Right For The Wrong Reasons . . .

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Vol. 24 No.4b

December 2000

RIGHT FOR THE WRONG REASONS . . .

 

Over a year ago I wrote Volume 24, No. 4 of the CommonWealth Letters which attempted to deal with the post-Y2K world once all the furor had died down.  In it I made several predictions for the near-term future that turned out right:

 

1.  No matter what the political or economic situation might be, given a choice, most people would still choose to live in a single family house in preference to any other kind of lodging because a family’s home would continue to be a crucial element in the nurturing environment that produces responsible citizens.

 

2.  Most people would continue to sacrifice to live in their own homes rather than rent.  They’d commute over long distances and elect to fore-go vacations and expensive toys in order to live in better neighborhoods with better schools.

 

3.  In the most desirable middle class neighborhoods in any area, with the best schools, lowest crime rates, most involved residents, you’d continue to find the highest percentage of home owners.  Home ownership would continue to create citizens who were politically involved in defending their “turf”.

 

4.  Conversely, areas where a majority of the residents rented rather than owning  homes would continue to be marked by poor schools, high crime rates, and crumbling infrastructure, lack of community involvement, absence of responsible citizens.

 

5.  Politicians would continue to make it easier for Americans to become home owners via a variety of home purchase financing plans.  During this past year it would be easier to sell at higher and higher prices because of the availability of low cost and easy access to loans for more buyers.

 

6.  As we changed our national focus from defense to international trade, world-wide, American influence would be on the rise in a time of unparalleled cooperation among the nations of the world.

 

7.  Preparation for Y2K would result in hundreds of thousands of businesses upgrading their computer systems and revamping the way that companies worked together.  As a result of this increased capital spending, the American worker, and American businesses would become the most productive in the world.

 

8.  This would translate into millions of jobs for Americans at higher rates of pay in comparison to the 1990s.

 

9.  Initially, we would experience a falling stock and bond market and rising house prices.

 

10. The first ten years of the new century would offer a cornucopia of opportunity to both stock market and single family house investors.  Leverage at low interest rates would create fortunes for both investors and entrepreneurs who became actively involved.

 

Despite the fact that I was wrong about the seriousness of Y2K, those who took action to either get out of the stock market, or to “short” it, and those who invested in single family houses would have avoided loss and realized significant gains in the value of their investments.  There’s no reason to believe that the party is over yet.  For the next year, things should remain on an even keel.  It seems clear that only those issues that are widely supported by both parties are likely to be enacted into law.  Among these might be a new tax bill that will include reducing the “death tax” on estates; and subsidies for users of prescription drugs.  Of course, that presumes that we’ll find out who really won the election.

 

BISMARCK SAID IT BEST . . .

 

German Chancellor Bismarck once remarked that those who like sausage or the law should watch neither of them being made.  He might have included the election of political candidates.

 

From start to finish, at the national level, the 2000 election served as a text-book example of inherent weaknesses in the democratic process.  Supposedly, in a democracy, the people get to select their leaders, but from the start, this selection was limited to two flawed candidates who were selected by their respective political parties to run for office.  Throughout their respective political careers, both Presidential candidates owed more to the political power-base inherited from their fathers, Senator Gore and President Bush, than to their own achievement.  Outside of politics, what has either ever accomplished on their own?  Which of them previously demonstrated the passion, intelligence, integrity, and leadership capability to hold the most powerful political position in the free world?

 

In the final analysis, Campaign-2000 boiled down a contest to see who could buy the most television advertising and get the most publicity.  It has been estimated that in excess of $300,000,000 was spent on campaign 2000.  Where did all that money come from?  Who contributed it?  What do you suppose they expect to receive in exchange?  Who will pay them back?  That’s where the citizens come in.  No matter which party comes into power, Americans will pay higher prices for energy, medical care, social services, drugs, services provided by union labor, farm products, automobiles, homes, insurance, and education; as well as sales, excise, death, gift, franchise, income, state and local taxes.

