July 1983
Vol 5 No 10
What do Robin Hood, Black Beard and Government have in common? Each of them survived by stealing from someone else and dividing up the spoils among their followers. The principal difference among them is less a matter of morality than of scale. Mere brigands and pirates are pikers compared to government when it comes to transferring wealth from your purse to theirs. And in this recession year with a shrinking revenue base from taxes, government at all levels is in desperate straits. Having bought power at the polls with gifts of tax payer's earnings, politicians are faced with being voted out of office unless they can continue to provide the cornucopia of government goodies to constituencies of voters that are, in turn, divided in their quest for more benefits.
The United States of America isn't united anymore. Our complex society is composed of disparate groups of self-seekers whose tug of war at the public purse strings is fracturing fiscal and monetary policy. Ultimately this is reflected in a wandering foreign policy, uneven distribution of favors and benefits of citizenship, and a lack of discipline in budgetary matters that is being felt throughout our economy. Labor, small business, state and local government, the elderly, students, farmers, oil interests, real estate developers, ERA, EPA, AMA, ABA, home buyers and builders, blacks, Hispanics, liberals, conservatives, the moral majority alternatively bribe and threaten our elected representatives into a state of catatonic inactivity. Even Ronald Reagan, who won a mandate to shrink government expenditures and to free enterprise, has floundered in his leadership.
Apparently conservative leadership is going to hark back to the wisdom of the past and resurrect the New Deal and Maynard Keynes. It appears that two powerful, all encompassing tax strategies will form the framework within which we must wend our ways collectively and individually toward financial security. If implemented fully, they will affect our investments through the remainder of this century. This issue will deal with strategies which will enable us to adjust our methods to protect our assets in the 80's.
THE FLAT TAX IS A CERTAINTY!
Harry Brown offered as an alternative to taxation the concept of planned 10% inflation in one of his early books. When the government can increase the money supply by 10%, it reduces the purchasing power of the consumer by that amount through inflation. Thus, without any lengthy committee hearings or individual political accountability, all of us will have been taxed. ALL OF US! Orphans, widows, rich, poor, churches, mafia, lenders and borrowers, white and black, savvy tax sheltered investors and spend thrifts alike will pay the piper for inflation. It seems clear that Reagan will re-inflate to find the money with which to support bad banking decisions, inept foreign governments, short sighted politicians, and non-producers among us. Hence, we'll all pay inflation's flat tax!
The more ominous aspect of the inflation tax is that IT'S NEVER REPEALED! If we permit 10% inflation to continue for 7.2 years, it will cut the purchasing power of our dollars in half. Yet, inflation is like a habit forming drug to those who depend upon it. Think of all those inept politicians, those negative cash-flow investors, those marginal businessmen, those debtors who can't succeed without inflation. Without it how would we ever pay off the national debt? How would other countries ever pay us back for our loans? In June, Argentina devalued its currency by removing 4 zeroes from a 10,000 peso note to make it worth one peso. It takes $12 to become a peso millionaire. That's what eventually robs savers who depend upon currency denominated assets to hold their savings. Those in Argentina who held their wealth in real estate and other tangibles will weather the storm unless the government encourages a policy of envy among the losers in the population. In that event, visible wealth will be a hazard to those who managed to retain it.
What can we learn from this? To maintain a balanced approach to investing which will give us enough easily liquidated assets to pay emergency expenditures while leaving some money invested into inflation-oriented assets which will increase with inflation. Of course, the single family house fits admirably into this scheme. But so do things like Options which enjoy added privacy as well as relatively risk free leverage. Any debt we carry for others should be of short duration and at high interest rates. When one looks at the line up of contenders for the throne in the 1984 elections, it's difficult to see any retreat from the easy policy of spend, spend, spend; tax, tax, tax. Isn't it odd that our leaders never consider putting budget cuts ahead of their own political careers? Yet they entreat us to put government's need for money ahead of our own need for security.
THE FAIR TAX ACT OF 1983 COULD BECOME LAW!
Consider for a moment your current portfolio of leveraged single family houses. You've been smart. You bought with “nothing down“. You obtained “interest-only“ loans and fast write down under Accelerated Cost Recovery System so that you were virtually building your estate with saved taxes. Over the past few years you accumulated 15 SFH worth $1 million. You are 100% leveraged at an average interest rate of 10%, so you've been deducting $100,000 per year in interest deductions as well as another $96,000 in depreciation. Your tenants paid the interest to you in the form of rents, and you were able to offset your family income against the $96,000 from depreciation so that your income was totally tax sheltered. You're just the guy the Fair Tax Act of 1983 is aimed at. And, if it becomes law, it could deprive you of your future financial security.
