |
-0‑ |
-0— |
2800.00 |
* Based upon 10% down without regard to vacancies, taxes, insurance, at true $75,000 value.
What you're trying to do in this example is to trade off price (and thus future profit) for cash flow income which you can shelter in the year earned. As you can see, by offering price/loan increases for interest/payment decreases you eventually reach the zero interest rate at which time, with the same payment, the loan period is shortened to 18 years. This, combined with the higher price, is usually quite attractive to the seller who is carrying back the loan. And it makes the entire transaction much safer for both of you.
By paying a reasonable cash down payment, you create credibility with the seller as well as a better negotiating position for yourself, all of which enables you to enjoy positive cash flow over the entire payment period without regard to rent increases.
TAX DEFERRED EXCHANGES . . . THE NEW FRONTIER!
What Howard Ruff once called the greatest open secret in America is finally going to come into its own. Under the current tax laws, it's possible for you to SELL FOR CASH AND NOT PAY TAXES! EVER! Section 1031 of the internal revenue code has been around for over 60 years, used primarily by a select few real estate brokers and accountants/tax attorneys. Under the provisions of this code section, properties used in your trade or business, or held for investment can be sold and taxes on the sale deferred providing you re-invest the proceeds of the sale in another property held for investment or for use in your trade or business. You can't use property held for sale or that you live in under this section, nor can you exchange Notes, Trust Deeds, Mortgages, Stocks and Bonds or Beneficial Interests in Trusts. But you can exchange almost any other kind of real estate for real estate; or personal property for personal property when it's done correctly under Section 1031.
Let's follow an exchange through to see how it might be handled. Suppose you had a cash buyer for a property. You've owned the property for several years during which time you gradually paid the loan way down and depreciated your tax basis in the property. When you sell it, you'll have to recognize a large taxable gain which could push you into the 28% bracket. You don't want to pay this tax, but you do want to sell the property. Here's what you can do to legally avoid the taxable event in 1987's high tax transition year:
1. Execute a purchase and sale agreement in which you state that 'the transaction is to be closed in such a way as to provide the seller with the benefits of a Section 1031 tax deferred exchange' and proceed to close the transaction.
2. Have the escrow agent/lawyer/broker sign an agreement whereby an escrow is established into which the cash sale proceeds are to be placed and over which you shall have no control whatsoever. Any interest in that account to accrue to the benefit of the cash buyer. The escrow agent to use the cash to purchase a replacement property designated by you within 45 days, and said purchase to be closed prior to the 180th day following the closing of the cash sale of your property.
3. Now go out and look for replacement properties. Generally, one of your best bets will be in the distress markets. There should be lots of property owners who can't find a willing cash buyer. Contact Accountants, Tax Attorneys, Lenders and distressed owners. Many properties will seem less attractive under the new tax law. They'll be bargains!
4. Once you find a replacement property, execute a purchase contract between the seller and your escrow agent. Have your escrow agent close the transaction using the cash proceeds from your prior sale, plus any 'paper' or additional property which might be involved to complete the transaction. You closing statement should reflect that you EXCHANGED your original property for the replacement property, and your tax basis should be adjusted appropriately to reflect that exchange.
This procedure is the one to follow if your property has sold for cash and you have yet to locate a replacement. It's one which will be much more prevalent over the next few years and the technique I feel will be most profitable for you. On the other hand, there will be many opportunities for you to do an exchange in which you already know of a replacement property for which the owner wants only cash. In this instance, get the seller to agree to enter into an exchange, SUBJECT TO YOUR BEING ABLE TO FIND A CASH BUYER FOR THE PROPERTY YOU'RE OFFERING TO EXCHANGE HIM. This way he'll get the cash he needs while you'll be able to complete the tax free exchange.
Or, you can go around the other way when you have a cash buyer and you don't want to accept the taxable event. Your contract should say: 'BUYER AGREES TO ACCEPT TITLE to (your) PROPERTY FROM A THIRD PARTY AND TO TENDER THE CASH PAYMENT TO HIM IN ORDER TO PROVIDE THE SELLER WITH A TAX DEFERRED EXCHANGE'. The language isn't as important as the concept and the agreement of the cash buyer to convey cash to someone else so you can avoid the taxable event.
TENANT MANAGEMENT REMAINS THE KEY INGREDIENT . . .
It's amazing how many people have management problems with single family houses. I've taught my copyrighted system to virtually everyone in the single family seminar and investment courses, and they've been passing along fragments of my system to their own students. Something is obviously being lost in translation. It's like everything else in this world, copies rarely are exact duplicates. Let's take another look at what your own management system should try to do.
First of all, bear in mind that you've got to attract the best tenants if you hope to avoid management hassle. And the best tenants will only compete for attractive, conveniently located housing which meets their needs at a price they can afford. Because your rental HOUSE is going to be a tenant's HOME, the amenities offered by the neighborhood are critical in attracting the tenants you want. That's a fundamental of a good management system that's too often overlooked in the quest for 'nothing down' leveraged transactions.
Let's take it from the top. On page two, I demonstrated how negotiating for terms could generate cash flow from market rents. But, built in to that cash flow were expenses of management and maintenance. And I showed how elimination of that expense increased your cash flows. So the first thing to learn about single family house management is that you can find tenants who will eliminate the need for on-hands management or maintenance. How? By offering them a better house at a lower price than anyone else. By getting good tenants to COMPETE for your houses. Look at it this way:
If rents are pegged at $500 for an average single family house, then an above average house at the same price should cause that competition. And you can offer that low rent for an above average house because you structured in the cash flow terms when you first bought it. You (hopefully) also selected a house with broad market appeal within its price range. Hence, it's located in a decent neighborhood near schools, shopping, sources of employment, etc. And since you want to hold down repair costs, you picked a house for which maintenance costs were expected to be low the first few years. In other words, it was in good condition when you bought it, or you brought it up to snuff out of the money withheld from the down payment at time of purchase.
Now, with a good clean three bedroom single family house (not a condo, duplex, townhouse, etc.) in a decent neighborhood, priced so the rents can be offered at competitive rates, you'll have a selection of tenants to choose from. I like to use a local tenant screening agency to be certain that they have both a good CREDIT rating and a TENANT rating. That means, not only do I check on their payment record, but their stability, whether their prior two landlords have any negative comments and whether they'd be willing to rent to them again. In addition to this, I also perform an EXTENSIVE INTERVIEW prior to renting to them. I don't rent to those who can't meet my standards even though it might cost me vacant days.
My rental contract is the standard of the single family house industry. I doubt any exist which contain my discounted rent, Option to Renew, Christmas Plan or Credit Card collection system which weren't lifted intact from my original concepts. I'm proud of them because they truly work when administered properly, enabling me to have limited expense or involvement with the rental operation, and leaving me time for financial management and long range planning. And they can work for you too. Over the coming issues, I'll be going over many of the contract clauses. Because I no longer offer the seminars and the books, I'll use this part of the CommonWealth Letters to explore new and better ways to manage rentals.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
