July 1986
Vol 9 No 9
Since August of 1983 I've been telling subscribers about the impending revision in the tax law. In spite of the political maneuvering and all the interim proposals, it seems clear that real estate is going to be the whipping boy selected to bear the brunt of coming changes. More particularly, real estate INVESTORS will find themselves paying more and enjoying it less once the final votes are counted. The only thing that isn't clear is WHEN the ax will fall and precisely upon whom – and how hard. Maybe it's time to try to put things into perspective. Here's what the Senate is proposing with regard to real estate investments:
a. Top tax bracket payers will pay about 32%. Low bracket payers will pay 15%.
b. Long term capital gains will be taxed about the same as ordinary income.
c. 1st and 2nd home mortgage interest would be deductible.
d. Investment interest would be deductible up to the amount of investment income. This would be phased in between now and 1990 to allow for some excess interest to be deducted over investment income on a gradually reduced scale until that time.
e. State and local property taxes would be deductible.
f. Up to $25,000 in losses on PERSONALLY MANAGED REAL ESTATE can offset other income.
g. Residential depreciation will allow 27 1/2 years for write offs. 31.5 years for com'l.
h. Investment Tax Credit will be eliminated.
The effective dates of these changes will fall mainly in 1987. But this could change. That's the bad news. Here's the good news:
a. Personal exemptions for most people will increase to $2000.
b. Maximum corporate rates fall to 33% with lower rates retained up to $75,000.
c. Corporate capital gains rates would remain at 28%.
d. Dividends received by corporations would still be 80% exempt.
e. While IRA's would be restricted, corporate pension plans still look good.
f. The standard deduction would rise to $3000 for singles, $5000 for marrieds.
g. Personal property will retain fast write-downs.
There are lots of other aspects to the Senate proposals with special rules for those who have incomes at the very top levels, but these are the main points which affect most of us. And some portions of the IRC have been left pretty much alone. For example, personal residences can still be sold and taxes deferred under IRC Section 1034. The $125,000 one-time exemption remains on the gain of the sale of the 'over 55's' homes. And the provisions for tax-free exchanges under IRC Section 1031 remain intact.
In the short term, it may appear that we'll all be paying more taxes. On the other hand, we may find that our incomes increase even more than our tax bills once we've adjusted to the new tax rules. More to the point, anytime there's massive change, those who can adapt find new opportunities abandoned by those who aren't able to change with the times. Now might be an excellent time for you to review the more creative sections of your old CommonWealth Letters to seek out the necessary tools for dealing with changing markets.
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ONE MAN'S MEAT IS ANOTHER MAN'S POISON . . .
Let's look at two kinds of people in today's single family house market: those who bought houses for the benefits they confer and those who bought houses as a defense against government tax and economic policy. In the first instance, when a house is bought to provide shelter for the owner and his family or to provide a rental income stream which can support the owner's lifestyle or increase his wealth, that house will continue to work quite well even with the new tax law. Here's an example: I've owned some properties almost 20 years. Their 20 year depreciation has almost run out. They've been producing rental cash flows in excess of the shelter they generate for several years, so I've been using the excess income to buy other properties with. The proposed tax law won't make much difference to me insofar as these properties are concerned if I keep on doing what I've done so far.
Those who invested for Tax Shelter will fare differently. In one case I know of a syndicator who sold a 'tax package' to investors. Nothing down. Negative cash flow. High interest rate. 5 year balloon Notes. Inflated values. Non-recourse financing. He made his profit from commissions, management fees, construction profits. Now that the loans are coming due, the investors will find the condos make no sense at all under the new tax proposal. The lender is soon going to be the proud possessor of these condos. No one else is going to want them. The prior owners will be able to walk away from their loans. These tax-shelter type properties are going to be a drug on the market unless the lenders discount them heavily to attract new owners, and provide easy financing at low rates.