 

Ironically, despite all the money that was spent, the election came down to a few counties in Florida (under the administration of brother Jeb Bush) where votes were either miscast, miscounted, or missed entirely because of voting “irregularities“.  One wonders how many earnest citizens spent hours trying to evaluate the best qualified candidates only to have their votes cast aside because of faulty handwriting, faulty voting machines, or faulty tabulation.

 

If it did nothing else, the 2000 election revealed the seamy underside of the democratic process where un-elected judges made the final decisions that ultimately decided the victor in this election.  Not the voters, but political appointees who got their jobs as a result of the political spoils system the enables candidates to repay supporters by appointing them to powerful offices.

 

Perhaps the best thing that will come out of the 2000 presidential campaign will be the realization by many Americans that something needs to be fixed if we are to live in a country where the government truly represents all the people equally.

 

Campaign-2000 wasn’t the first time that a son gained the presidency on his father’s coat-tails, or the first time an election was won because of suspect votes.  When the “will of the people” is “too close to call”, and Congress is also almost evenly divided between Democrats and Republicans, the result is often a stalemate caused by deadlock.  Without the full support of a clear majority of the people, only an exceptionally charismatic leader is going to get much done.  John F. Kennedy typifies this kind of President.  This letter is being written while the courts continue to dither over who the next President will be, but history suggests that neither Bush nor Gore will be able to accomplish much in their term of office.

 

This may represent the best of all possible worlds.  Despite dramatic increases in energy prices, there is no sign of any significant inflation; with the prospect of lower interest rates, the American economy is doing just fine.  The dollar remains strong.  The stock market is building a foundation for a rebound.  As incomes rise, so will the demand for housing.  The current political fiasco might wind up as a curious footnote in history that will have little effect.

 

TAX-FREE EXCHANGING CONTINUES TO BE A POPULAR OPTION .

 

IRC Section 1031, the code section that permits tax-free exchanges of “like kind” property, has been around more or less in its present form for over 70 years.  In the past few years, four break-throughs really spiced things up:

 

(1)  As a result of the “Starker” ruling, it became possible for a owners of property held at least one year for investment, the production of income, or for use in a trade or business, to sell it for cash or on terms, have a qualified intermediary hold the sale proceeds until a suitable replacement property could be acquired, then use the cash or Notes received on the sale to buy that property.

 

(2)  Recently, IRS regulations were released permitting a “reverse Starker” exchange.  In this situation, a person can buy a qualifying property whose title is held by a qualified intermediary.  Afterwards, a qualifying property can be sold for cash which will be used to buy the property from the qualified intermediary.

 

(3)  In November, 1992, Revenue Ruling 92-105 was released in which the IRS permitted beneficial interests in certain types of grantor land trusts to be exchanged for real estate.  These trusts had to be formed under State law that specifically permitted the beneficiary to direct the Trustee.  Safe harbor states were California, Hawaii, Illinois, Florida, Virginia, Indiana and North Dakota.

 

(4)  As a result of a 1994 ruling, gain that is recognized because of the fall through of a bona fide delayed exchange that has extended beyond the end of the calendar year is treated as an installment sale in which the first payment is received in the year of the fall-through rather than in the year of the sale.

 

Exchanging has always been a country cousin in the real estate brokerage business.  Rarely are real estate license holders experienced in putting transactions together.  The tiny minority who are have stretched the Exchanging envelope in every imaginable way, and can be given much of the credit for the evolution of Exchanging into a viable alternative to paying capital gain taxes for anyone selling low-basis, high-gain property.  Here are some variations on a theme:

 

Case A:  Seller #1 had a cash buyer for a free and clear commercial building.  He used the cash proceeds to negotiate the purchase of a large private residence at a discounted cash price from a motivated seller.  Seller #2 had refinanced the home with a home equity loan and could no longer afford the payments.  He used the cash to pay off his debt and to increase his disposable income.  He agreed to lease the building back at market rents for a minimum of 18 months.  At the end of that time, Seller #1 moved in, converting the property from real estate held for the production of income to his personal residence.  A little over two years later, he sold the residence for cash and moved on.  Let’s see what each accomplished:

 

