October 1983
Vol 6 No 1
One of the redeeming features of real estate investment for years was its consistency. Winds of change could blow gales in the securities, commodities, gem and collectable markets while single family houses continued to plod like the proverbial tortoise steadily toward virtually assured profits. Events of the past 12 months have altered my concept considerably. Consider what's transpired.
About a year of so ago Congress re-enforced a Supreme Court Decision to allow lenders to have control over the right of one party to pass along favorable mortgage terms to another. This Due-On-Sale decision had an immediate effect on the value of SFH equities that measured in the thousands of dollars on a single house, aside from all other considerations of desirability. And conversely, it added value to all of those FHA and VA loans we've been advising you to buy over the years which you can either sell on wrap around loans to gain high yield or ask premium prices for in return for allowing a buyer access to fixed term, level payment low interest mortgages.
In some areas, specific relief from this legislation has been built in through “window periods“ created by virtue of legal decisions in affected states. Freddie Mac will not accelerate loans assumed by credit-worth people when the loans were assumed or originated within the following time periods for the applicable states. Arizona: July 8, 1971 – Oct 15, 1982, California: August 25, 1978 – Oct 15, 1982 Colorado: July 1, 1975 – Oct 15, 1982, Georgia: July 1, 1979 – Oct 15, 1982 Iowa: July 1, 1979 – Oct 15, 1982, Michigan: January 5, 1977 – Oct 15, 1982 Minnesota: June 1, 1979 – May 8, 1981, New Mexico: March 15, 1979 – Oct 15, 1982 Utah: May 12, 1981 – Oct 15, 1982, Washington: August 19, 1976 – October 15, 1982.
The law also contains other provisions which permit some maneuvering by buyers and sellers who are seeking ways to legally by-pass this legislation. Junior liens can be placed upon the property; it can be passed by operation of law to a joint tenant or an heir, or to a divorced spouse as a result of a property settlement. It can be leased up to 3 years if there's no Option involved, or be placed into Trust if the borrower is the beneficiary. And there are myriad rules now used by thousands who use the loopholes in conjunction with private agreements to evade the effects of this law. But enforcement of the law is being implemented by new banking regulations which are beginning to close many of these new loopholes. However, with each layer of subterfuge devised to skirt these regulations, the property liquidity is lessened. New buyers and lenders will be less willing to accept risks undertaken by owners in the fevor of creative transactions aimed at giving them the benefits of “non-assumble“ loan rates.
The negative effects of the Garn-St. Germain Act included slow down in resale housing, more foreclosures, and reluctance of new buyers to accept a hodge-podge of new loan schemes on new homes. Local mortgage bond programs sprang into existence, a mortgage backed mutual fund was started by the National Association of Realtors, laws were proposed to prevent foreclosures on VA loans for out of work veterans, and FNMA started buying 2nd's, wraps, seller-carry-back financing valued in the billions. The stops were pulled out on creative financing gimmicks to make homes more affordable. Some of the side effects have been positive in terms of opening up new opportunities. We'll take a look at new trends in this issue to see where SFR investors go from here.
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Credit Unions continue to offer favorable financing. Last week I heard of a 30 year loan which closed at 12% for investor financing with 2 points. During that same period the FHA rate was 13.5%. In another situation, the borrower didn't want to pay off an older 8% loan, but wanted to borrow out some of his equity. He arranged with his mortgage lender to purchase a CD in the amount of $15,000 and to place this in escrow with the lender for the purpose of paying off the $15,000 existing first in the event he ever defaulted on either the old or new loan. The lender then loaned him $55,000 on his appraised value of $68,750. He netted $40,000 in cash after depositing the $15,000, and still retained his old loan rate without the need for a wrap or paying it off. Since this constituted a junior lien, it didn't trigger the due-on-sale clause of his 1st.
NEW TAX DECISIONS AFFECT BASIC STRATEGIES.
Let's start with EQUITY SHARING. This concept first appeared in these pages in 1979 as a form of joint venture between an investor with deep pockets and an entrepreneur with high ambition. The investor bought the property and the entrepreneur leased it for a stated longish term at a stated net cash flow. Based upon his performance, he then had an Option to buy the property at a price which would equally divide the profits. It was never envisioned that the entrepreneur would actually OCCUPY the premises. Here's where it all began to go wrong. As others leaped aboard the band wagon with books and seminars, they changed things. First of all, the entrepreneur didn't find a wholesale deal. He found a house which carried high negative cash flow. He then got the investor to put up some of the money and got the tenant to offset some of the negative. In this way the investor received a highly leveraged yield and tax benefits. Emphasis migrated from the ability of the entrepreneur to the PAYMENTS of the tenant to make it feasible.
