June 1994
Vol 17 No 10
Last month we started discussing negotiation techniques from the standpoint of getting information upon which a negotiation strategy could be based. We covered ways to get answers to Who, Why, What, Where and When questions. This month we'll try to cover 'HOW' to use this information to structure deals.
'HOW'? Ah, there's the rub. All we've done thus far has been to define the problem. Solutions are the tricky part. By and large, if you don't provide an acceptable solution, you don't make your deal. But the more thoroughly you understand the problem the more probable that you'll be able to find a solution. The most interesting part of this process is that other buyers can't compete effectively once the seller sees that you're trying to solve his personal problem while acquiring his property.
There are no short cuts to problem solving. It requires broad knowledge of conventional and creative finance, management, tax law, exchange techniques; zoning, density and use regulations, Options, Leases, and 'paper'. Lack of knowledge is why so many people fall short of achieving their estate building goals in real estate. They aren't prepared to study the field on a more or less continuing basis despite the fact that knowledge in the field commands one of the highest premiums of all and ignorance extracts the highest costs.
In the process of finding solutions, you can break things down a little. Do the people need cash now, or can they wait? If they have income tax problems, would it be better for them to exchange their property for something that they'd be able to borrow against? Or, would an installment sale be better for them? Maybe more tax shelter? Is occupancy of their current premises critical to them? Are rising property taxes the culprit? Or inflation? Do estate taxes affect decisions? What about management and maintenance? Do they need a secure income stream? What do they need the cash they are receiving for? Can you help them meet their goals in some way that saves you cash, gain and interest?
In almost every instance, except dire distress, you'll have to 'sell' your proposed solution to the sellers in order for them to understand and accept it. Straight cash for large discounts is simple to understand, but difficult for sellers to accept. On the other hand, the subtleties of 'paper' and terms can generate equivalent profits for the buyer and are a lot more acceptable to the seller. It really pays to learn all you can about creating and using mortgage notes in buying houses. Let's look at some structural variations
TAILOR YOUR STRUCTURES TO MEET INDIVIDUAL NEEDS!
There's a tenancy for people to look for 'cookie cutter' techniques that they can use over and over, but it has been my experience that standardized methods produce only average profits. If you want to excel, you have to put a little more effort into assembling various strategic components parts of a transaction to add value. What might these be?
Every transaction has a potential tax effect which produces gain or loss which may or may not be recognized for income tax reporting purposes, depending upon the structure. Anytime that high tax bracket sellers or buyers are entering into a transaction, taxes should be on everyone's mind. The tools we have at our disposal to minimize the tax costs to a seller include
(1) Sale of an Option: Suppose I need cash, am 'borrowed out' and have a tax problem. Selling and recognizing gain will merely make the tax problem worse. By selling an Option, I can defer the tax until the Option is either abandoned or exercised. In 1982, GMC sold a 10 year Option on its headquarters building in New York City for $500 million, deferring taxes for 10 years with full IRS approval.
(2) Installment sales: For the most part, a high bracket, cash basis seller only has to pay tax on profit as he receives it. Tax on gain may be deferred for decades under the terms of a note on which only interest is being paid. Otherwise, tax on gain may be spread out over the term of a self amortizing loan.
Even situations in which gain would be attributed because of mortgage debt in excess of adjusted cost basis, an installment contract wrapping around the underlying loan can effectively prevent that gain from being recognized. The essential feature is that the money being spent to pay down the original debt be segregated from money being received under the terms of the contract.
(3) Changing the fiscal tax year in which taxes will be recognized: A property can be contributed as capital to a corporation that uses a fiscal year rather than a calendar year. Then it can be sold by the corporation. This effectively moves the sale into a subsequent year.
OPTIONS AND TAX FREE EXCHANGES CAN WORK WONDERS
(4) Option Techniques: Instead of using a corporation to change the fiscal year, why not use an Option to switch the year of the transaction itself. An Option might be sold in one year and exercised in another to switch years. This works well under Section 1034's residence replacement rule in which a cash sale of a residence may be rolled over no more than once every 2 years in order to avoid tax on gain.
Suppose a party had a willing buyer after only 1 year. If an Option were sold and 2 years were to elapse prior to consummating the sale, the problem would be solved and cash received tax free. Section 121 allows a one-time deduction of $125,000 for those over 55 who are selling their principal residence. The Option gives a seller time to reach age 55 prior to completing the sale. Timing delays can save taxes under IRC Sections 1031,1034 and 121.
Timing is also critical under Section 1031 which requires a holding period of one year prior to, and following, the closing of a tax free Exchange. The same delaying technique using Options will work with Section 1031 as with Section 1034, and also with Section 121 to control the timing of the transaction.
(5) Exchanging: You can trade property for other property and defer taxes indefinitely if you follow these rules under Section 1031 of the IRC: Only property not held as inventory in the ordinary course of business or for personal use can be exchanged under Section 1031.
On the other hand, any property used in your trade or business or held for investment for one year (2 years between related parties) prior to and following the exchange can be traded tax free with a few exceptions and limitations. Under IRC Section 1031, real property must be exchanged for real property and personal property must be exchanged for personal property. You can't exchange Notes or Contracts, stocks and bonds.
With free and clear property, there's usually no problem. With encumbered property, any reduction in net mortgage debt following the exchange will be taxed as gain. So long as a person is exchanging for properties with more debt on them than on the properties being given up, there isn't much of a tax problem. Here's how this works.
I once owned a $70,000 house with a $3000 loan on it that I wanted to sell in order to buy more houses with higher leverage. I found a guy who had 15 houses worth about $25,000 each with $300,000 in loans on them. He needed cash and didn't have enough equity on any of his highly leveraged houses to secure a new loan. I paid off my loan and we made an exchange.
