November 1987
Vol 11 No 1
Aerodynamically, science can prove that the bumblebee's wings can't support it's heavy body – but nobody told the bumblebee. According to all the pundits, real estate won't be able to fly either in the face of all the changes brought about by TRA-86. But nobody told real estate. Before you become too despondent over the current state of your tax shelter, look at the benefits which remain intact for owners of SINGLE FAMILY HOUSES:
For 1987, you can deduct up to $25,000 in rental losses from all other income IF you ACTIVELY participate in management. For houses owned prior to 10/22/86, you can still deduct 65% of passive losses against all other income, whether or not you actively manage the rental property. The $25,000 deduction is phased out for those who make over $100,000. Interest expense on rental houses is fully deductible to the extent of rental income and any excess is subject to favorable passive loss deductions as stated above. The 35% of passive losses lost under TRA-86 can be carried forward and used in future years to offset passive income. 1st & 2nd home interest is deductible – on loans existing on 8/16/87 or on any new financing up to the amount of those loans or your basis in the property, plus any additional amounts used for qualified medical or educational expenses. But there's more:
All of the IRC Sections dealing with EXCHANGING remain intact. You can use 1034 to sell your primary residence for cash and purchase a replacement within 2 years prior to or after the sale and defer taxation of gain. But the replacement residence has to cost at least as much as the property you sold or a partial recognition of gain would take place. But, there's still another loophole: Section 121. If you're over 55 and neither spouse has ever used it before, you can exempt $125,000 in gain from the sale of your home. Suppose you wanted to move 'down' from a home you've sold with a $200,000 gain; all you have to do is to finance a loan to buy a $75,000 residence, and you can walk away with the cash.
Section 1031 is a horse of another color. You can't use it for any 'personal use' or 'inventory' property. But it works just fine for your rentals or property held for use in your trade or business, or for investment. You can exchange any real estate for any other real estate so long as it qualifies under this section, and escape recognition of the gain so long as you follow the procedures correctly. You can't do that with stocks or bonds.
Before you dismiss these, bear in mind that they can be used in creative ways TOGETHER to do myriad things that couldn't be done any other way. Those who've attended our 'Do It Yourself' seminar have seen some of these. And if you're too young to obtain the benefits of Section 121, get your parents to do it instead. Or your clients. Remember, properties you inherit begin their depreciation schedules all over again at fair market value. These 'Exchange Sections' can form the foundation of serious estate planning.
Economic considerations also are favorable for houses. TRA-86 took thousands of builders out of the picture. Despite higher mortgage interest rates, moderately priced houses are still selling. Loss of tax-shelters has effectively REDUCED SPENDING POWER for those with higher salaries/wages. Some can't qualify for home loans. Some don't want to tie up credit and life-style in mortgage payments. They're entering the rental market and paying high rents. This has a ripple down effect which reduces supply and allows rents to rise. So we're seeing solid price increases in houses in the middle and lower ranges along with rent increases and a lot of firming up in what was a soft rental market. And, because SFH rentals are usually lower priced, the $150,000 installment sale floor on proportionate dis-allowance doesn't affect us. It looks like house owners are on the brink of prosperity.
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TENANT MANAGEMENT IS MORE IMPORTANT THAN EVER . . .
In order to realize one of the truly unique benefits associated with real estate income property, the owner has to actively participate in management. To a certain degree, it's possible to use agents and on-site representatives under the owner's direction, but, the owner must still DOCUMENT involvement with the operational aspects of rental management. Only then will he/she be able to use the special $25,000 deduction against other than the passive income generated by the rental income. The problem is that few owners who bought rental property for tax shelter rarely came into contact with the tenants or the property.
The starting point for any rental management program then is the selection of the tenant. Since this is one of the areas which the owner must become involved with, it seems appropriate to consider selection criteria. First of all, the law generally limits the degree to which the owner can discriminate in the selection criteria. Remember, as a business person, you're expected to discriminate against those who would be unsuccessful as tenants based upon credit history, ability to make rent payments, prior tenant history, degree to which a tenant is litigious, cleanliness, willingness to accept landlord policy and rules, etc. You generally are not permitted to discriminate on the basis of race, creed, color, sexual preference, age, disability, marital status, presence of children. And in some areas, you can't refuse to rent because of water beds or pets.