Except for a few hundred dollars in recognized capital gains due to recapture of depreciation, Seller #1 effectively converted his low basis, completely depreciated income property into tax-free cash.  His initial exchange was tax-free by virtue of IRC Section 1031, which he was able to use because of his renting the house back to Seller #2.  Thus, it was held for the production of income (a qualifying use) for at least one year.  At the end of that time, when he converted the property to personal use, his adjusted cost basis became the lower of the fair market value of the house, or his former cost basis.  Thereby hangs a tale:

 

Under Section 1031, anytime one property is exchanged for another, both the holding period and the cost basis of the relinquished property is transferred to the acquired property, with some adjustments due to any mortgages given up, assumed, or created in the Exchange.  Therefore, Seller #1’s completely depreciated adjusted cost basis in his exchanged property became the basis in his home once it had been converted to his personal use.  And when he sold the home, all his profit was tax-free under IRC Section 121, a completely different code Section.

 

Section 121 was the key to the entire transaction.  Without it, the Seller #2 couldn’t have sold his home for cash and repaid his debt tax-free.  Under any other circumstances, debt must be repaid with after-tax dollars.  This is what drives many people into bankruptcy.  But, when debt can be paid off with tax-free home-sale profits, it is effectively paid with pre-tax dollars.  This can be a powerful motivating force when negotiating with home-sellers to buy their homes; particularly with those who have been living beyond their means through the use of consumer credit, and who are now at the end of their wits.

 

By offering them the cash to pay off bills, while also insisting that they continue to occupy their former residences at a reasonable rent, the buyer can often make a very attractive deal for himself, while saving the financial life of the seller.  And, with a seller-lease/back, the buyer has few management problems, no vacancies, and can often withhold a year’s rent from the sale proceeds.  That way, there are no rent collection or payment problems on either side.

 

Using Section 1031, in conjunction with Section 121, also affords Seller #1 a way to cash out a lot of low-basis real estate tax free over a three year interval.  As long as each has both owned and occupied the house as his principal residence for 2 out of the last 5 years immediately preceding his sale, Both Seller #1 and #2 can both walk away tax free.  That’s good.  Could it be better?

 

When it comes to creative applications, there are many variations on this theme.  For example, if the owner of a large home wanted to diversify his equity into multiple investment properties without discommoding himself, he might Exchange his home equity as a down payment on ten rental properties, refinancing the balance of the purchase price either with seller-financing or conventional loans.  A quirk in the tax laws would enable him to add the fair market value of his residence to the debt he used to acquire the investment properties to arrive at their depreciable basis. Thus, without moving a single piece of furniture, the home owner can become a real estate mini-mogul, enjoying all the benefits of real estate investment without the use of cash.  Ain’t life grand!

 

SYNDICATING OWNERSHIP IN MULTI-PARTY/MULTI-PARCEL EXCHANGES

 

One upon a time, a long time ago in a land far away, an investor, contemplating retirement in a few years, wanted to relocate a remote, under-performing real estate rental into his local area and to consolidate his real estate interests into a single property.  He had his eye on a large home in an exclusive area that he hoped to Exchange into.  Unfortunately, his rental equity didn’t add up to enough to enable him to swing the deal, so he went shopping for other investors who were tired of management, and who would welcome a net-leased rental in the form of an expensive leased home.  He found three others who were willing to join him in using their equities to acquire the residence.  Here’s what they did:

 

First, the original investor obtained an Option on the large house.  Then each sold his equity, and all used the same Qualified Intermediary to hold the cash proceeds until sufficient money had been assembled to buy the targeted residence.  Then they closed on it, each winding up with undivided fractional ownership interests as Tenants in Common with each other.  The original investor signed a Master Lease with the other three at fair market rents.  Then he sub-leased the property to the seller for the obligatory year.  This suited the seller perfectly.  He wanted to build a smaller home, and this gave him both money and time to complete the project.  At the end of the year, the original investor moved in, converting his undivided Tenancy in Common to a residence, while the other investors continued to enjoy appreciation, cash flow, depreciation, and freedom from management chores.

 

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