These two illustrations go to the heart of the effects of the proposed tax law. On the one hand, good properties will continue to be good. Marginal properties will be dumped. Their prices will plummet. Lenders will find themselves overloaded with empty houses and condos requiring expensive maintenance – or full houses requiring expensive management which they can't provide for themselves. Or they'll have to sell to liquidators at deep discounts. Regardless which course of action they choose, people who have the skill and experience that are needed will be able to command a high return for their talents.
On the other hand, owners of sound, well located rental properties which produce stable rents, and owner/occupants of reasonably financed homes will continue to enjoy the benefits that SFH can provide. With each house that finds itself in a lender's inventory a rental unit will be removed from the market, making the rental market just a little bit tighter. And supply/demand will drive rents a little higher, making good properties just that much better. It's still going to be pretty hard to beat profitable rental houses.
Increased taxes add to the costs of doing business. These will be passed on to the consumer in the form of higher rents. At the same time, landlords will be getting a little help from the deductions and depreciation they currently take, so they should be able to continue to enjoy profits normally associated with real estate ownership. Under the tax proposal, it will pay to become a DEALER in real estate, since short term and long term gains will be taxed a comparable rates. And as we'll see, combining corporate and personal forms of debt with BUSINESS can generate advantages which match those we've known under current law. The trick is to see ourselves as being in BUSINESS rather than as being passive INVESTORS, and to take advantage of the benefits the tax law confers on an operating business. You'll still be able to shelter a lot of income one way or another.
In recent letters we've pointed out the opportunities for ancillary businesses associated with rental management. These include: Rental Agencies, Tenant Screening Firms, Collection and Eviction Services, Maintenance Coordinators, Residential Security, Lawn Maintenance, etc. Lenders will be captive consumers of such services as their inventories of foreclosed houses mount. This happened in the mid-70s and can happen the same way again. As a result, opportunities for those with management know-how should continue to accelerate under the new tax laws. And payment for management services comes right off the top of the rental cash flow. It won't necessarily be as easy as it sounds, but let's be realistic. By driving investors out of real estate the new tax law is going to create massive opportunity for PROPERTY MANAGERS, MAINTENANCE and SECURITY companies, LIQUIDATORS, APPRAISERS. Ownership of both the property and the mortgages may change hands, but the properties themselves will remain. As a result of the recession of 1960 one project near a military base in South Georgia remained vacant for over 10 years during which time it was managed and maintained by professional PROPERTY MANAGERS with lucrative government contract.
IT'S ALREADY BEGUN TO HAPPEN . . . THE EARLY BIRDS ARE OUT TO GET THE WORMS . . .
I've already been contacted by an organization attempting to buy out an entire subdivision in which I own a rental property. They've solicited my offer to sell based upon my NET OPERATING INCOME and CASH FLOW AFTER DEBT SERVICE. They are looking for a 10% return on their cash investment without regard to tax savings. As you can imagine, that has the effect of lowering the price on houses in the subdivision with high interest rate loans and/or negative cash flows. One resident called me and determined that, after 61 payments of $840 per month, he had a NEGATIVE VALUE of over $4000. He vowed to abandon the property to the lender. The lenders are scared witless by this type of borrower.
The panic is spreading to partially completed projects. In one instance FDIC influenced the lender to renege on a permanent financing commitment. They gave as their reason the anticipated need for FDIC funds to shore up DALLAS lenders in preparation for massive bank failures in the oil patch. Effectively, this transported the distress from Texas to Florida. With a little imagination, it's possible to predict other areas where the new tax laws will create financial distress. By abandoning the Investment Tax Credit, government is effectively removing incentive in all heavy manufacturing, refining, and equipment-intensive businesses. We can expect to see growth in the service-oriented types of businesses. These put a lot of people to work, but generally pay lower salaries.
WHERE DO WE GO FROM HERE?
Back to basics! Why do we buy houses? Probably first of all to build net worth. We use AMORTIZATION of the mortgage to reduce our debt. We use OPERATING CASH FLOWS to pay the expenses and the monthly payments and put any overage into our pockets. Usually, as we build our portfolio one house at a time, we have little concern about taxes because we continue to put surplus funds back into the next purchase. Even with the new 27½ year depreciation schedules, we'll pay very little taxes. So it won't affect us much until we start to see high positive cash flows. Because it will affect others so much more than the beginners in real estate investment, we'll see lots of bargains in both houses and loans which we'll be able to pick up either as owners or as managers.