Only in 1981 or so did the IRS reluctantly agree that the property could be depreciated when a holder of “equitable title“ also used it as a residence. Now the fun is beginning to start at the audit level in which the auditor gets to make up his own interpretation of HOW MUCH rent is fair market rents, or whether or not a GIFT is involved, or whether there is a dis-proportionate allocation of tax benefits to the one who pays the small down payment vs the one who gets the benefits of capital gains and who must do the maintenance etc. It will be several years before these questions have been resolved definitively. In the meantime, it will pay to revert to our original idea.
Last summer the SUB CHAPTER S REVISION ACT OF 1982 threw open the doors to passive real estate holdings. Because this form of corporation is taxed like a partnership, it offers many benefits as a vehicle for joint ownership of property between a limited number of people. And it offered ways to maintain a low profile in communities where a large number of properties were controlled, since multiple corporate entities might be used to disguise centralized control. Coupled with the entitlement of the owners to convert to an ordinary, closely held corporation, with all the attendant pension plan benefits, and its relative immunity from investment interest deduction limitations, the corporate form of holding rental property is worth considering.
For several years SFH rental properties have been on the borderline of being considered INVESTMENT properties because of the inherent characteristics of rentals in which tenants were responsible for most of the maintenance and management. In the event that the IRS were to consider them as such, then the $10,000 investment interest rule could come into play. Under it, all interest expense in excess of net rents remaining after depreciation could be deducted up to $10,000. Everything above that amount would NOT BE DEDUCTIBLE. Picture the typical highly leveraged property, i.e. $100,000 with mortgages totaling $95,000 at an average interest rate of 16%, interest-only payments. In 1982, $14,250 would have been paid out and about half of that paid in in rents. But depreciation on that property would have completely offset rents. So only $10,000 would be deductible. The owner would have to pay ordinary income taxes on an additional $4250 EXPENSE that had been paid by rents. But if this property were a CORPORATE asset, this wouldn't be a problem, since assets held in corporations aren't usually investments.
In the process of destroying IRS myths, in Holmes, TC Memo. 1983-442 you can't deduct the cost of a trip to an area in which you have rental property to inspect when the primary purpose of the trip was for recreation or personal reasons. On the other hand, if your primary purpose was to attend a seminar and you spent your idle time in other pursuits nearby (i.e. Disneyland), they haven't taken away that deduction.
THE CASH SQUEEZE IS GENERATING VARIED RESPONSES.
Stockbrokers are beginning to offer Homeowner Equity Accounts. They've spread to a dozen or so states and provide a line of credit for homeowner purchases. You can't use the cash to buy stocks, but creative people should be able to come up with a use for cash in the SFH market. Merrill-Lynch, E.F. Hutton, Shearson, & Dean Witter brokerage houses can give you more information. Use these to defuse EMERGENCY balloons.
With long term rates beginning their rise to the 14% that I predicted last winter, your balloon notes pose an even greater threat. The recent up-tick in FHA rates drove an estimated 438,000 out of the housing market – straight into the rental market. But those rates signify a shortage of credit as consumers and the Feds rush to get loans before expanding business soaks it all up. Uncle Sam is going to have to borrow $100 BILLION in the next 90 days to refund its deficits. How much is a Billion? A billion seconds ago we were fighting WWII. A billion minutes ago was before the first Easter. A billion hours ago we lived in caves. A billion DOLLARS ago in Washington was YESTERDAY!
