November 1986
Vol 10 No 1
Bismark once said, 'Those with an appetite for sausage or the law should watch neither being made.' Amidst all the wrangling of the special interests and pressure groups, a new tax law has been hammered out which represents a miracle of legislative interaction. As a result, Americans are seeing one of the most profound changes in tax philosophy since the inception of the graduated income tax being enacted mere weeks ahead of the election.
Why now? Why this law? How did it get such a wide consensus among citizens, corporations, politicians, businesses, organized labor and government? How did it avoid being decimated by powerful lobbies on all sides? I think everyone realized that we were on the precipice of wholesale tax revolt! AMERICANS WERE MAD A HELL! THEY WEREN'T GOING TO TAKE IT ANYMORE! And the American dream was being eroded by the welfare state which, in spite of unprecedented deficit financing, explosive expansion of the monetary base and artificial economic life support systems, continued drain vitality from our country.
In the short term, it might appear that real estate is going to bear the brunt of the changes in the tax law, but that's deceptive. Over the remainder of this century, we're going to enjoy truly golden years brought on by the new opportunities presaged by this new tax philosophy. Why? Consider what has really happened.
1. For the first time in 54 years since you-know-who became president, the tax law is oriented toward production of income rather than social engineering per se. Someone finally realized that all social programs are placed in jeopardy when insufficient tax revenue is produced to support them. By concentrating on raising revenues instead of dispensing favors, the new law will ultimately benefit our society more. Here's how:
2. This law penalizes rank speculation, profligate consumption, imprudent debt both in the hands of lender and borrower, consumer and investor. It deprives marginal and obsolete/non-competitive enterprises of a large degree of government tax-subsidy. It discourages non-productive sectors of the economy – including over-building, over-financing, under-utilization and inefficient management. Over the past few years we've seen more and more of this in the real estate field, to the detriment of all of us.
3. The new tax law underscores incentives for the more productive enterprises. I can remember when we had a 92% maximum tax bracket. Then 70%. Then 50%. Now it's capped at 33% for people, 34% for corporations. Oh sure, with all our deductions hardly any of us paid the maximum tax, but we were all aware that our tax brackets took bigger and bigger bites out of our profit as we earned more. So what did we do? We stopped trying to become more efficient. We made less and spent more. We bought 'tax shelters'. As a result, we performed beneath our potential because it paid to do so. And we deprived ourselves of the true rewards of seeing how MUCH we could do rather than how little.
To a certain degree, real estate tax-shelter investors behaved like welfare mothers who've learned that the greater the expenses, the greater the rewards so long as they could get other tax-payers to share the load through government largess. Now, we're both going to have to get back to work, producing income and economic benefits in order to enjoy the support of our government. Enter the ENTREPRENEUR. His time has come!
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WHAT'S IN IT FOR ME? The Five Most Important Words in Business . . .
Once a person reaches the top bracket, THE MORE HE MAKES THE MORE HE KEEPS! What a refreshing concept. Look at it this way. In the majority of cases, write-offs will be limited to income in real estate as in other activities. Income will push the tax bracket into the 157, then 28%, then 33% range. At the same time, more and more expenses will be deductible to offset income. They'll work to reduce the tax bracket while allowing NET AFTER TAX INCOME TO CONTINUE TO RISE WITHOUT LIMIT. Now, we can concentrate on producing that income rather than in trying to stay out of the next higher tax bracket. Thus, under our new tax code, entrepreneurs, innovators, inventive and creative people will wind up on the top of the heap. That means YOU! Otherwise, you wouldn't be reading this newsletter!
What might some of these approaches be? First of all, we've got to STOP DOING THE THINGS THE TAX BILL PENALIZES and start doing what it rewards. Let's list these.
a. Reduce Expenses! Remember, after January 1987 your write-offs will be severely limited. Think of a typical house in terms of income and expense. YOUR MOST CRITICAL EXPENSE IS VACANCY! Next is usually INTEREST. Next comes MANAGEMENT. Then MAINTENANCE, TAXES, INSURANCE, UTILITIES, FEES,etc. These will vary with your individual situation. You'll have to deal with the art of the possible. Concentrate on filling those vacancies and getting all foreseeable repairs completed and paid for over the next 6 weeks. Pre-pay your taxes in 1986 together with your insurance if possible. Pay for accounting and legal fees. Put any funds you can into your IRA too. Renegotiate interest rates if you can to reduce them to current rates. Calculate which effort will yield the greatest after tax reward in both 1986 and 1987. Remember, 1987 taxes will be much higher than those in 1988, so keep your eye on all 3 years.
b. Bring income into 1986 from 1987! Of course if you're in the 50% bracket, you might want to consider these moves carefully. Your top bracket will be 38.5% next year and all long term capital gains will be taxed at a flat 28% regardless of your personal tax bracket. You may discover that your 50% bracket replete with deductions could actually result in less taxes than the 1987 transition brackets will afford. Proceed with care.
