September 1995
Vol 19 No 1
She was 54, widowed, and broke! She owned a 2 bedroom house that was free and clear on a large lot she’d bought with the proceeds of a small insurance policy for $4500. Taxes on her home were being increased again. Her property had been re-zoned from residential to commercial usage. She needed income just to be able to survive in that austere time of balanced budgets. Back then, there were few social safety nets in America for anyone below the age of 65. Her only assets were her house, her kids, her friends, and the goodwill she’d built up through years of service to her community; and her own self-reliance. She had no debts.
How might this little story relate to all of us today? In her time, the man was the economic mainstay of the American family. Not so today. One might change this story from ‘widow’ to ‘widower’ and find the same desperate situation. Ask yourself if you know any unemployed men over the age of 54 who would be unable to support themselves without government assistance? Look around! You find them hitch-hiking or on street corners holding ‘work for food’ signs every day.
It’s not difficult to imagine a family being under-insured today either, with real family purchasing power having been stalled for 25 years at 1970 levels, but there are differences in 1995. Two generations ago, before credit cards and television commercials, Americans of the depression generation weren’t consumers. They were savers. There was very little personal consumer debt to drag them down.
A small insurance policy might buy a home free and clear then. Today, the proceeds would probably be used to pay off accumulations of debt to clear an estate. A house might be too expensive make free and clear. There could be no money left over to pay for food, shelter, clothing, transportation and medical expenses if insurance money were used to retire existing debts or to pay off a home mortgage.
In many ways, the TV generation family is a different kettle of fish too. Shortly after the unexpected death of the widow’s husband, her teenaged kids moved out and became self-supporting. Today, it’s not uncommon to see parents supporting kids clear into their mid-30s. In every community, one can find parents paying off mortgage hand, how many kids send money to needy parents in 1995? When Americans began to rely upon their government rather than their family ties for security, life became pretty precarious for most of them.
The same thing can be said for communities. In June, at the Miller/Schaub Reunion, Gary North, who writes the Remnant Review observed that for hundreds of years communities have supported ‘the deserving poor’. These were unfortunate people in whom the community at large saw something worth supporting. There were also ‘undeserving poor’. Bums! Vagrants! Those who took from the community rather than those who supported it. They were usually escorted to the city limits and urged to go elsewhere.
Once big government took over the indiscriminate care and feeding of all citizens alike, the distinctions between the ‘undeserving’ and the ‘deserving’ poor were eliminated by legislation. Once everyone became entitled to the same benefits, there was little incentive for people to support their communities or to provide for their families. Today, with bars on our windows, burglar alarms on our cars, a self-destructing schools system, and three generations of welfare recipients, we’re reaping the harvest of this policy. We’re also paying for it in the form of higher insurance and property taxes, and more regulation over our private lives.
WHEN THE GOING GETS TOUGH . . .
In 1955, solutions to problems had to be created without government support. So the widow created a solution. A member of her church located a real estate investor for her commercially zoned property. He wanted to build a motel on it, but couldn’t finance it until he owned the land free and clear. Unfortunately, while he owned property, he had no cash with which to pay her. If she sold her house, without realizing cash from the sale, she’d never be able to qualify for a loan with to buy a replacement home. Moreover, she might have to pay capital gains taxes out of her meager reserves. She needed another solution. She then turned to a local attorney with whom she’d worked on a fund-raising drive to build the local Community Center. Here’s what they devised between themselves.
First, he legally divided her property into two parts. One part consisted of the widow’s home itself. The other part was comprised of the large commercial lot on which it stood. His position was that the house was a personal residence, but the lot, from the time it had been zoned for commercial use, had been investment property. Next, he made a deal with the investor under IRC Sec. 1031 to trade her land for a vacant lot a few miles away in a residentially zoned area. He also got the buyer to throw in three free and clear rental properties which would provide enough income to meet his client’s income needs if she managed them herself.
To touch all the technical bases, he had a moving crew jack up the house and cut all utility connections. At the point of severance of the sewer and water lines, it legally became personal property since it obviously was not intended to be permanently a part of the land. It had the same legal status as a mobile home. Once the house was in transit to the new lot, he closed the exchange. Only after the house had been re-connected to utilities did its new lot become non-qualifying personal use property. Exchanged property could be converted to a non-qualifying use at any time back then. Now, you have to wait at least a year. Afterwards, the widow resumed occupancy, situated in better surroundings off the busy commercial street. She also had achieved a measure of financial independence with an income level that she could nurture and multiply through her own property management efforts. This transaction sustained her for the next 24 years until her death at 78. How do I know all the details? I ought to. I’m her son.
