Decisions which are made at the Federal Reserve, like interest rate changes, and IRS rule changes or other political rule changes ( like Dodd-Frank) all have a serious affect on real estate investors ability to make a profit or even do business. That’s why it’s important to keep information of any tax or law changes which affect your business.
This article, from Jack Miller’s Dollars and Sense book, gives more details about why you need to stay informed of tax and law change.
As Boy Dylan sang, ‘things, they are a-changing’ and we’ve got to be able to adapt to them. First of all, we’ve learned that national news headlines don’t always affect our local situation. In some regions, real estate is booming. In others, it’s depressed. In some areas, state and local tax policy is aimed squarely at real estate profits and values. In other states, real estate has privileged status.
We know now that the selection of the political and economic environment in which we invest in real estate can make a big difference in how much money we make. The biggest favorable indicator as to the desirability of an area for investment is where population is growing and the average per capita income is rising. This is happening in the Southeast.
It doesn’t do much good to have a growing population of poor people who will drain the welfare rolls and cause taxes and crime to rise. Nor does a relatively rich population with rising incomes do much good if people are moving out. It takes both disposable after tax incomes and housing demand for real estate yields to rise and for investors to prosper.
When we consider the immediate effects of politics and economics, we can see that the Carter influence was for the most part inflationary, as was the Johnson and Clinton influence. Conversely, the Reagan and Bush administrations’ tax policies depressed prices and interest rates.
In the 90s many people discovered that our recession for the first time affected white collar workers more than blue collar. Executives filed for bankruptcy protection in record numbers. Reduction in defense spending at the national level created an uneven playing field as closing of bases and defense plants in some areas such as California created much more distress than in other areas such as Texas did. Anytime government is the source of wealth rather than non-government business activity, real estate is vulnerable.
To be a successful investor, we have to be able to keep abreast of political decisions that affect our rents and property values. Because real estate is fairly illiquid, we have to be able to predict trends as far out in the future as possible and take remedial action.
For example, I know of one person who sold all his houses in 1981 and carried back fixed rate 15% Notes from the buyers. He was a big winner as appreciation slowed and interest rates dropped. Good mortgages were a better choice than house ownership when prices fell.
When the 1986 tax act turned so many properties into alligators, he avoided all the losses because he’d sold his houses to owner occupants who’d bought them for their personal use rather than to investors who might have handed them back. With lower interest rates, they refinanced their loans, paying him off in cash. Now he’s ready to buy houses.
Once again, things are once again about to change. The 1993 tax bill restored unlimited write off of real estate accounting losses against all other types of income for those who earn at least 50% of their income in real estate. Tax credits for low income rehabilitation projects have been restored permanently together with tax free municipal bonds used for home financing.
Holding investments in small business corporations can offer much in the way of tax benefits so long as the corporation earns at least 40% of its adjusted ordinary gross income is derived from active operations and not from investments.
Added to the advantages of more write offs, these small corporations pay much less taxes in lower brackets and enjoy many more deductible write-offs that individuals simply aren’t entitled to. By using corporate tax years that are offset from individual tax years, many tax advantages can be obtained.
In the current litigious environment that prevails in many areas, landlords and real estate investors have much more need for ways to protect their asset. Small corporations in combination with Land Trusts can shield personal assets from investment related liability. These are just a few of the ways investors are beginning to adapt to changes.
Tax free property exchanging is another technique to avoid taxes and increase profits. Although Exchanging has been around for 70 years, it’s just now coming into its own. Here’s how Exchanging works: Rather than merely selling and paying taxes, owners of property held for trade or business, investment or for the production of income can be sold and the sale proceeds reinvested in replacement property held for any of the above purposes with all taxes avoided.
But, there can be problems for those people who have taken maximum accelerated depreciation over periods shorter than the loan amortization term, or who have borrowed on their rising equities through refinancing or equity loans. They are going to pay some taxes when they Exchange their properties. To the extent that their mortgage debt exceeds their adjusted depreciated tax basis, gain will be recognized and taxes incurred. Nevertheless, the balance of the exchange will be tax free. That’s no small thing.
