October 1984

Vol 7 No 1

THE TAX REFORM ACT OF 1984 – IS IT MERELY A STALKING HORSE?

Abstracts of the new tax law are everywhere. I'm sending this letter out early to give you time to take action. While the law itself is over 1300 pages in length, even the shortened versions are virtually incomprehensible. Look at these provisions:

1. For long term capital gains: 6 month holding period for assets purchased after June 22nd. 12 months for assets bought prior to that. If you sell an Option at below market prices on STOCK you own, your holding period starts after the Option expires.

2. Real estate you bought or started to build after March 15th must be depreciated over 18 years. But low income rental housing retains the 15 year schedule. So does real estate bought before March 16th IF it will be ready for productive use by 1987.

     
      3. Cars bought after June 18th are under the new law. Those costing more than $16,000 must use longer cost recovery schedules. They get lower investment credits. And you must document business use in excess of 50% to get 3 year write offs. Detailed logs will be required on most of your ^“mixed use^“ equipment to justify tax deductions.

      4. Seller ^“carry-back^“ financing must carry effective interest rates equal to 110% of comparable Treasury obligations. If they don't, the IRS can IMPUTE 120% based upon the present value of the income stream. Personal residences up to $250,000 and farms up to $1,000,000 can use the old 9% rate. The effective date is January 1, 1985.

        5 . Buyers will be able to DEDUCT imputed interest based upon the rate sellers should have charged. Of course this will pin point the sellers for the IRS after they file.

 6 .  Tax Shelters which offer more than 2 for 1 will have tough sledding. Even those which the IRS approves will have to carry an IRS approval number which will have to be put on the tax returns in order to be acceptable. Big brother appears to alive and well!

When you sell on an installment sale, any accelerated depreciation which exceeds the straight line rate will be taxed as ordinary income in the year of sale instead of being deferred until the end of the contract as it is now. Applies to properties sold after June 6th or under contract for sale as of March 23rd. Hurts commercial property.

 
      7 .$100,000 IRA and Pension exemption will be taxable to estates after 1984. Plan ahead!

      8. Top limits to estate taxes will remain at 55% until 1987. And increases in the value of estates which can be passed tax free will not be phased in as rapidly as foreseen.

9. Rules pertaining to interest free loans are tightened. Family loans will be treated as gifts of the un-charged interest IF they aren't used for business purposes or as part of a tax avoidance strategy. Loans carrying unstated interest or stated interest below IRS limits will incur imputed interest, taxed to the lender and deductible by the borrower. Corporate loans to shareholders will be treated as dividends under the same general standards. And loans to employees will be taxed as additional compensation. These rules are retroactive to June 7th. Because the rates must meet those paid by the government on similar obligations, demand loans could have imputed rates that change on a daily basis! These rules are going to make ^“creative^“ paper difficult to evaluate.

10. The had news is that ^“Starker^“ type delayed exchanges must be completed within 180 clays following conveyance of title. And the replacement property must have been identified within 45 days in order for the Grantor to get the benefits of a tax-free exchange. But the good news is that Congress thereby officially recognizes “Starker^“ nationwide.

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What^'s your first reaction to the preceding page? BURNOUT? It^'s overwhelming for most people. CPA firms are heading into banner years. They^'ll be preparing tax returns for people who^'ve NEVER needed help prior to this year. Bear in mind that the few items I've sketched are only the tip of the iceberg! There are many revised portions dealing with corporations, partnerships, farms, estates, gifts, stocks and bonds, etc. The IRS is going to apply time value of money concepts to your taxable income streams. In a world where even IRS agents can't keep up with the changing laws, I can imagine an audit where the present value and internal rates of return for discounted and created paper are being arrived at by an agent who can^'t advance beyond the grade of GS-9.

 

As usual, Congress^' hasty election year ^“fix^“ will hurt more people than it will help with no lasting benefit for anyone and higher costs for everyone. This law will leave lots of victims in its wake who don't know how to adjust their activities to avoid being injured by it. It will have a negative impact on the American automobile industry, personal computer sales, apartment and office building construction, real estate sales, capital formation and savings. How can this make any sense? Is this more than it seems?

 

IS THERE AN ULTERIOR MOTIVE FOR THE 1984 DEFICIT REDUCTION ACT?

