December 1986
Vol 10 No 2
By the time you receive this letter you'll have less than 60 days in which to do everything necessary to minimize your tax bill for 1986 and 87! I'm doing all I can to alert you to possibilities while there's still time for you to act. Re-read your old CommonWealth Letters from July 1983 and 85 plus those I've written since July 1986. In all of these I've given you some ideas to help you optimize your financial situation. Here are some 1-liners to get you started. Bear in mind that what you do depends upon whether you expect to pay MORE or LESS taxes as a result of the new tax act. And keep things into some sort of perspective. Remember that some of the changes such as consumer interest and real estate rental tax shelter losses will still be 65% deductible against other income in 1987.
THINGS TO DO IN 1986 (if your net tax bill will increase in 87):
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1. |
Pay property taxes. |
11. |
Pay for deductible improvements. |
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2. |
Pay state sales and income taxes. |
12. |
Dump marginal tenants. |
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3. |
Do all required repairs and maintenance. |
13. |
Sell marginal properties. |
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4. |
Pay any maintenance contracts. |
14. |
Pay your children. |
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5. |
Pay Condo and association fees. |
15. |
Gift appreciated property now. |
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6. |
Pay accounting fees (for investments). |
16. |
Match income to outgo if possible. |
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7. |
Pay any bonuses. |
17. |
Pre-pay subscriptions/seminars. |
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8. |
Pay utility bills. |
18. |
Renegotiate Purchase Money Paper. |
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9. |
Make IRA contributions. |
19. |
Take $5000 one-time deduction. |
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10. Pay annual retainers. |
20. |
Do any preventative maintenance now. |
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Here are some ideas to help you bring income from subsequent years into 1986 so you can pay for the cost of all the above expenses. You should try to balance out the tax you'll incur with losses-which will be limited next year. Your biggest problem will be to get sales completed in 1986 for cash without extreme discounting. The problem being that any purchase money notes you carry back on property you're selling will be taxed at the ordinary income tax rates in 1987 and beyond. So you've got to take a look at your 'paper' portfolio to calculate whether it's best to continue to carry it, or to discount it for cash. If you carry it, you'll be able to defer the taxable event until a future date, but be taxed at a higher rate. On the other hand, if you discount it, you'll lose some of your return and be taxed at a lower rate in 1986. Or try this: you can modify your note, make a gift of it, use it in a transaction to buy property or to pay off a debt and it can then be deemed a 'constructive receipt of taxable gain'.
Whether you choose to do this or not will depend on the tax results. If you can then offset the taxable gain with shelter in 1986, or if you have enough cash and motivation to pay taxes on income you haven't received, it will move the long term gain forward to 1986 instead of its being taxed as ordinary income in a later year. It's a brain-bender which only a session with your calculator and the tax tables will be able to resolve. To increase 1986 income which you can shelter, if you decide its best for you, try these:
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1. |
Sell OPTIONS on your property tax free. |
6. |
Get your salary paid in 1986. |
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2. |
Sell on installment sales, declare in '86. |
7. |
Stock/Bonds, buy back later. |
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3. |
Renegotiate Notes ballooning in 1987. |
8. |
Get Corporate Dividends in '86'. |
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4. |
Buy 'paper' with 'paper' to trigger tax. |
9. |
Pay |
yourself a Bonus if you can. |
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5. |
Exchange real estate for personal property. |
1O. Sell for existing Note/Paper. |
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11. Give your tenants an incentive to pre-pay rents in 1986 to keep them out of 1987.
12. Give discounts to get people to pay off paper you're holding in this year.
13. Capture any long term capital gains on stocks, bonds, real estate, etc. in '86.
14. Lease seasonal rentals with entire season's rents pre-paid this year.
15. Sell for CASH in 1986 and elect a Starker Deferred Exchange in '87 if profitable.
16. Definance – trade equity for debt relief in return for cancellation of balloons.
17. Substitute collateral off of investments onto personal residence and SELL.
18. Take severance pay in 86, then CONTRACT to do your old job in '87'.
19. Where it's favorable, liquidate corporations under the current law.
THERE'S NO SUCH THING AS A FREE LUNCH . . .