I use a tenant screening agency. Before I agree to meet with an applicant for a property, I must have an approval from the agency. The applicant pays $17.50 at the time of application. The application lists Social Security Number for everyone over 18, their telephone number, current rent amount, current and previous residence with the name and telephone number of the landlord/manager, the length of time in each location plus the rent; the name and telephone numbers of the employers, length of time employed and wages and supervisor's name. Any additional sources of income are listed together with credit references and name/phone number of nearest relative. The agency I use is Housing Credit Services, Inc. (813)239 1316. They operate a National franchise. In the event you'd like to locate one, or start one you might contact them at that number.
The screening agency guarantees that for 6 months the tenant won't be in default for non-payment of rent. There are a variety of options available including special payments if the tenant abandons the property within a guaranteed time period. Each option has a special cost. I usually just take the 6 month guaranty which includes prepaid legal fees for any attorney involved in an eviction for non payment of rent. I include a specific portion in my rental agreement authorizing me to report tenant performance back to the screening agency at the end of the rental term in order to help them help me. I've found that this is a major portion of my selection effort. Many otherwise attractively qualified tenant applicants have poor credit histories which would only bode ill for me in the long run if I were to rent to them. In some cases, while credit history is good, the applicant has a history of obnoxious or destructive behavior which also eliminates him/her.
By screening out known problems PRIOR to renting the premises, I save a lot of grief. Next, I schedule a long interview which typically runs about 2 hours during which time I go over my 7 page Rental Agreement. Passages from this have been quoted in prior letters. I don't make the agreement available outside of management seminars. During this interview I'm interested in several key factors. (1) Self Respect and mutual esteem between spouses. (2) Personal grooming. (3) Intelligence – ability to understand what's being said. (4) Accord – stated willingness to abide by the agreement. (5) Self-reliance – ability and willingness to assume some of the management burden commencing with a thorough inspection of the property and extending through prompt payment of rent, lawn care, minor maintenance and acceptance of responsibility for everything and everyone on the property during their term of residency. Unless I find these things at acceptable levels, I won't rent to the applicant. I accept no one on any form of public assistance or Section 8! They don't qualify! I'm willing to keep a property vacant while I await a suitable tenant rather than to solve today's cash flow squeeze at the expense of tomorrows legal and repair/vacancy cost.
WHEN IN DOUBT, REVERT TO RENTAL 'POLICIES'
Sometimes a successful management procedure is hard to defend on rational or logical grounds to a tenant who disagrees with it. For instance, a cat fancier and/or a dog lover would never agree that these animals are detrimental to property values. When their pets are rejected because they generate flea infestations, noxious smells, ruined carpets, polluted lawns, etc., they are prone to become abusive and even when they agree to rent without their pets, they bear a grudge which manifests itself in tenant complaints about virtually everything the owner/manager does. There's a way to handle this.
In any negotiation, the trick is to keep the conversation on an objective level. Any subjective assertion gives rise to resentment and emotional responses which can kill the transaction. So, instead of listing all the reasons why you won't take animals, you can take a fall-back position and say that you are prevented by the owner's policies. It might be tempting to construct these policies on a case by case basis. This will just get you into trouble. If you're going to have a policy, make it one that applies to everyone. As long as you're going to write down a policy manual, you might as well state your policy regarding water beds, telephones, deposits, late charges, insurance coverage, extra guests, maximum number of occupants, parking of automobiles, repairs, door locks, etc.
I've even gone so far as to incorporate these 'policies' in my rental contract. This makes it pretty long, and it can frighten tenants away who aren't accustomed to a long contract. An alternative might be for you to have a simple contract, but to incorporate a set of policies/rules by reference which can be handed to the tenant at the time he signs. This will give you a chance to take special care to point out your 'policies'.
I've also found it beneficial to accentuate the positive and eliminate the negative by giving the tenant 'options' rather than to impose penalties. Here's what I might do in a policy guideline: (We'll number them by policy number in this example.)
1. Residents shall have the option to share quarters with up to 2 pets with a maximum body weight of 7 pounds each providing they pay $25 per month per pet and provide the owner with a liability insurance policy in the amount of $10,000 per pet covering any damage to the premises or persons during their tenancy. They agree to forfeit all deposits and to surrender the premises anytime written complaints concerning noise, fleas, animal waste or nuisances to other residents are not resolved within 5 days.
2. Within 10 working days, tenants will notify the owner of their telephone number.
3. Tenants may install water beds on the ground floors only upon payment of $75 each, and purchase of an insurance policy indemnifying the owner against any damage caused by leakage, mildew, mold, collapse of structural members or loss of value to the premises.