We’ve all been lulled into a false sense of security by 30 years of social safety nets. These have experienced cancerous growth commencing with the Johnson administration. Now, many of the social programs upon which both you and your tenants have been relying may be phased out in the brave new world envisioned for you. Down-sizing of government, the proposed flat tax, plus a balanced budget is going to affect not only us, but our lenders, tenants and suppliers of labor and materials. In the long run there’s little doubt that this will be beneficial for America. But, in the short run, these won’t be good times for the unprepared.
Take a look at your own financial situation at a point 10 years into the future. What will the ages of your family be? How much will you be spending on your lifestyle? Will your major purchases of a home, education for your kids, insurance, investments, etc. be ahead of, or behind you? Who in the family will be producing income, and what will be its source? What will be your largest expenditure? Will you have any retirement income outside of government or employer plans? In 10 years, if you were widowed and broke, would you have any free and clear assets which you could employ to produce enough income to live on? Would your kids be financially self-sufficient? Would they be willing/able to be supportive?
By working to increase family self-sufficiency ahead of actual need, you’ll be prepared for the uncertainties of America in the 21st century. The ability to create or increase sources of income from real estate may one day save your financial life. Starting today, what better steps could you take to increase your personal financial independence and security through your own efforts to acquire and employ real estate assets that would provide an independent income?
PROPERTY EXCHANGING OFFERS A ROUTE LEADING TO SELF-SUFFICIENCY
It’s a mistake to automatically assume that the reason for ‘exchanging’ is solely to avoid taxation. While that’s certainly an important consideration, taxation isn’t necessarily a factor when one is trying to stave off financial disaster. Before getting bogged down in all the rules for tax free exchanging, let’s look at the other reasons people trade properties, and how it may be accomplished.
The biggest reason to trade rather than to sell a property is lack of liquidity in the markets. From a historical perspective, the use of money and credit is a fairly recent innovation. It’s only been around in any great measure in the hands of those who work for a living for a few hundred years. Oh, royalty has minted gold and silver coins for thousands of years, but if you were to travel back to America’s economy leading up to revolutionary times, you’d find very little currency in circulation. Virtually all transactions were conducted through a system of barter. While among tradesmen the economics of the deal have always been important, the benefits each participant hopes to acquire in a transaction often supersede the monetary value. Here’s an example?
Imagine the following scene: On a hot, sunny, humid day in mid-August. Two men are bargaining. One raises chickens and has eggs for sale that he gets as a by-product of the chickens that he sells for meat. He is bareheaded. The other sells hats that he makes himself from straw waste on his farm. He marks them up 100% over his costs for resale. He is hungry. They agree between themselves to exchange one hat for five eggs. Each is convinced he got the better of the other because he got what he wanted by trading something that he had a relatively small investment in for perceived full value. Yet, because each wanted what he got more than he wanted what he gave up, the transaction is concluded satisfactorily on both sides. Doesn’t the exact same thing happen when you spend money voluntarily to buy something you want more than you want money? It also explains why some people don’t buy many things they don’t need. They like their money, and the financial security it provides, more than what it can buy.
A funny thing happens in your head when you’re exchanging. Although you may have bought something at 25% below market price which you subsequently are trading something else, you mentally compare what you paid for the property you’re trading to the value you perceive in what you’re getting back. On the other hand, if you’d sold your property and converted its value to cash, you’d be much pickier about the price you paid for what you’re getting. This is most often seen when people trade real estate for ‘toys’ such as jewelry, art, boats, airplanes, RVs, vacation homes, travel and vacations. Barter professionals know this, and take advantage of it.
