October 1994
Vol 18 No 2
Financial risk affects all of us. Last month we focused on those among us who are 'starters'. They've got just as much to lose as the 'rich-man' When someone with little to lose, loses a little, he's just as broke as someone who loses the last million dollars he owns. Jim Napier once told me that, once you've lost everything, it doesn't matter how much wealth you once had. The 'rich-man' winds up just as broke as the person who's never had anything.
The title line of this month's letter portrays a kind of financial regression as society moves down the economic scale. Each lower level denotes a failure of one kind or another to build and/or protect assets whether they be in the form of money, property, skill or education in some trade or profession.
Note that, the lowest order in line is the politician. He's demonstrably devoid of skill with any economic value just like the beggar man but is usually rich. He becomes a rich-man by destabilizing the social order while systematically robbing the other members of the group, even the thief, through manipulation of the law, taxes and financial markets for his own career longevity and personal gain.
Scarcely a day goes by without yet another political scandal being exposed in the nation's press, but that's not where politicians do the most damage. Rather, it's the result of virtually unbridled power that they can exercise willy nilly over the fortunes of all of us. Because of this, politicians are the most dangerous of the entire group. Through control of the legislative and judicial processes propose special threats to investors. Particularly real estate investors. They, more than others bear the brunt of politicians' disregard for property rights.
All real estate has a political component completely apart from its economic substance. Because of this, real estate and investors in real estate have always been political targets. Investors see political risk manifested in inclusionary zoning and land use restrictions, rent and profit controls, condemnation actions, special tax rules for passive losses, EPA regulations, and the use of tax incentives and credits to manipulate markets.
Government also creates extraordinary civil liability for real estate investors. Landlords in southern California can attest that courts routinely confer on illegal aliens rights which are superior to those of native born tax paying citizens. Added to this in 1994 is the emphasis on classifying those who do only minimal work on property as employees. This makes the owners liable for payroll taxes, workers compensation, and meeting OSHA workplace standards.
CONCEALMENT IS THE BEST DEFENSE FOR THE WEAK
Speed, stealth, force, cunning all have their place in any asset protection scheme, but because real estate is highly visible, politically sensitive, and firmly attached to the earth in defined political arenas, concealment of ownership is the first line of defense for the real estate investor.
In the past few months, we've discussed LLC and Trust concepts and strategies which limit risk by concealing ownership. Another technique is to avoid ownership by being a lender rather than an owner of property. Let's see how we might divide up the benefits of real estate ownership through creative use of credit rather than property itself.
A quick review of the major benefits of real estate investment might include USE, INCOME, TAX BENEFITS, APPRECIATION, LEVERAGE, AMORTIZATION, and as a HEDGE against inflation. Let me construct a little fable to see if we can't see how these can be captured by a lender rather than an owner.
Able wants to buy an expensive building as an investment. He wants to avoid management and risk. He might find a reputable third party buyer in need of finance, or he might form a corporation or a limited liability company, contributing 20% of the property price to it for use as a down payment. The ownership of the company can be held in Trust if he chooses. It buys the property in its name after obtaining a loan secured by a mortgage from Able. So far go good. He's the lender not the owner, avoiding ownership risk of real estate. Let's track the benefits to see who gets what.
MORTGAGE TERMS CAN CAPTURE BENEFITS . . .
The terms of Able's note are such that the property has break even cash flow after payment of the loan each month. This yields Able as much income as direct ownership of the property would have. The Note he holds also provides for 80% share in any appreciation which might take place in property value in excess of book value at time of sale. Thus, as the title holder takes depreciation while the property rises in value, Able will get the benefit of this in the form of a higher yield on his investment at time of sale.
So far he's captured appreciation, income and amortization. What about use? If he has a real need to use the property, the owning entity can either rent Able space, or use the property itself for Able's purposes. His shared appreciation mortgage will also capture gain from inflation which might take place. What about tax benefits? The owner of the property will be entitled to the tax benefits. For purposes of this example, we'll restrict these to depreciation and capital gain or loss as well as operating losses.