What about those who've been buying houses for several years and who have high cash flows over and above their depreciation? Perhaps now is a good time for them to go into business. Incorporate. They might sell their properties to their corporations now at prevailing capital gains rates (20% maximum) or they might contribute their properties to the corporation and allow it to sell off the marginal houses while keeping the rest. Initially, the sale might be done on an installment sale contract with a due-on-sale clause requiring the payment to be completed when the corporation sells the property. On those other properties retained as rentals by the corporation, income could be contributed to the pension plan tax free to reduce taxes once allowable depreciation had been taken inside the corporation. Or a combination of the above might be structured to produce maximum benefits. In this specialized area, the services of a good tax counselor are crucial. But there's still time to do something creative if you're vulnerable to high taxes this year.
Of course, the easiest thing to do is to continue to build your pyramid. But now you've got to be discriminating. The house has to make economic sense on its own without calculating the tax benefits. That means you have to pay less interest and be able to rent it for more cash flow. So SELECTION will be much more critical. In my MILLER TIME seminars I've been stressing this. Now, it's even more important than ever.
LOOK FOR THE SILVER LINING . . .
The proposed tax revision is fundamentally anti-tax shelter and anti-consumer. Serious investors, entrepreneurs, business/property managers, residential brokers, builders and developers, dealers, small corporations, distressed property buyers and liquidators will find ways to offset its negative aspects and to even increase profits if they try. Here are some strategic and tactical moves you might want to consider.
1. Use the residential preferences in the new law: $125,000 exemption for the over 55s, tax-free cash sales of personal residences, unlimited interest deductions for both 1st and 2nd homes. Anytime you can receive tax-free cash from sale or mortgaging of your residence (or anyone else's for that matter) and use it to pay off non-deductible consumer interest, you've managed to beat the system on that part of the tax act.
2. Use BUSINESS preferences. Sole proprietorships can employ spouses and minor children. They don't have to pay Social Security or workman's comp. Give your kids Notes you. can buy at discount in lieu of pay. They can collect up to $1000 interest-each year tax free to use for a college fund. Use their lower (15%) tax brackets to reduce yours. Combine operating losses on rental real estate with business profits to lower the overall tax bite. Start thinking of your investments as being a part of your Rental Business. Combine management you do for yourself–with management services you do for pay for others. This will give you write-offs for business losses investors won't get.
3. Use CORPORATE preferences. Become a one-man corporation. You're both the owner and the employee. Build in allowable fringe benefits such as cafeteria plans, insurance, prepaid legal services, health plans, below market loans, dependent or child care plans, pension plans. Maximize all retirement deducts- you can this year. Rent your property to your corporation for use in its business and take the deductions. Or put a low basis building into your children's' corporation. They can retain earnings or take the income at a much lower rate than you. And this divides the income AND the brackets. Use separate corporations to get additional fiscal years to spread income out.
4. Property held for investment or for use in your business can still be exchanged tax free: You'll still be able to sell for CASH, have it retained in escrow while you locate a replacement property which you can buy wholesale from a distressed lender, have the funds paid directly out of escrow to the seller, and have the property deeded to you. This is a tax-free move which will generate tax-free profits while allowing you to sell marginal rental houses to consumers in this hot market and to buy better investments.
5. With the top bracket at 32%, bear in mind that the best strategies will yield only that amount. Start focusing on ways to EARN MORE! It will cost less to speculate on sound ventures, to take more ordinary income from interest/dividends. To buy and sell rather than to buy and to hold. And the easiest cash flows will come from managing others properties – especially that held by receivers, trustees, lenders, etc. All cash-flow businesses which use little equipment and command high fees/profits will do better. This is a premium time to start thinking about converting your skills to cash flow. Look around for business opportunities you can buy with your real estate or mortgages which will generate high cash profits. The world is changing. So must 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