The whole idea is that you try to bring income into 1986 from all sources against which you'll still be able to offset real estate rental losses. Then you accelerate these losses by bringing all deferred maintenance up to snuff, paying for every foreseeable expense that might be non-deductible in 1987, and thereby reducing both 1986 and 1987 income and expenses.
c. Capture your long term capital gains while you can! After January 1, 1987 all proceeds from sales will be taxed as ordinary income. That includes payments of principal on any 'paper' you may have carried back from a prior transaction, to the extent it is gain on that sale. If you sell on an installment contract, you can elect to declare that as if it had been a cash sale, and pay the tax on 1986's return. If you should use any existing 'paper' previously treated as an installment contract in a prior year to pay for anything, it is automatically treated as constructive receipt of cash to both parties in that transaction. So you might want to go out and BUY a house using your old Notes to pay for it, or for a down payment, and trigger long term capital gain.
d. After this year, you can kiss the good old 19 year cost recovery goodby. That means it will pay you to buy in 1986 if you've been waffling over a purchase. And this is the last year you can buy from an owner who's willing to carry all the paper without any recourse against you IF you want to depreciate the entire value of improvements. Next year, you'll have to be at risk to get the depreciation. Remember, the purchase will count even if you only put $10 down on an installment contract and close in 1986.
LET'S SUM UP: If you should accelerate income and expenses, refinance loans, sell and buy all before the end of the year, it's going to be a busy season indeed. Maybe you should bring some deeds, notes, mortgages, and installment contracts to the next few seminars!
MEANWHILE, BACK AT THE RANCH . . . OPTIONS!
There's an old Chinese saying that I've just made up, 'If they're going to take away a lot of tax deductions, maybe owning real estate isn't the final, best approach!' Last year I toured the country with my MILLER TIME seminar showing people all the benefits of real estate ownership, and NON-OWNERSHIP. This year, in the remaining 2 of these I'll be doing (BOSTON/Framingham Oct 18/19th)(San Diego Nov 15/16th) my MILLER TIME. I will deal with some precision with the NEW BASICS to use in real estate. The new bottom line is that the most predictable form of profit for the long-term real estate owner will be AMORTIZATION of the loans and CASH FLOW above all expenses and financing. If you go way back to the earliest issues of the CommonWealth Letters you'll see me advising Single Payment, Zero Interest Rate, Non-recourse, Non-Institutional Financing. That's still good advice under the new tax law because it still captures amortization and cash flow.
Practically speaking though, in 1987 you're going to lose depreciation unless you sign personally in most instances. That's a no-no! What should you do? Back to the old drawing board – what benefits remain for the real estate investor. Let's see, we can't deduct operating losses in excess of income once the new law phases in (65% of losses in 87, 40% in '88, 20% in '89, 10% in '90 and zero deducts in 1991). We're going to stretch out depreciation to 27½ years for residential/31½ years for commercial property. There probably won't be much appreciation for a few years until the panic subsides, surplus space is used up and/or inflation resumes. That leaves leverage. Lenders love home owners and hate investors. 42% of HUD foreclosures involve non-owner-occupant-investors. Even at the (low nominal)(high real) interest rates prevailing, high loan to value financing will yield NEGATIVE CASH FLOW which can't be completely written off. Not to worry, there's still hope.
What if we could control income without any borrowing, risk, investment? Sort of like having your rich Aunt Tilly leave you to collect receipts while she was away, and then giving you a percentage for your efforts. Isn't that exactly what a sandwich lease does? You lease an income property – it could be anything, not just a house – at a rental which is below the actual, audited rental history of the property. Then you sub-lease it to a USER at market rates, keeping the difference. You write into your lease the right to terminate it anytime you want, or to extend it over several future increments. You try to negotiate fixed, level payments while giving yourself the right to increase rents at will. And you place limits on your obligations regarding repairs and capital improvements, putting the owner in the hot seat with regard to these plus increases in taxes and insurance. Can you see, this could be a lot better than actually owning the property?
