April 1988
Vol 11 No 6
Probably the most important tax form for you to get in will be Form 4868! It gives you an automatic four month extension on the date you have to file your return, IF you send in the full amount of tax you think will be due along with it. But it has to be submitted on or before April 15th. If you're abroad on April 15th (think Mexico or the Bahamas, Canada), you have until June 15th to file and pay your taxes. The 4868 will give you two more months after that to send in your full return. If you can substantiate the need for additional time, then you file Form 2688. This can provide up to 6 months extension to the filing time. But IRS has the last laugh.
They can cancel the extension or refuse to grant additional time. If you fail to pay at least 80% of the tax due, you could be hit with a penalty. But late filing may really be in vogue this year. With mere weeks left until the deadline, tax payers are plagued with incomplete instructions, tax forms that don't reflect the latest law, and tax preparers who would rather be in a different profession until they get clarification as to the requirements. Now might be an excellent time to buy H&R Block stock. They're going g to be busy. Or you might drop in on your local computer group. Both IBM and APPLE have programs which can help a lot. Your last resort is to settle down to a cozy evening of reading J.K. Lasser (your local newsstand $8.95), Mike Samson's book, ('Tax Guide for Residential Real Estate', $25.00. Call (202) 488-3866 to order.), or Commerce Clearing House's Master Tax Guide – the issue with the Revenue Act of 1987, December 22, 1987 if it's available – costs about $17.00 – look them up in your local Yellow Pages.
If you think it's bad this year, wait until next year! It's critical that you already have your 1988 tax planning underway. Remember, the phase ins for passive losses and excess interest deductions will fall to 40% this year, and 20% in 1989. Also, if you plan to liquidate a small corporation and take out appreciated assets, it must be completed by December 31st or you can be taxed both corporately and personally on any gain. 1988 may well be recalled fondly in coming years as the year in which American citizens paid the LEAST taxes. It's almost a certainty that TAX INCREASES will be high on Congress' list as soon as the elections are over. Millions of dollars of budget funds have been allocated to hiring more auditors to find out whether you've been naughty or nice. The IRS is just about the only PROFIT CENTER in government. Congress is discovering that each additional dollar of budget can return about 21 dollars of revenue. Who could resist expanding this budget?
One of the new taxes under serious consideration is a national sales tax. This was predicted in The CommonWealth Letters about a year or so ago. From the standpoint of the government, it makes a lot more sense than the Income Tax. Here's why. It only taxes CONSUMPTION, not savings. It doesn't lend itself to elaborate tax-shelter schemes. It's easy to collect at millions of cash registers and credit card processing centers all over America. It applies to all consumers: Churches, Charities, Elderly, Disabled, Aliens and employees of foreign embassies, crime lords, businesses alike. It rewards prudence and thrift. That's the good news. There's bad.
It's regressive in that it taxes the poor at a higher percentage of their income than the rich and it takes more of their earnings because they spend virtually everything they earn. Many states currently have state sales taxes at the 5-6% level. Suppose 10% were added to this by the Federal government. That's the same as increasing the costs of everything you buy or sell. So it reduces consumption to some degree. Less consumption = less profits = less need for production = less need for employees = less jobs = less income.
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
IT'S NOT TOO LATE TO PRACTICE A LITTLE THRIFT . . .
If, on the one hand, they're taking away some of our passive activity deductions for losses, and on the other hand, they're going to tax our consumption; it seems logical that we should try to limit our expenses. For the things we must buy, we should try to pass on as much of these costs as we can in the form of higher rents. At the same time, by involving tenants in the maintenance, collection, rent-up and management function, we can try to reduce the amounts we have to spend so that we'll be able to optimize our tax burden.
Let's take these one at a time and look at the possibilities. Higher rents. Why does anyone pay higher rents over the current market? Because they feel it's worth the extra cost. This gets to be pretty subjective, but what most people want is SECURITY, SERENITY and STABILITY. Tenants are about as insecure a group as you will find. If you can give them a stable situation, guarantee it, then leave them alone, they like it better. On the other hand, this can increase your cash flow while saving you management/repair expense.