I’ve just mentioned taxes in passing to bring home the point that no serious wealth builder dares to remain ignorant of the effects of taxes on a growing estate. Here’s one illustration of the effects of taxes: Let’s say that you were able to routinely earn $30,000 per year by buying and selling, and that you could invest this in mortgages which earned a consistent 15% yield year after year.
Without any taxes at all, after 15 years, you’d be able to retire comfortably with a net worth of about $1.5 million. That’s not very likely. Here’s why. Let’s look at what happens if you’re taxed in the 28% bracket over the entire period.
The $30,000 per year would be reduced to $21,600 and the 15% yield would likewise be reduced by 28% to 10.8%. Using these figures, you’d only have accumulated the sum of $731, 379 – about half as much as before without any taxes.
If you were able to continue to invest at the same 15%, your retirement income would have dropped from $214,000 more or less to about $80,000 per year. That’s the difference between luxury and middle class life style. It’s also why it pays to understand ways in which taxes can be minimized or deferred. Every hour spent learning tax rules can pay off for the rest of your life in terms of higher net income.
For the present, it looks as if the Obama administration might also add to the deficit crisis, and this could easily translate into higher inflation rates, rents and house prices. Implementing inflation-oriented investment strategies will work to create fortunes for those who know how to invest in things that inflation helps.
On the other hand, there are deflationary forces among us that could move incomes, rents and prices down. We can anticipate that each year more and more money will be consumed by government in the form of taxes, fees, licenses, fines, penalties, etc. Adoption of universal health care will surely raise the deficit if government fails to raise taxes to cover it. So will welfare reform for a time.
Of course there’s the constant threat of war. Obama, Reagan, Bush and Clinton have each involved us in military adventures which legally gave servicemen and their families the right to live in our dwellings without having to pay either rents or mortgage payments. This proved a disaster for those who were affected by it.
In recent years, we’ve seen what deflation has done to the Russian economy and what inflation has done to the German economy. Both are in shambles. What should we do? The bottom line is that we have to HEDGE in order to take advantage of both inflation and deflation. And if neither takes place, we’ve got to be able to deal with that eventuality too. How?
Inflation Can Radically Alter Investment Decisions.
When inflation starts to rise, the Federal Reserve clamps down on credit by raising interest rates. This causes variable interest rate loans and new loan rates to go up too. Unless rents can be increased to offset increases in operating costs and interest, the value and liquidity of most real estate and the yield starts down. Fewer buyers can qualify for loans. Fewer banks are willing to lend as much on the inflated equity values, so credit starts drying up, leaving real estate sellers high and dry without buyers.
Fixed rate Mortgages and Leases held by investors also start losing value. Let’s say that a given Mortgage or Lease offers an income stream based upon 10% of the $100,000 value of the Note or leased property which we’ll say is $10,000 per year over the next 10 years without regard to any principal payments.
Suppose inflation were to cause lenders to raise interest rate yields to 15$ to offset inflation and the higher tax brackets that accompany it. That means that a rational investor looking for the best possible safe yield wouldn’t pay more than enough to provide him a 15% yield.
The value of the Note’s or Lease’s income stream would have to be discounted to yield 15%. This would compute out to about $75,000. The owner of the Note or Lease would have lost 25% of its market value even though interest rates would have only gone up 5 points. Let’s look at the other side of the coin.
When we borrow money on a fixed rate loan or sign a lease, as a tenant, with a fixed rate return, inflation is good for us. It permits us to raise our rents and prices while paying the old interest and/or lease expenses. This is mitigated to a certain extent because, as our profits rise, so does our tax bracket and operating costs. As lenders and Lessors, we should either work on short term Notes and/Leases, or implement some sort of indexing mechanism which will cause our yields to match the inflated market rates.