When you can't borrow, SELL! Your tenants are prime prospects. They're locked away from home purchases as affordability becomes increasingly rare. If you can build in after tax cash-flow payments which they can afford, they'll buy. How might that work? Suppose you have a house with a fair market value of $60,000. Under current FHA rates, the buyer would need to make payments of about $750 including interest and taxes. But he can only afford $600 even with his tax deductions, even though he might be able to qualify for the FHA loan. Here are some things that you might try in order to sell him.
a) Offer to rent the garage from him for storage for $150 per month the first year.
b) Hire him to perform maintenance at $150 per month on a contract basis.
c) Give him a “decorating allowance“ which would offset a year's payments.
d) Give him a cash re-bate for future maintenance contingencies.
e) Let him pay a high proportion of his down-payment with a note secured by other property, or with the other property itself, and reduce his loan amount.
f) Lend him the cash for his payments on a private line of credit up to $1800.
g) To the extent possible under the law, buy down the interest rates, payments, and down payments under currently available financing schemes.
h) Give him an allowance for fixing up the property for maximum loan value,
Don't overlook the strategy of discounting your property to an investment syndicate at wholesale, with the provision that you'll either lease it back, buy it back, or both to generate the benefits they need. For instance, suppose you sold 5 houses with a fair market value of $300,000 and an equity of $60,000 to a group of investors for $25,000 plus a non-recourse note, payable at 10% interest only. You have the option of buying back the property, one house at a time, for $5,000 plus assumption of all loans after 5 years. If you bought them back yourself, this would have been tantamount to borrowing their money interest free for 5 or more years. Plus you'd have cash-flow from their note for the period. And they'd have all the management headaches and maintenance in exchange for an attractive investment package which they'd buy at wholesale prices.
“Thousands of people bought houses in 1980 with 3 year balloons. There just isn't enough money to go around for all of them. Start re-negotiating yours now. Offer a higher interest rate, a higher principal, points, an interest in another property or a partial interest to represent the value of the balloon IN THE PROPERTY YOU'RE BUYING. One fellow leased a Mercedes Benz and made the monthly payments for relief from paying off a loan. Another offered the use of ocean front vacation timeshares. Be creative!
IN THE POTPOURRI DEPARTMENT . . .
Affordable homes are a vanishing breed with higher mortgage rates. New houses are averaging about $92,000, registering 12% annualized increases in value. Medium income families can't buy. They're looking elsewhere – at Mobile Homes. 30 year VA loans are available for them. So are FHA. And Condo MH parks are a hot item. Especially in Texas, Arizona, California and Florida. Even the factories are getting into the act. By selling the sites, many landlord and tenant disputes are eliminated. And Mobile Homes on permanent sites appreciate just like houses. Think about it, there's not much competition for buying MH at distressed prices in good locations as rentals.
Sears has been threatening one stop shopping for years. Coldwell Banker has announced several trial locations in which shoppers will be able to buy land, condos, or single family houses together with all their personal furnishings. They'll be able to trade in their old homes in one area and buy another one across country. They'll be sold their insurance at Sears. They'll be able to invest through Sears. Tallahassee and Fort Myers outlets and Miami stores are already open with a total of 100 planned.
Lots of new books are out. “Turning Home Equity into Income for Older Homeowners“, $3., Consumer Information Center, Dept 235L, Pueblo, CO 81009. Write to the same place ATTN: PROPERTIES if you want to broker Govt land sales. Gwen Fitzpatric at The Kiplinger Washington Letter, 1729 H St. N.W., Washington, D.C. 20006 will sell you a 300 page book: “Buying and Selling a Home in Today's Markets“ for $4.40. And James Warkentin has a new course workbook: “BUYER BROKERING“ to support his excellent course. For information, write 6641 Backlick Rd, Suite 201, Springfield, VA 22150.
Representative Ron Paul has a new Hot Line (202) 225-5241 with a 3 minute message which brings callers up to date on current legislation dealing with the Fed, money and finance, The Treasury Department, and various committee hearings. Call on your dime!
You can save $25 – $50 by buying T-Bills directly from the nearest Federal Reserve Bank's Fiscal Agency Dept. Write: “This is my tender and non-competitive bid for the Treasury Bill auction on (date) for__ (13) (26) week T-Bills“. Bills must be denominations of $10,000 initially then in multiples of $5,000. Include your social security number, name of entities in which you want bills issued and include a cashiers check made out to U.S. TREASURY. You'll receive a receipt and your interest after the auction which takes place every Monday. They'll even roll over the Bill if you want. In recent court rulings IRS can seize and sell jointly held property to pay taxes owed by only one spouse. And the US Supreme Court ruled that a landlord's property can be sold to satisfy tax liens of a LESSEE under certain conditions.
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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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