October 1986
Vol 9 No 12
Remember the good old days? You bought a house using multiple mortgages to get 100% financing. You got the owner to carry back the financing for as much as possible of the purchase price by offering to pay high retail prices and high interest rates, and you willingly paid the resulting negative cash flows. Why? Because you'd found this terrific secret to wealth, LEVERAGE. Combined with INFLATION and government subsidies in the form of TAX WRITE-OFFS, you couldn't miss. Millions of people made millions of paper dollars using this fail-safe technique that they learned from the various minstrels who wandered from investment club to investment club and across the TV screen on a continuous cycle.
And there were even more benefits. Someone came up with the brilliant concept called Equity Sharing wherein the entrepreneur negotiated the purchase of an investment property using the above super leverage, found another party whom we'll whimsically call the 'INVESTOR' who could borrow enough at his own bank to fund a small down payment, then located another party who agreed to pay extra high rent payments sufficient to defray most of the negative cash flow in return for a share of the appreciation. Wow!
Regardless how the properties were purchased or managed, operating losses added to depreciation and accelerated cost recovery could be deducted in the year they occurred against ordinary income to lower tax brackets of high income wage earners. After inflation had driven up the price and the property was sold, 60% of the gain was exempted from taxes through the mechanism of long term capital gains. And even the remaining 40% could be spread out into other years when the seller elected to report gain on the installment basis. This was magic. It didn't take people long to learn how to make it even better. When the properties were bought, the financing might call for interest-only payments which would be fully deductible. And why buy the non-depreciable land beneath the buildings when it could be left in the hands of the seller and deductible land rent could be paid on it to provide even more profound tax benefits. We also learned how to 'pull equity out tax free' via new loans. No wonder so many people became closet moguls through ownership of real estate.
The Joker in the deck was that, with highly leveraged property, we were able to harvest these benefits even though the property was effectively still owned by the lender. And he jumped in too by structuring negative amortization loans whereby we didn't even have to pay the interest, but could let it compound to be paid later after the property had enjoyed the benefits of rapid appreciation. After 1980 everyone wanted to get into the act, so syndicators flocked in from the oil and gas fields and started selling real estate that neither they nor their eager syndicatees really understood. All they needed to know was that property generated write-offs. They competed to pay higher and higher prices, driving costs to astronomical levels and creating market conditions in which real estate began to behave like commodities rather than as functional tangible assets. It was a fool's paradise!
I NEVER PROMISED YOU A ROSE GARDEN . . .
Beginning with the July 1983 letter, and over the past 36 months I've been warning readers of the effects of the new tax act and recommending specific actions which would minimize any negative impact on your portfolios. And since the first issue, I've told you was to buy property which, if followed, have kept you safe from any damage to your
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single family house portfolio. Now the count down has started. With most of the new tax act's provisions scheduled to start taking effect in 1987, you've only got 3 months in which to complete any actions needed to adjust your portfolio and your activities under 1986 laws.
First, look for the major thrusts of the new tax act you need to consider. In 1987 you'll only be permitted to deduct 65% of your losses in excess of your income from real estate. And you can't include any income from non-real estate sources such as dividends, interest, royalties, wages and salaries, etc. With rentals where the owner/tax payer takes an active part in the management, an additional $25,000 will be deductible against other non-passive income, but this won't be available to those owning less than 10% of the rental real estate generating the losses. And it will be phased out on incomes over $100,000.
That means that 1986 is the year to catch up all that deferred maintenance, pay off any high interest rate loans you can, sell negative cash flow properties to USERS for CASH and use it to prepay property tax bills in December if possible, buy materials and expensible supplies. In short, you're going to try to pay on any foreseeable expenses you can during 1986 when they'll still be fully deductible against your other income. If you don't have the cash, consider setting up a line of credit so you can pay for these in 1986. Depending upon your personal situation and tax bracket, you may decide to use your cash to pay consumer loans. Interest won't be deductible fully in 1987 either. And since sales taxes won't be deductible in 1987, if you're planning on any major purchases, better do it this year. Remember, deductions won't be worth as much to most people after this year.