In the real estate business, commission income is directly related to sale prices rather than to the owner’s profit. So inflation brings higher rewards to sales people, loan brokers, and vendors and in fact most people who can raise their prices enough to stay ahead of it. When you perceive inflation beginning to affect the market, look around for a business you can buy into with fixed rate mortgage paper. For example, I was recently offered a piece of a real estate brokerage I could have bought with Notes I own. You might use any fixed rate mortgages as down payments on houses.
Try to sell or trade in property on which there are long term fixed rate leases. Only accept cash, other marketable property, short term or well secured variable rate notes in payment. Use any cash to buy deep discounted Note, and then give the payor an incentive to pay you off early via refinancing. And raise all your rents as often as you can.
Remember, Income, Amortization, Depreciation benefits continue to hold value in inflation, but appreciation is the name of the game, and will make you the most profit. When you can participate in an inflationary market with high leverage, you can realize profits far in excess of the actual inflation rate. Here’s where the value of fixed rate and zero interest loans shine. But the all-star champion of the inflation game is the lowly Option. It provides maximum safety with maximum leverage and potential profit. What have we learned from this?
Inflation causes the value of fixed rate financial assets to drop. It reduces the bottom line profits because income rarely keeps up with rising costs of expenses. It reduces the real cost of interest in terms of income and yield and it removes much of the market risk associated with highly leveraged real estate.
This is the time to become a dealer, buying and selling as prices move up. You can make money tying up improved property and land with Options, joint venturing construction and rehab projects, syndicating investor groups and using debt free funds to buy and sell. It’s also the time to develop operating lines of credit to use in quick turnaround buy/sell operations. Anytime you can freeze your costs and increase your rents and prices, you’ll benefit from inflation. To the extent your costs rise with inflation, you’ll miss out on some of the goodies.
Deflation Requires the Opposite Strategies
The term deflation simply means that prices are going down for most things. Rents, Interest, Growth, Profit margins, etc. Where the real cost of high interest in inflation might be negative, low interest rates in a deflation are much higher than one might suspect. Here’s an example:
In 1980, fixed interest rates on 30 year California mortgages ran as high as 17.5%. Houses were appreciating at about 24% per year. The true cost of interest was negative 6.5%. Today, there are still many 7% interest rate loans available, fixed for 30 years, and interest is being hailed by the politicians as being at an all-time low.
In 1994 in many areas including California, property values aren’t rising at all. In fact, they’re dropping 2 – 3% per year. So the ‘low’ 7% interest rates are actually about 10% in real terms, far higher than the 17.5% of the early 80s. Failing to realize the true costs of credit in relation to net income and rising appreciation on a house can rob the borrower without his even being aware of it.
When we become accustomed to a certain stated level of return, we can make mistakes when we fail to factor in the fact that many of our costs are also dropping. Tax brackets, operating costs, assessed property tax values, interest rates, etc. Added to this is the odd fact that rents can often be raised in a recession because of the fall off of construction, which causes more demand for rentals.
The same rational investor who’d demand a 15% return before buying a Note or a Lease is now quite content with 8%. Using the same illustration as before: $100,000 value, $10,000 per year income for 10 years. The value of our position would have increased in a deflationary environment to $125,000 at an 8% yield. Up 25% in a deflation.
When a property has a good solid income stream from a well secured lease, the 8$ yield rate which a rational investor might use would cause it to rise in price too. So, what should we do in a deflationary scenario?
A. Convert real estate into well secured Notes and Leases to lock in the old yields before they fall.
B. Sell assets for cash and retain it to use to buy in after prices have dropped.
C. Buy with variable rate loans which allow payments to drop to match falling rents.
D. Refinance and try to stretch out loans to give you more cash flow.
E. Sell options to tenants to increase rental cash flows and to hold them as paying renters and to lock in higher prices while pulling some cash out tax free.
F. Buy first mortgages in the market at high discount rates before capitalization rates fall and their price goes up.
G. Do the same with fixed rate, well secured leases. Start negotiating with lenders to use your cash to buy their foreclosed properties once they start taking them back.