First, let's look at who benefits from this act. Populist politicians who count on the votes of an envy-driven, uninformed, un-thinking instant-gratification oriented electorate. So long as the “Boobus Americanus^“ thinks he^'ll be better off if no one earns any more than any one else, he^'ll vote into power those who promise a “fair tax^“ which takes from someone else and gives to him. There will be more non-productive citizens voting in the 1984 elections than ever before. They^'ll be intent on strengthening their claim on transfer payments from the productive sector and Congress is betting the election on this.

Who else wins by this act? INSTITUTIONAL LENDERS! When sellers must charge higher interest rates than banks, buyer^'s will float more conventional types of loans. They^'ll be paying lenders interest instead of sellers. But they^'ll be buying less since they won't have the advantages of “creative financing^“. This will affect single family houses in viable investment price ranges less than other types of real estate, but pity the unfortunate individual who owns a small apartment house valued at over $250,000. He^'ll have problems attracting a buyer who must pay ruinous interest rates which no apartment will support. And those who do qualify for institutional loans will be signing adjustable rate mortgages which will guarantee loss of income and possible financial ruin. For a brief period, until those loans go into default or the borrowers go into bankruptcy, the lenders will prosper.

 

But I suspect even more ominous portents. The 1984 tax act is supposed to incite outrage! Next year Americans are going to be lured by promises of a simplified tax. In August of last year I first warned about the BRADLEY-GEPHARDT Fair Tax Act proposal. It really simplifies the tax picture. Under it you won't have to concern yourself with interest deductions, Alternate Minimum tax, indexing, 18 year depreciation schedules. Their proposal allows home mortgage interest deductions up to 14% – nothing over that. Fringe benefits will be fully taxed as income. Doubles small business tax rates. Increases long term capital gains rates by 50%. Eliminates most personal deductions. Bill Bradley has put this into a paper back for $4.95 available on magazine racks. Sale proceeds are being used to lobby for his bill. He really understands the system. If you can^'t get a bill passed on its own merits, pay for professional help to sell it to your fellow Congressmen.

 

Don^'t stop reading now folks, there^'s more. Why not a new Federal sales tax? Everyone pays! Easy to collect! Encourages thrift for everyone but the government. Only the consumers are charged. Generates high revenues with low collection costs. Or we might adopt the European system of a Value Added Tax (VAT) which taxes every stage of production. All these taxes are ultimately paid by the consumer. He buys less. The economy slows and he^'s laid off. Now he need not pay any taxes at all since he doesn^'t earn anything. He becomes a government dependent whose vote can he counted on in the future when needed.

IF YOU CAN KEEP YOUR HEAD WHILE ALL AROUND YOU ARE LOSING THEIRS. .

First what can you do that's defensive? Write to your Congressman and Senator! They KNOW this law^'s a mess. And they know it^'s an election year too. Remind them! Point out the effect this law has on YOU and on your business. The National Association of Realtors is already working on getting hearings to amend the law.

If you^'re a real estate licensee, avoid liability if you can! You might try to put a statement into all contracts which state that the seller and buyer warrant that the interest rate charged on any ^“carry back^“ paper is subject to future interpretation by IRS and will be adjusted to reflect the minimum required by law. Maybe this will keep you from being sued in the event the seller doesn't charge enough, or the law is changed in some way which reduces the required rate. You might get both parties to sign a letter which forbids them from filing a suit against you in the event there are any IRS claims.

Let^'s talk about ways we can work around the new law. We^'ll make this purely hypothetical since there are no court cases yet. First of all, the SELLER is the one who runs the risk of being assessed penalties for insufficient interest. The buyer benefits! I'm presuming for now that you^'re the buyer. I'll deal with the seller later. Try these: A. Lease the property with an Option to buy. B. Option the property with periodic payments which count toward the down payment. C. Go on a buying spree now before the new law takes effect on January 1st. D. Buy property using ^“paper” which you create in 1984 against other equities at favorable interest rates. This way the seller is being paid in full and not lending you any money at all, so the law may not apply. E. Exchange other property for the property you^'re acquiring. Under the new law you have 180 days to close on another acquisition providing you can identify it within 45 days. You can use a ^“neutral vehicle^“ such as raw land, then exchange it once the seller has located a property he'd like to keep. F. Buy from the Seller's pension plan. Imputed interest doesn't hurt a non-taxable entity. Be sure to run any of these ideas past your tax counselor to see what he thinks.