My rental contract has continued to change over the years to help me accomplish this. First I start with the Tenant attitude. By carefully screening both credit and tenant history through Tenant-Chek, I try to eliminate those who wouldn't be responsive to my policies. Next, I use a rebate 'check' each month to 'reward' them for paying rent on time (the last day of each month) with a MONEY ORDER and to keep the property maintained to a standard that is agreed upon when they move in. Here's how I do this. The have to sign a special part of my rental contract which states that they've been warned against paying check and are willing to pay a late charge, bad check charge and lose their rebate check any month a check bounces. They retain the choice of what they elect to do to pay the rent, but in the event a check is returned unpaid for any reason, or a payment is late, they lose.
In return, I hold rent increases to an absolute minimum to maintain my NET CASH FLOW from the property. I explain to them that this includes 'administrative' costs when rents are late or I have to deal with tenant complaints and inquiries. They're given an emergency number to call for bonafide emergencies, but all other calls can cause them to lose their rebate check for that month. So can any repair expense. Here's how it works. Suppose the sink trap rusts through because the drain cleaner they've used was too caustic. They're expected to replace it themselves, or to hire someone to do it. Sometimes something more serious happens such as a water heater rusting out. They then call the emergency number. A repair contractor fixes it. They'll be billed (i.e.) $50 and I'll pay the balance. If they fail to pay the first $50, they'll have it deducted from their rebate check that month.
When the tenant learns that each repair costs him FIRST before it costs me, he starts being careful not to incur maintenance and repairs. When he discovers that his bank's errors can cost him money, he starts paying by money order – and we eliminate all bank 'float-time' on our collections as well as checks on which payment might be stopped. By keeping the premises maintained, the property continues to be attractive to the tenant. And by our placing him in charge of his own repairs, we rarely see or contact him. Our rental HOUSE becomes his HOME. We give him lots of leeway in making decisions regarding it. And we make him sign an agreement to be fully responsible for any accidents to anyone HE involves in doing chores around the house.
Now, we have to deal with tenant security. We allow the tenant to BUY an option to renew his rental agreement for an additional year rather than to pay us a deposit. And this option is extended year by year so long as the tenant follows the rules, paying on the date due with a money order and keeping the property maintained. This secures him two ways. (1) The property won't be sold under the terms of his rental contract except subject to his renewal option. This guarantees his occupancy regardless of the ownership. (2) It also puts a cap on any future rental increases during the entire base and Option period. Capricious rent increases are a continuing concern to tenants. By stabilizing his living costs, we also stabilize his occupancy. And as we've pointed out before, reducing turnover is the true key to cash flow profits from a rental. All of our costs are also minimized.
INCREASING RENTS VIA LEASE-OPTIONS ALSO CARRIES RISKS . . .
If one were to sum up a central truth to human existence it might be that 'there's no such thing as a free lunch'. Lots of people use the lease option to increase cash flow. Typically, they might add 10 – 15% to their rents and call it option consideration, then give the optionee/tenant the right to buy the property after a few years of paying high rents. Let's look at some of the economics of this approach. Assume a fair market value of $75,000. Market rents would be about $550 per month. By paying an additional $100 per month, the tenant will get a credit of $150 on each payment provided that he not default on his lease which runs for 3 years. His purchase price will be $85,000 which is based upon ½ the growth over that period. Look at the results:
The property is continuously rented for 36 months without any repair expense to the owner at a price of $650/month. Total cash flow received would be $23,400 of which $3600 would represent a premium over fair market rents – assuming no market rent increases would have been possible. Let's first assume that a sale is completed. The owner has had a fairly easy time of it with his tenant. He's made a $10,000 profit on the property and $3600 on monthly cash flow with which to carry the property. But he's had to give a credit to his tenant of $5400, reducing his $10,000 profit by $1800 (excess of credit given over option consideration received) to $8200. Still, that's not too shabby for a quick deal.