Voila! For $3000 out of pocket, I wound up with 15 houses that were already rented up subject to $300,000 in loans. This gave me a depreciable basis equal to the basis in my former house plus the debt on the houses I'd acquired. He got a free and clear property against which he was able to borrow $50,000. He paid some taxes on his debt relief but I paid none.
LEASING AND GIFTING STRATEGIES HELP MAKE DEALS
(6) Leasing techniques: Leases can act a lot like notes that are indexed to the inflation rate. I just spoke to someone about a property that had been leased for 17 years to a quick food restaurant chain with 8 years left on a fixed rate lease that produces $25,000 net per year to the owner.
For $250,000 I was offered the restaurant and land SUBJECT to the lease which would produce 10% net in income for 8 years. At the end of 8 years, all rights in the land and improvements, which are fairly valued today at $150,000 today without the lease, would revert to me. If inflation averaged 10% annually for the next 8 years, the purchase-power of the lease income would be diminished by 10% per year by inflation without counting any income tax increases. On the other hand, the underlying property would have appreciated to $321,538 based upon real estate values.
Suppose, to raise the $250,000 purchase price, I were to get another buyer to put up $150,000 for the land and improvements alone, and in a separate transaction, I were to pay $100,000 for the lease itself. The other buyer would more than double his money, and my own yield would rise from 10% to 18.6%. Everyone would be happy, but I'd be a lot happier, especially in a market where savings earn 3%.
Let's reverse things. Suppose the high bracket owner structured a lease Option under the terms of which, the property would be Optioned for $100,000 at year #1 with $50,000 required to close the Option when the lease expired. Assume that the lease sold separately for $100,000 as above. The Optionor would retain depreciation benefits and defer taxes on the $100,000 for 8 years Then he'd receive an additional $50,000 at the end of 8 years upon exercise of the Option to help pay capital gains taxes. Assuming the land to have appreciated to $321,538 as above, the land buyer would have boosted his yield on the $100,000 price with little effort or risk to over 15.7%. That means his investment would have been going up twice as fast as the 10% inflation rate by using the Option.
(7) Gifting strategies: Suppose low basis, high bracket sellers were willing to sell with nothing down on a well secured note yielding 8% interest only in today's market. Recognition of the gain on sale would place their payments into the top income bracket. In the 36% bracket, 8% interest would amount to only a little over 5% after taxes. Suppose they needed at least 6% after taxes to support their lifestyle? They might make a gift to a qualified charity in return for a lifetime annuity of 6% per year. That would provide security and a predictable income stream while saving capital gains tax expenses. So far so good. Where do you and the charity come in?
You agree to buy the property from the charity and to pay 7% interest-only with a balloon due within 180 days of the demise of the last of the sellers to die. This way, you get the property at 1% lower interest rate. The seller gets a tax write-off for the market value contribution of the property without any taxable recognition of gain at all. The charity gets the 1% more than it pays out in income as well as the final principal balloon payment later on. Nobody loses. Everybody wins. Except Uncle Sam.
SELLER FINANCED MORTGAGES WORK THE BEST!
Howard Cook's Mortgage Report ((813) 376-5617) is the be-all and end-all of newsletters which go into the details of discounting and compounding loans. It's far beyond my competence. But for now, we ought to at least consider some basic variables and relationships of debt instruments.
Anytime you can defer payment at below market interest rates, your effective price is lower. If the market calls for 10% on a $100,000 loan and you can pay 7% over 10 years, you'll have saved $14,345 in payments. This increases to $21,517 over 15 years and $28,690 over 20 years. If you can negotiate rates down by just 1% less from 7% to 6%, you'll increase the savings to over $6000 during the 10 year loan repayment period. Your main negotiating thrust should be to reduce interest rates by offering to pay higher payments or a higher price.
Suppose you offered to pay back $125,000 total for a $100,000 house loan including 10% interest with payments of $800 per month on the loan until fully amortized. It would take 156.25 months to repay the loan. Contrast this with a loan of $100,000 plus 10% interest with payments of $888.57. It would take 30 years to buy the house. Look at the difference: You'd pay $88.57 less each month for the first 156.25 months and $800 less for the next 203.75 months for a total savings of $176,839 over the entire term. Who would accept such terms. You'll never know until you learn to negotiate them, but many people accept zero interest financing. Why? First of all, they get a much faster pay back of their principal. Second, they're mesmerized by the extra $25,000.
In many instances, a higher payment level and shorter term may be required. 1% of the loan balance per month for 100 months has gained wide acceptance. That's a full repayment in 8.5 years. Or, a larger cash down payment may be required – say 20% rather than 10%. But when the transaction can be structured to give the seller the tax and cash flow benefits he or she needs, it's often possible to dispense with interest of any kind. Try it, you'll like it. And once tried, you'll never feel comfortable about paying interest again.
Let me tell you a little war story. Out of State seller, single, 55 years old, had a free and clear house he'd bought at a foreclosure sale for $26,000 marked up to $64,000. It was worth about $50,000 retail value and none of the local brokers would work on it at all. He wanted $6000 down and was willing to carry the balance for 20 years at 10% interest payable at $483.33 per month. He had lost his job and needed income to bridge the gap between age 55 and 65 when he'd get Social Security payments.
He accepted an offer of $64,000 with $5000 down and $500 per month for 120 months including all interest. Why? Because it gave him more income, got his house sold, cured his anxiety about vandalism, stopped his need to pay for taxes and high priced insurance, put money into his pocket. Most of all, he accepted the offer because it was the only one he'd received from someone who asked him why he needed it.
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