Admit it! Some of these things just don't make sense to you do they? And some of the others sound too complicated. The others will take too much time. It just isn't fair is it? Unfortunately, I don't have enough time or space to explain everything that's written. But your old newsletters will if you'll look up some of the concepts in your back issue index. This past year I've given away complete sets of back issues at both of the CommonWealth Conferences so that attendees would have as complete a set of tools as I could put into their hands. And I've given three seminars on taxes in the East plus a seminar on Corporations in the West. All of these have been low cost seminars ranging in price from FREE to $125. I'll do one more in the West in mid-November on the new tax bill as it will affect the ways we'll have to do business. After that it will be too late for 1986!
1987 will pose a new tax environment within which we'll all have to operate. More than ever, the new law will separate us into different tax-payer classes despite claims of 'fairness'. Singles will have vastly superior advantages over marrieds. Positive cash flow landlords could pay less than negative cash flow landlords. Savers will beat spenders. Contract employees and small corporations will pay lower taxes than those who file 'W-2' forms on earned income. Active, profitable, expanding businesses will have potentially more tax shelter than passive investors. Renters may come out ahead of owners if they can lock in lower rents for the long term. Home owners will have myriad tax strategies open to them which will be unavailable to investor/landlords. Entrepreneurs will be better off than major corporate entities. Those over 50 will have better pension plan benefits. In some instances, Dealers will outdistance investors. It'll be a brave new world indeed!
Just when you need help to make far reaching decisions about your portfolio and business activities those upon whom you rely for advice will be going back to school to learn the new rules themselves. Or they'll be avoiding you! It's going to pay you more than ever before to become involved in your own tax planning. That means devoting a large portion of your time to learning the rules, finding the loopholes, developing strategies to fit a particular situation or to exploit special opportunities. It's going to take time away from your leisure activities but the more you comprehend the ramifications of the new tax act, the more effective you're going to be as an estate builder and/or business person.
And you ain't seen nothing yet folks! Alice in Wonderland should be so lucky. For instance, under the new law there's a quiet little thing called Alternative Minimum Tax Income. Finally when you think you've got everything zeroed out it sneaks up on you and taxes you at a flat 21% on tax preference ANTI. This includes depreciation taken over periods less than 40 years. Installment sales on transactions in excess of $150,000. Any installment sales by dealers. Charitable contributions of appreciated property. Tax shelter losses from farms and passive business activities. All of these are subject to the computations to arrive at AMTI. There are only a handful of deductions from AMTI without regard to the deductions you used to get to your regular tax bill.
I'll stop before you overload. My point is that YOU are going to be taxed at a different rate than I will be. Each of us will be treated differently according to our own particular situation so we'll each need our own strategies. Access to the kind of tax help this complex situation requires will be extremely limited and expensive. Furthermore, if you aren't careful, some of the wild advice you get might backfire as Congress once again changes the rules. So you've got to be both knowledgeable and flexible. I'm gradually beginning to catch on to what they've always said, 'Money can't buy happiness.' But saving it can sure make life interesting. Look at it this way; taxes are another expense of doing business. You try to reduce this expense just as you'd try to reduce the purchase price, down payment, interest rate and payment amount in order to make a larger profit. What you can't avoid, you pass on to the consumer. In order to survive or prosper as SELLER/LANDLORD you raise your prices or your rents or your interest or your payments or your down payment. What else is new? Don't become emotional or burned out. Just recognize that taxes and tax strategies are going to be an integral part of your economic life all of your life!
LOOK WHAT THEY'VE DONE TO MY SONG, MA . . .
Here's a short tax course for 1987 and beyond: all income and expenses will be divided into 3 categories plus a few exceptions. These are called PASSIVE, ACTIVE, and PORTFOLIO. Don't be misled by the words. This isn't English, it's Tax-speak. By law, most rental ACTIVITY is called PASSIVE! So is activity in Business where the tax-payer owns less than 10% or where he isn't involved on a 'regular, continuous and substantial basis'. So is Limited Partnership interest. Hotel and rental car activities are singled out as exceptions to the passive rental rule, but slum apartments, condo and house rentals, apartments, mobile home rentals despite the efforts required to generate the income are deemed to be PASSIVE!
Once you've rounded up all this kind of income, then you get to deduct any losses and expenses generated in the production of PASSIVE income from PASSIVE income. You don't get to deduct rental losses from your interest income or from ACTIVE business profits, wages, salary income as a rule, but if you're actively involved in the management of rental real estate you can deduct up to $25,000 against any other income except AMTI. Clear so far?
Now, you add up all the income from wages, salaries, tips, profits from active and material involvement in business of which you own more than 10%, General Partnership profits in non-real estate rental activities. You deduct all expenses and losses attributable to these activities. If there's a profit, you can deduct the $25,000 in rental losses from the total. If there is any of the $25,000 left over, you can deduct it from Portfolio income.