This isn't necessarily a typical situation. Every conceivable arrangement could be made, but let's use this to point out some aspects not readily apparent. First, anytime option terms are offered which create a compulsion on the part of the optionee to complete the purchase, IRS guidelines and case precedent have held that an EQUITABLE TITLE INTEREST have been transferred. What was thought to have been a lease/option was in reality merely a financing device. Thus, the landlord was really receiving payments on an imputed contract of sale rather than rents. All his depreciation would have been improper and interest would be imputed to the transaction. The buyer would have depreciation accrued against the house without the benefits of the deduction during the time he thought he was only a tenant. And the interest and taxes would have been legitimate deductions to him, not the landlord.
Robert Bruss' newsletter recently reported that the interpretation of a lease and option as being an installment sale contract could have ominous results in a state where it requires a JUDICIAL foreclosure rather than a non-judicial to get a property back once it's been transferred through this interpretation. He's a nationally syndicated columnist who writes two newsletters: the CALIFORNIA REAL ESTATE NEWSLETTER and the REAL ESTATE NEWSLETTER. Contact him at 251 Park Road, Ste 200, Burlingame, CA 94010 for subscription information. The problem is that the various states have 'rights of redemption' which permit a foreclosed evictee to have anywhere from a few days to several years to pay up the indebtedness and reclaim title to the property. In the interim, the former owner who foreclosed is in limbo not knowing who will eventually wind up in title. But he's got to continue to make payments on any underlying loans, pay the taxes and insurance, and maintain the property.
Like everything else in the business world, knowing what to do and how to do it is the key to success. It's possible to operate successfully with only a dim idea of the law, then to suddenly lose everything when someone challenges what you've done. If you're going to use lease options, research your state laws regarding them. In the event they might be deemed installment contracts, recognize the difficulties and avoid them. In the event there is no problem in your state, then avoid the tax problems by doing several things. First, remove the compulsion on the part of the tenant to buy by not specifying the price, by placing all costs of closing and financing on him, by not charging more or less than market rents and by NOT giving credit for rents collected against the purchase price.
If you want to just use the lease/option as a tool to hold good tenants, then why not give them an incentive NOT TO EXERCISE THEIR OPTION? I offer to return all their payments in excess of market rents at the end of a long rental period for them to use to buy ANOTHER property. Each monthly increment acts like an additional deposit, because, if they don't fulfill the lease, they don't get the 'bonus' at the end of their stay.
DID YOU EVER SEE A LIGHT BULB JUST BEFORE IT BURNED OUT?
In the next few months we're going to see some exciting possibilities. Interest rates are going to drift a little lower. House sales are going to perk up. Until the first of July or so, things are going to be pretty good. This would be an excellent time to try tot those who owe you money on mortgages to refinance and pay you off in cash for a couple of reasons.
Interest rates are going to rise toward the end of the year as the politicians go full bore trying to put a chicken in every pot prior to election. Every pork barrel project imaginable will be taking money. A falling dollar will prompt many depositors to seek safety in equities rather than in debt instruments. People will take this opportunity to refinance their houses and pay off installment debt which can't be deducted any longer. And people will finally be confronting their tax bills and will need to borrow to pay them. Inflation will start moving up, making bond and stock holders nervous. At the same time, Chairman Wall of the Federal Home Loan Bank Board has declared war on weak savings and loan associations. There are going to be some real upheavals in the financial markets.
If Congress can't do anything meaningful about debt/deficit reduction during an off year, it's a cinch nothing will be done during this election year or by a lame duck Administration. It makes a lot of sense to wind up the year in a good solid cash position. NONE of those running for President have exhibited the leadership and specific programs to solve our current economic problems and there's little chance they'll improve once elected. Time may be running out for those who are leveraged too much with too little cash flow. Hopefully, I'll be able to address these subjects during the first half of the year. The next issue will deal in depth with some of the problems that could boil over in the next couple of years.
Heretofore, maintaining financial privacy has been an important strategy. Privacy will soon be a thing of the past for most people. If you drive, if you use credit cards, if you have a bank account, if you file an income tax return, if you have a telephone or are connected to a public utility, if you're employed or have employees, if you travel you are already in the computers. Your movements, background, activities, purchases, business and investments can be charted. So can all your transactions. This is an outstanding year to clean up your act if it needs cleaning up. Your life may truly become an open book to virtually anyone who wants to access the data bases that are already up and operating.
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