Don Tauscher, a creative Florida Exchangor, capitalized on this principle when he came up with a formula for acquiring property which he named ‘Cash, Trash and Paper’. He likes to offer a seductive amount of cash, an attractive ‘toy’ aimed squarely at the other party’s fantasies, and a junior mortgage Note secured by what might otherwise be extremely hard to finance property such as land, or buildings in a ‘red lined’ area. By acquiring the ‘trash’ at wholesale and the ‘paper’ he’s offering at deep discount, he can offer to ‘buy’ the property under acquisition at a reasonably, negotiated discount from market value. In other words, he creates a ‘private currency’ which contains a discount which is transferred via the exchange into the property being acquired.
Here’s an example: from time to time I attend automobile dealers’ used car auctions where, with a little patience and less emotion, I might be able to buy a car for 60% of retail book value. Let’s say I could buy a $10,000 car for $6,000 cash. From time to time, I’m also able to buy a 2nd Mortgage Note at 25% or so discount from face value because it carries a low interest rate, or has a long term to run before it pays off. Let’s say that I might buy a $20,000 Note which paid $175 per month for $15,000. Suppose I offered to give a financially distressed party $5000 in cash, plus the $10,000 car, plus the $20,000 note, and take over payments for a house with a fair market value of $75,000 on which a $30,000 first mortgage remained to be paid.
The seller would perceive that, by making this deal, he was avoiding losing everything through foreclosure. He’d be getting $65,000 for the property in the form of cash he could spend; a car he could drive, borrow against, or sell; and monthly income to pay bills. He’d also be getting someone to make the payments on his current mortgage which might have been in default. On the other hand, because my total out of pocket cash investment in everything I gave up plus the loans I took over only amounted to $56,000, I’d have converted by $9,000 profit in what I bought to equity in the property acquired. We’re back to eggs and hats. We’re booth happy with what we got and gave.
THROUGH EXCHANGING, YOU CAN FREE AND CLEAR HOUSES WITHOUT CASH
One of the most successful real estate wheeler/dealers I ever met bought over 550 houses in a single year by finding people who were relocating who had homes with loans equal to approximately 60% of value. He’d also locate owners of free and clear building lots of equivalent equity value. He’d offer the homeowner one of the lots free and clear in return for the owner’s equity. And he’d offer the lot owner a 2nd mortgage at low interest rates and low payments in return for the lot.
At settlement, the homeowner would deed the house to my friend. He’d sign a Note and Mortgage and give it to the lot owner, who would deed the lot to the homeowner. The key to these transactions lay in the terms on the note he signed. These were always pegged to the rental income of the property so he avoided negative cash flow problems. Eventually, over a couple of years, he’d accumulated hundreds of houses with virtually no equity, but which threw off more tax shelter than he had any use for. He wanted to convert his equities to cash. He sought out property owners with free and clear rentals who were out of depreciation, and offered to exchange 30 of his leveraged houses for one of theirs.
Here’s how that might have worked. Let’s assume all houses were worth about $100,000. He’d give up $3,000,000 in assets with little or no equity in return for one asset free and clear worth $100,000. In a little over a year, he’d accumulated over a million dollars in free and clear rented houses that produced about $75,000 per year. The other parties re-leveraged and stepped up the depreciable basis in their portfolios without qualifying for any new loans, and without paying any taxes.
Another way debt can be eliminated from income properties is by getting lenders to allow you to substitute another property to collateralize a loan. There are several keys to do being able to accomplish this. First, you’ve got to make it an article of faith that you’re not going to use institutional finance when you acquire properties. Either the seller must agree to carry back the financing, or you’ve got to cultivate private financiers who will lend you the necessary funds. Another key is to offer the lender something in return for allowing you to switch collateral. Usually this will be a shorter pay-back period, higher payments or a higher loan interest rate, or higher quality ‘paper’.
Let’s suppose that you could switch collateral from being a 2nd mortgage on a rental house to a first mortgage on vacant land. At this point, the rental would be free and clear. The next thing to do would be to advertise the land for sale on an installment sale contract which wraps the loan you’ve placed on it. By wrapping your loan, you’d keep the faith with your lender, insuring that his payments were made as promised. You might also mark up the interest rate a tad if the market would bear it. In any event, you’d have someone else repaying your debt on the land, while you’d be enjoying the cash flow income from the rental property. Of course, if you set as a goal the freeing and clearing properties, each time you investment cash flow increased, you could use the surplus to reduce principal balances on outstanding loans remaining unpaid. This would be a major step in achieving your own financial independence.
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