Those are fairly simple approaches. Here are some more complicated ones. For instance, buy a house with a purchase money note which leaves the interest rate unstated except for a statement that it will be as determined by IRS at time of audit, and the balance of the payment will be allocated toward reduction of the principal amount. You might say something to the effect that the loan will carry 120 payments of $500 per month including the legal minimum interest amount as determined by current law. As a buyer, you^'re not REQUIRED to deduct interest. Do it only when it has been determined. But the total price you'd be paying the seller in this instance would be 120 X $500 = $60,000.

Or you might get the seller to ^“create^“ a mortgage payable to his wife, child, parent, corporation, etc. with a (i.e.) 9% interest rate. He places this against the property with a Mortgage or Trust Deed. Suppose his $75,000 house had a $50,000 first on it and he placed a $20,000 second which he'd created. Then you give him $5,000 down and take title SUBJECT TO EXISTING LOANS. You^'d be paying below market interest rates. He^'d be collecting on the existing loan which he^'d created just prior to the sale. If there were imputed interest, he^'d be paying income tax as the creator and deducting the same amount as the payor. You^'d still be buying at reasonable rates.

Use corporate paper, or paper you've created which is secured by other notes you^'ve bought in the market at discount. Give this to the seller in lieu of cash or his carry back ^“paper^“. Remember that paper sells at both a premium and a discount. Suppose the IRS says that 14.37 is the required seller carry back yield. Here^'s what you can do: Suppose he^'s asking $75,000 but would be willing to carry 10% paper except for the law. Let^'s say the principal amount of $20,000 would require 120 monthly payments of $314.15 at 14.3%.  At 10% that would he $264.30. All you have to do is to reduce the principal amount until the 14.3% interest on that amount would equal $264.30. This would be $16826.33. Thus you^'d he paying the some as if your interest were 10%_, but meeting the requirements. 

Of course, you could also offer him full price of $20,000, hoc build in an automatic discount of $3173.67 anytime that you elected to pay your note off early prior to the 120th month. Then you could merely pay off your note one month early and take the discount. The total amount you might have paid would he about equal to 10% interest. But suppose you were the seller? One day we^'ll all eventually sell. The new 6 month holding period for long term capital gains encourages it provided that we take care not to co-mingle capital assets with inventory. Here are some more flights of fancy.

 

1.           In 1984, create mortgages and place them on your property. Contribute them to your solely owned corporation as paid in capital and record them. Specify 9% interest. In 1985 or later, you can offer your properties for sale with fully assumable 9% loans which might represent 100% of the equity and a small cash down payment. Your financing will enable you to increase the price of your property, and the increase can comprise the cash down payment. There will be no ^“seller carry back financing^“. Your higher price will offset the lower interest and the cash will be about the same as points. The buyer will be making payments into your corporation to build cash flow. Next, your corporation can put the cash together with corporate debentures representing those 9% mortgages. It can go into the market and buy houses from other sellers using its unsecured notes plus some cash. In the buyer's market that the new tax law will generate, this could be very profitable. There shouldn^'t be much competition from people using conventional financing.

 

2.          Structure attractive market interest rates but have the buyer indemnify you so as to pay your imputed taxes and penalties which might be charged by the IRS in the future. Adjust the interest on your carry back Note and Mortgage to reflect that imputed by the auditors once they established it. The buyer is effectively playing audit roulette.

3.            Sell an undivided interest in common each year for a single cash payment. For example, suppose your house had a $25,000 equity and an assumable $50,000 loan. Agree to sell 10% for $3000 cash and the buyer would agree to make payments on the underlying loan in return for the right to occupy the property. Next year, and for the next 8 years after that, he repeats the process. After 10 years he^'ll own 100% of the house. You can adjust the yearly figures to give you the yield you desire. Since there^'s no carry back ^“paper^“ you won^'t have imputed interest. You^'ve both avoided ^“mortgaging^“ entirely.

 

4.            Sell a rolling option on your property. The buyer pays on the same schedule as above. The Option expires after 5 years if you haven^'t been paid in full. He gets to lease the property and to occupy it for a rent which will cover your payments until he closes his Option. You structure the transaction so it won^'t be taxed as an installment sale. All these approaches are untried and unproven – but so is the tax act, isn't it?

LOCATE THE FIRE ESCAPES BEFORE THE FIRE STARTS!

This letter attempts to give you the tools you need before you need them. I think 1985 will present more tax problems than 1984. In fact, I wouldn^'t be surprised to see the 1984 act defanged before the election. But next year will be a bear! 

 

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Quotation not permitted.  Material may not be reproduced in whole or part in any form whatsoever.