Portfolio income is any income received from interest, sales, dividends, royalties annuities, REITs, S-corporation dividends are excluded. They retain their characteristics relating to the type of activity which generated them. Also, sales from rental assets are excluded from Portfolio income. When you borrow to buy an asset which produces Portfolio income, you can deduct expenses associated with that purchase, such as interest on loans you use to buy 'paper' with. Any income left over can be offset by whatever is left of the $25,000 (above). Now, let's tie it all together.
Suppose you owned 5 houses which you actively manage. Each produces $500 a month in gross rents, but your expenses cost $100 per month. That leaves $400 with which to pay the mortgage, taxes, insurance. You use up all the cash to pay the payments, and you have $30,000 in losses – say $6000 per house. Thus there's no taxable income on the houses.
From your job/work/business you have $20,000 of taxable income after deducting everything that you can. You can use up to $20,000 of your passive rental losses and zero out the taxes on your regular active income. And after you add up all the portfolio income from investments, you can deduct the remaining $5000 against these. Doesn't sound so bad does it. But what about the person who has greater passive losses? In 1987 the phase in rules will allow him to continue to deduct 65% of these losses PLUS $25000 against other income. He'll have to carry the remaining 35% of losses which he can't use forward, but he can use them to offset any passive income from the property which generated the losses up to the time he sells, then deduct any remaining unused losses from profits on it's sale.
IF THE CUSTOMER WANTS A BLUE SUIT, TURN ON THE BLUE LIGHT . . .
What does this new tax act say to us? That Congress no longer approves of tax shelters without any economic merit. That we've got to be weaned away from spending every dime we have or can borrow for consumption items. (They're allowing only 65% of consumer interest deductions in 1987.) That the States will have to either raise more taxes or learn to stop depending on the Feds for money to waste. That businesses will have to start to make more than they spend and businesses owners (including landlords) will have to go to work and make their investments earn a profit if they expect to get tax breaks. That doesn't seem so bad does it? Real estate's ox isn't the only ox being gored. Look at these:
Farmers are going to lose some of their deductions. Welfare payments will start being taxed. Bankers who've been cooking their books for years will have to play it a little straighter. They're also going to lose some of their 'loan loss reserves' tax break. This will increase their taxes too – and our fees for banking. We're all going to have to get lean and mean – and efficient if we're going to make it. What does that mean to us?
Over the next 5 years we're going to see effective tax rates rise as deductions are phased out and new taxes phased in. The new 'level playing field' which gives the voters a 'fair' tax is already pretty lumpy with all the 'transition rules' aimed at loyal fund raising organizations. After all, this is still an election year. Grow up! The trick is to ANTICIPATE the direction the law is going to take and to stay out of trouble. It seems to me that all marginal property will become less and less desirable. Especially rental property which is functionally obsolescent, poorly located, poorly financed, poorly built and which produces negative or break-even cash flows. Since July 1983 I've been telling you to sell this property. It's even more important to do it now.
If you held shares of stock which you thought were going to lose value, wouldn't you sell them? And replace them with something which was going to gain value? Do the same with your houses. In recent issues I've described the tax-deferred exchange using cash. You can do the same thing using installment sale paper. And you can combine Section 1031 exchanges of rentals with Section 1034 exchanges using your house to great advantage. The crowning technique is left to the over 55's who get the $125,000 one-time exclusion on sale. Suppose you owned an expensive house on a large piece of land. You might survey off the house portion and sell it, capturing (i.e.) $225,000 in gain. You could move into a new house using $25,000 as a down payment and still have $200,000 in cash remaining tax free if the new house were worth at least $100,000. Then you could sell the land for (i.e.) another $100,000 and use the money to purchase cash flow properties for income, TAX FREE. See, the sky isn't falling after all for those who can structure productive transactions.
When the tax code rewards you with an extra $25,000 to manage your properties, it seems obvious that you should learn to manage. You might find that your profits will be much greater than $25,000 if you take a hand in producing them. If you have too many passive losses, think about selling your rentals to your dealer corporation. Remember, business expenses will remain virtually 100% deductible and a dealer is in business. If your job is producing too much unshelterable income, consider incorporating, getting your employer to pay your corporation as an independent contractor, then sheltering your income through the use of a corporate pension plan. The older you are, the more you can put into it tax free.
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Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
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