Installment loans are going to be tricky. It won't pay you to carry paper after this year on loans made prior to January 1, 1987 since all installment payments received after that time will be taxed at ordinary income rates. This is a judgement call, but as a rule, any loans that might pay off in the next 4 or 5 years will be taxed at a lower rate overall if they're paid off this year. If you can induce the payor to advance the payoff into 1986 you'll get long term capital gains treatment. Minimum tax will be at a lower rate if it's involved. And you'll be able to use the cash to get your properties repaired.
In the event the payor is also going to lose his interest deductions, you might point out to him the advantages of his paying off his loans too on his own investments. On the other hand, if the payor is living in a house that you're carrying 'paper' on, you should show him how his payments would be reduced and/or how he could pull extra cash out of his residence to pay off his own consumer interest items while still getting to deduct his mortgage payment interest on his personal residence. You might even offer a bonus to induce the conversion of outstanding paper to cash in the form of a discount. Of course, if your ordinary income tax rates can be reduced to a level below the current capital gains rates as a result of the new tax act, there's no point in worrying about whether the payments you receive are capital gains or not. You're going to have to do your own calculations. But there's one more thing to consider on 'paper' you're carrying.
Suppose you decide that it would be better to pay taxes in 1986 on paper gains rather than in a subsequent year. On new loans made in 1986 you can elect NOT to have an installment sale and you'll be taxed on the full paper profit in your Notes. If you have existing loans which are currently being treated as installment contracts, you can use the Notes and/or mortgages/Trust Deeds to buy something else with. This will automatically cause them to be fully taxable this year. What might you buy? That new car, another house, maybe another Note or stocks, bonds, etc. Remember, don't take unnecessary losses lust to avoid 1987 taxes. Do your computations as to the present value of any course of action you might take FIRST to be sure it's to your advantage. And get the best tax advice you can from the most competent person you can find. Until the cases are judged, virtually anything you do could be determined later to have been ill advised. We're all flying blind. Until the new tax act is passed and effective dates are published, you should be able to get 19 year write downs on any properties you buy for investment or for use in your trade or business. Be on the lookout for panic-sale bargains at year's end.
THERE'S NO PLACE LIKE HOME . . .
Section 1034 of the IRC says you can sell your house and still keep the cash profits tax free IF you buy another replacement home within 2 years. And if you're over 55, you can still sell your home and take up to $125,000 in gain tax free whether or not you replace your home. But there's more. Under the new tax act you're entitled to own two residences, mortgage them up to your adjusted cost basis, and use the money for any purpose you choose while continuing to get full deductions for the interest.
The single family home appears to have sailed through the new tax reform act virtually unscathed except for those which were bought more for tax shelter than for true investment purposes, and the combination of special tax breaks for them are going to make them even more attractive both as investments and for those in BUSINESS of buying, selling, fixing them up as inventory held by DEALERS. They're going to get to be a lot better once the impact of the new tax act has been absorbed by the real estate market. In the meantime, there are several concepts which might be workable. On a purely theoretical level – and that's the only level there is when one considers an unwritten, unpassed tax law as the basis for planning a strategy for the rest of this year, consider these approaches:
Assuming that you're going to be in trouble with negative cash flow houses unless you reduce the interest payments, you might sell your current residence if it has a high equity, use the cash to reduce debt and lease a replacement residence for two years until you're able to find the home you're looking for. The condo market is a great place to find a willing owner who'd welcome a year around resident. Condo owners are going to be hurt more than most when the maintenance fees are added into the other costs of ownership. And in resort areas, with seasonal rentals, it might be possible to snap up a real bargain as a replacement home if you're so inclined. This would allow you to deduct 2nd home interest.
It's easier to tell you to sell your home than for you to actually take the steps to make a move. It will be easier for those who can take advantage of the over 55 $125,000 one-time exemption. They'll have more incentive and they'll be able to use the cash to buy some real bargains in the next year or so as thousands of properties come on the market at distressed prices. If we can use the depression of the '70's' as an example, leveraged Real Estate Investment Trusts were in about the same position as General Partners are in tax shelter syndicates. They'd signed personally on millions of dollars in loans and they gave properties back to the lenders and bankruptcy trustees by the thousands. It will happen again as the full impact of the new tax rules are felt. And lenders will be willing to sell at prices and with terms unlike anything seen since the mid-70s on foreclosed properties.