4. One family of two adults and 3 children under the age of 18 may occupy the premises as permanent residents, however, 2 additional overnight guests may be lodged at the option of the resident for a maximum of 3 days. This period may be extended by written notice to the owner accompanied by supplemental rent of $50 per day per couple.
5. Tenants desiring to improve the property may do so with the written permission/approval of the owner. The tenant should present satisfactory evidence that he has necessary skills, licenses, insurance, etc. to indemnify the owner against any mishap or code violations which might occur for any reason or cause injury or damage to any person whether tenant, guest, contractor or employee of the tenant or owner resulting from said repair. Tenants are urged to use licensed professionals for any repairs with the prior approval of the owner. They shall be responsible for payment for any other work.
6. There are no assigned parking areas. Tenants may park vehicles on any paved areas that have been designated for parking. Vehicles left untended in any other area will be subject to being towed away at its owner's expense without notice.
While I don't use this precise language in my rental contracts, I do cover these topics to avoid problems.
DO YOU WANT TO 'MAKE' $1,000,000 OR TO 'SPEND' $1,000,000?
On a recent interview program, a successful entrepreneur commented that most of those who failed as entrepreneurs had answered that question wrongly. When they claimed they wanted to make a million, they really meant that they wanted to spend it instead. The difference in motivation between these two 180 degree objectives created the climate for failure or success in entrepreneurial activity. Since seeing that program, I've tested this hypothesis in biographies of other successful people. It seems to hold up consistently.
Let's look at a couple of stereotypical patterns of behavior to see where you fit:
A. Five years ago began to attend investment seminars. Joined an investment club which presented a variety of speakers on the subject of creation of wealth. Purchased books and tapes extolling the virtues of 'distress buying', 'rehab profits', 'discounted paper', 'business opportunities', 'franchising', 'multi-level marketing', 'syndication', 'creative finance', 'equity sharing', etc. With each presentation, enthusiastically set off in a new direction only to be disillusioned. But kept trying, kept failing. Today, is no better off financially than when he/she started even after much hard work.
B. Five years ago began attending seminars too. Learned why houses are the superior real estate investment for the small investor. Realized that 'nothing down' usually involved high leverage, limited selection, negative cash flows when institutional financing was involved. Concentrated on negotiating feasible terms on good properties in appreciating neighborhoods. Learned to manage effectively. Kept the properties maintained with high 'curb appeal' to attract preferred tenants. Involved the whole family in the effort. Now has 5 single family rentals, positive cash flow, a growing estate worth $75,000 NET.
No one will exactly fit A or B above, but they can. illustrate my point. What's the essential difference between the two profiles? 'A' was working hard to find the 'easy road to riches'. One of the hallmarks of the con-man is that he appeals to your base instincts. In this case, reward without effort. Over and over, the appeal is made on the basis that wealth is acquired by some 'secret' which will be available in a tape or book rather than that it is the result of enthusiastic hard work, prudence, patience and persistence. That lack of persistence has been the undoing of 'A' above and it's cost him. He clearly takes joy in the prospect of SPENDING that fortune rather than in earning it!
On the other hand, 'B' is more interested in providing security both by acquiring property with a 'back-up' income stream and growing equity, and by ACQUIRING THE SKILLS HE NEEDS to continue to build his estate and to MANAGE it over the long haul. He's found out that few things of value in this life are available without cost and he's planned his route to wealth accordingly. There are tangible rewards awaiting the patient, prudent and persistent wealth builder, but the intangible rewards are often far greater because they can be realized almost immediately. Among these are the thrill of achievement, the feeling of finally becoming master of one's own ship of fate – of KNOWING that you're becoming more self-sufficient, independent of the whim of an employer, able to deal with political and economic fluctuations – and even an overhaul of the tax code. For the true entrepreneur, making the fortune is much more important than spending it. Otherwise why would Donald Trump, Stephen Jobs, Ross Poirot continue to work? The answer's simple, for the fun of it!
That's why I write this newsletter and present seminars. That's why I continue to stay involved in real estate. That's why you should too. And your kids. And parents. Here are some things you can buy:
TAX GUIDE FOR RESIDENTIAL REAL ESTATE – a great book written by Mike Sampson. $25. Order direct from him at 614 'G' St SW,Washington, DC 20024. It puts TRA-86 all together for you.
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