If the owning entity were to be a regular corporation that issued Section 1244 stock upon inception, operating losses caused by property operations, depreciation and costs of financing would offset operating profits each year. As a result, the corporation might be losing money for tax purposes even while it was producing cash flow. After the eventual sale of the building, up to $50,000 in losses could be taken by Able to offset his taxable personal income each year until they'd been used up.
Suppose Able wanted to enjoy the benefits of capital gains? His shared appreciation promissory note might include a provision for an Option on the property with a buy-out formula based upon 80% of any gain over book value rather than being characterized as additional interest. A business reason for doing things this way might well be that the gain from the shared appreciation feature could exceed the legally mandated usury limits. This would lay the foundation for Able's reporting the profit as long term capital gain taxed at a maximum of 28% currently.
Let's talk state taxes. Suppose the building were located in a state with high corporate income taxes. The corporation could be located out of state if it wanted to shield profits from taxation at state level. In this event, it would master lease the property to a local management firm to avoid 'doing business' as an alien corporation.
If it anticipated that it would be deemed to be 'doing business' in the state, it could use any operating losses against state taxes. If Able wanted to avoid state taxes, he might 'guarantee' the loan made by an institutional lender, letting his out of state entity buy it for 100% of value once it was funded, and letting the originating lender service it. This way, his profits would be received in the low taxed state.
If Able decided to use a Limited Liability Company to fund the loan, profits and losses could be passed through to the Able or another entity as he chose to minimize federal and state taxes. You can see that professional tax consulting fees might be a worthwhile investment for serious investors.
We started this series discussing avoidance of liability. Because Able is merely the lender, not the owner, and assuming that he doesn't restrict the activities of the title holder's business, he should be well out of the line of fire in the event anything happens in connection with the building which might create a liability for the owner. If the owner is a heavily indebted corporation out of state, there's little real threat of loss to Able as mortgagee.
INVESTORS AND 'FINISHERS' HAVE THE MOST TO LOSE
There might seem to be a contradiction in this letter when I've stated on the one hand that regardless of how much one has lost, everyone is on the same plane when they're broke. Financially, this is true, but from the standpoint of those whose prime earning years are behind them, with little time to make up losses, loss at the end of a long financial career can be devastating.
Unfortunately, many of us sow the seeds of failure even as we nurture our early investment dreams. How? By not taking pains to do things in ways that will cause us the least grief later on. As starters and speculators, we're prone to rush into institutional loans with full personal recourse, offering up complete details of our financial lives as sacrifices to lender computers in return for credit. Later on, these records will return to haunt those who have revealed too much.
The principal reason for this indiscretion is the feeling of urgency to make deal after deal as if they'll all be gone if we don't hurry. Only after a few years spent building an estate does it become clear that you'll run out of time, energy and money long before you run out of deals you can make. At about the time you learn this, you'll also become aware of the risk of loss that full recourse loan liability imposes. That's when you'll start taking more care in the way you borrow money and where, when and with whom to do business.
PICKING YOUR OWN PLAYING FIELD AND THE PLAYERS . .
A major source of potential liability stems from operating in the wrong legal and tax environment and doing business with people you don't know. As you proceed along the road to riches, it's important that you seek out fellow travelers who share your sense of fair play and ethics. Start with a little deal and make it a point to give the other party 51% of the profits.
Gauge reactions to see if your generosity will be reciprocated. Test the other party's tolerance to risk, financial capacities, skill and knowledge, ability and willingness to share profits and opportunity on transactions that are too big for one person. Make sure that you measure up to the same standards you impose.
As time goes on, gradually increase the stakes until you have full confidence in the other party. Repeat this process over and over again until you've formed a networking group. Hopefully, you'll have a mix of starters, finishers, speculators, managers, and financiers to work with carefully selected Accountants, Attorneys and Brokers through many transactions. The time spent forming your network will be repaid many times over as you work together to improve and support each other's financial position.
Asset protection never stops. It goes from maintaining financial privacy through Trusts, LLCs, Corporations to building in structural defenses through the uses of limited partnerships, winding up with estate plans designed to ward off the tax invaders and to provide for those who rely upon you.
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