Moving right along, now suppose Aunt Tilly falls on hard times and needs the cash herself. Instead of giving you the rent collections, she keeps them herself. Right now she needs money more than she needs your effort. Tilly might be amenable to your offering her cash, an income stream secured by a Note, services which she would otherwise have to pay for, materials and equipment she might not be able to afford, a line of credit, maintenance and repairs, etc. IN RETURN FOR THE RIGHT TO PURCHASE THE PROPERTY IN A FUTURE PERIOD. If you could arrange this, and if you set your price and terms to provide a profit at the time you exercise your Option, you've hedged any future appreciation/inflation while obtaining the benefit of amortization and future income potential. Of course you've got to be able to structure the transaction to yield the benefits that both of you might need going in.
Who in the world would be dumb enough to let someone capture income with a lease, amortization and appreciation with an Option, or both with a combination of these? Almost anyone trapped under the new tax act who either CAN'T or WON'T MANAGE his rentals FOR INCOME against which to offset property losses should welcome the Master Lease because it's able to produce PASSIVE INCOME PLUS $25,000 of ADDITIONAL DEDUCTIONS AGAINST OTHER INCOME which he might otherwise be denied. Or it can enhance the value of property anytime its appraisal is based on the income received. It's just plain good business for both parties. And who knows how many investors might be abandoned with management-intensive properties they can't handle?
But let's not overlook some of the other features of the Option. When good old Aunt Tilly gets paid for an Option, that's non-reportable, non-taxable income because of special tax treatment of Options. She gets to keep the money and use it to pay some of her expenses which were previously funded by tax deductions. Do you suppose there are any long suffering super leveraged investors left in the real estate world who've signed on loans with full personal recourse, who've found themselves in the top tax bracket without many of their old tax write-offs as a result of the new tax act? Think about this:
If they BORROW to pay expenses, the interest paid could be become non-deductible and have to be carried forward until a time when the income from the property increased. If they SELL property, they'll have to pay at ordinary income tax rates and the combination of recapture of excess depreciation, mortgage over basis, alternate minimum tax might well put them in the highest brackets, requiring even more cash with which to pay income taxes. They might even have signed a NON-ASSUMABLE LOAN which means no possibility exists to just jump off the property and let someone else take it over. And, under the new installment sale rules, they'd trigger a taxable event even though they sold with nothing down. About the only game in town for these people is to sell an Option on their property to someone else who can pay cash or supplemental income. If you'll re-read your back issues, you'll see that considerable time has been devoted to this subject in the past with lots of ways to do business for both buyer and seller.
One more thing to ponder . . . In order for Options to work, the seller has to be convinced that the property isn't going to go up much, or the person purchasing the Option will never exercise it because of unfavorable terms, time frames, or prices; or as in the above case, the seller has to be in some sort of distress. The climate today is ideal because the conventional media has been proclaiming the demise of real estate on a continuous basis for the past year or so. You might collect Xerox copies of some of these articles and use them as a part of your negotiation technique to show the reluctant owner. On the other hand, if he's in most areas of the country, with the exception of those with really hot markets, he's already seen a softening in prices. He may already be convinced that he has nothing to lose by selling an Option. And he may be RIGHT! But . . .
Here's what I think is going to happen. Lots of amateurs will bail out, leaving their properties to the lenders. Many of these too will founder and the properties will be liquidated at low prices, driving real estate down temporarily. Construction and financing will crater, causing disruptions in the work force and even more debt liquidation. But shortages of living space will start driving up rents, and with them market values after a couple of years. So any Option you SELL should be relatively short term. Say 1 – 2 years. But don't allow it to be closed in 1987. And specify CASH ONLY. If you're buying Options, then stretch out the date of closing, including extensions and renewals, until about 1991 or later. By then, prices should have increased smartly.
I'm offering rentals on lease/options for $2000 down, closing January 1988. I've found a lot of activity in today's market in my area. Thus, I'm garnering tax free cash, filling vacancies, selling inventory, increasing my income. In late December I'll convert the best of my new tenants into BUYERS with installment sale contracts and pay taxes in 1986 to capture my long term capital gains. On the others, I'll close on a deferred tax free exchange, and use the proceeds to buy into distressed properties to avoid taxes. That might make good sense to you.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