What about borrowing against your personal residence? Most of us only have one primary residence. I expect we'll all be owning two shortly because of the interest write offs. The trick is to get a high basis in a free and clear property, mortgage it at today's favorable rates, use the money to position oneself advantageously for the future by buying distressed properties, discounted installment sale notes from those facing loss of capital gains, paying off consumer loans and de-leveraging negative cash flow properties, deduct the mortgage interest under the primary and secondary residence rule. How might one do this?
1. Sell rental houses, carry back paper, use the paper to buy the F&C house. This would (a) trigger the tax on the paper in 1986 giving you long term capital gains, (b) reduce your negative cash flow on potentially undesirable houses which might need costly repairs in a few years or which might have escalating interest costs or taxes, (c) reduce your liability on loans while improving your financial statement so you could, (d) get an owner-occupant loan on the larger house which might be unavailable to you as an investor, (e) which loan proceeds could then be used to pay the taxes incurred by step (a). Your loanable basis in the new residence would equal the value of the paper you bought it with.
2. You could repeat the process above, but instead of putting a mortgage on the new residence, CREATE a mortgage and use it to secure existing loans on other investment properties so that they would be effectively financed by the equity in your residence. This is called substitution of collateral. It requires the consent of the lender, but he might be willing to accept the security of a primary residence in preference to investment property if he were approached in a constructive manner.
THERE'S MORE THAN ONE WAY TO SKIN A CAT . .
The effect of the new tax act will be to penalize leveraged investors, high bracket wage earners, corporations to the extent they can't pass their costs on to the consumers, and consumers who live from one credit card to the next. IT REWARDS THE SMALL BUSINESS MAN! For property used in trade or business, he'll still get 100% deductions to offset his business income. You won't be able to suddenly start calling your houses and rental units a business even though they might be placed into an 'S' corporation. But you will probably be able to deduct operating losses from dealer activities, re-hab/re-sell operations, retail space, office buildings, nursing homes, elder-care facilities, Pizza Parlors, Restaurants, etc. where the REAL ESTATE location and facilities make a major contribution to profits.
The new act permits you to offset losses from ACTIVE businesses against ACTIVE income. Motel operations are among those classified as active. Rentals are PASSIVE and only PASSIVE income can be offset by PASSIVE losses. Interest, dividends, royalties etc. are PORTFOLIO income. They can't be offset by passive losses, but those who manage their own portfolios will be able to deduct up to $25,000 of real estate losses against all types of income, and that begins to phase out on incomes above $100,000. The trick is to find a way to get ACTIVE income into a PASSIVE pocket. One way is to use a limited partnership. All income from a limited partnership interest where it represents 10% or more of ownership is defined as PASSIVE. There are still lots of loopholes for the entrepreneur left to find.
October's ART HAMEL SEMINAR is a step in that direction. The nation's PREMIER BUSINESS COUNSELOR is giving us a special 2 day symposium on ways to convert our PASSIVE real estate interests into ACTIVE, tax-advantaged, profitable cash-flow businesses that we can manage within our resources. After you've learned ways to do this for one day, I'll conduct a special EVENING SESSION to find ways to put this into practice with rentals. In the following 3 day COMMONWEALTH CONVENTION we'll pick out special formulas for buying that will avoid the negative impact of the tax act and give you ways to work out future problems.
We're poised at the edge of great opportunity! 85% of all tax payers will be in the 15% bracket as will most small corporations, releasing billions in spendable cash to consumers. Real estate fundamentals will re-assert themselves. We'll discover brand new concepts to use in buying, selling, holding, managing properties – and commensurate rewards. The new tax act leaves the playing field to those who can learn innovative techniques and put them to use. The CommonWealth Letters will remain in the vanguard so you'll prosper even though others may fail. And I think you'll find single family houses better than ever, once the new tax laws have driven the amateurs and speculators into other fields.
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Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
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