Here's what Senator Bill Bradley of New Jersey and Representative Richard A. Gephart of Missouri think is fair. They would change the rules in the middle of the game. Regardless of the risk to your investment or the years of effort expended in assembling your portfolio, you could become liable for thousands in taxes if your investments fit the above example. If you are like most SFH investors, you're cash-poor from “feeding“ your highly leveraged portfolio, so you'd be unable to pay your taxes. No problem! The IRS could tax-lien your houses, charging interest at 16% this year, compounded on a daily basis. Added to the existing financial burden, the result would be ruinous. You'd lose your investment as well as your credit rating, AND YOU'D STILL OWE THE BACK TAXES until you paid them – for the remainder of your life – plus compounding interest.
This is a perfect example of what inept politicians will do to retain political power. They'd destroy millions of small investors who had prudently saved and invested rather than consuming all their earnings or depending upon the welfare system to provide for their old age. They'd discourage future investment or capital formation where private investors need tax incentives. When they permit only 40 year depreciation schedules or deprive restorers of tax credits or eliminate long term capital gains or rob the elderly of their $125,000 one-time exemption upon the sale of their homes, they merely continue to penalize the responsible, productive citizenry to protect their privileged position. Of course, their version of fairness includes a surtax on higher incomes to a 30% bracket. Home owners would retain their property tax and interest deductions, but who will be a buyer in the resulting depression? Where will all the displaced people live if investors who deduct interest expense only to the extent of rents received RAISE RENTS TO COVER IT?
IT'S NOT TOO LATE TO TAKE EVASIVE ACTION . . .
For several years I've been advocating EQUITY versus DEBT financing to build your portfolios of SFH. When debt financing is used, I've counseled to avoid institutional financing and use private financing. In like manner, I've warned that negative cash-flow properties would sooner or later be attacked by the IRS and interest/depreciation tax deductions curtailed or eliminated. Unhappily, Bradley/Gephart makes all these dire predictions come true if it is passed. It could be a rallying point for Democrats in the coming elections. But there's still time to get set for it, if you start soon.
Let's take it step by step and see what we might do. First, they're going to eliminate investor interest deductions over the rents, but not home owner deductions. So put a home owner into your property! If you advertised for a responsible buyer and sold your property BEFORE the effective date of the law, you could take capital gains on the profits and carry back the mortgage yourself in the event long term mortgage loans weren't available. You could do this very fast either by selling to a tenant or to your own corporation. The tenant might pay $1000 down on a $61,000 house and agree to pay 1% per month on the balance, with the balance due in one year. He'd be paying $600 per month plus taxes, all deductible to him plus property taxes, deductible to him too. You'd pay taxes on the $600 per month, but that would leave you $420 after taxes even in the highest bracket. And $420 is about the year-around rent you'd expect to receive on a $60,000 SFH. By making the loan balance remaining “adjustable“ by the CPI each year and re-writing it, you'd be automatically indexing your payments and investment balance to inflation.
Or you might start buying houses and rather than paying cash plus a note which would call for non-deductable interest, you could buy ONLY THE IMPROVEMENTS AND LEASE THE UNDERLYING LAND. Suppose you had $5000 to buy a house with. You could agree to pay a high rental on the underlying land in return for a low interest rate on the house. Say the land were retained by the seller at a rental of $400 per month for 35 years and the house were sold to you for $20,000 after your down payment of $5,000. You'd pay 9% per year, say $200 per month for the house. After collecting rents of $500, you'd first pay interest, all of which you could offset against the rent under the proposed law. Next, you'd pay your land lease payments of $400. You'd be $100 in the hole, but because it was due to lease payments, it would be deductible to you as operating expenses. If you already own the house, why not re-negotiate your loan to obtain a structure as explained here?
Since the $125,000 is being placed into jeopardy, now might be a good time to sell your own comfortable house that's free and clear for cash. Legislation has been proposed which will allow the owner to sell and lease back his own home while getting the $125,000 exemption. So you could use the cash to free and clear some of your properties with high interest payments on them. Alternatively, you might borrow against your own home and use the money to buy free and clear properties. You could deduct the interest on your own home under the law, and use the money for investments free and clear. Or you could persuade another investor to co-venture with you, borrowing against his home and providing the cash to buy investment houses which you might lease with an option. All of these approaches could be used in conjunction with the land lease technique above to give you leverage in using your cash.
If you don't like to co-venture properties and you have a pension plan, you might borrow from your own pension plan to buy a new home, deducting your interest on it and receiving the interest tax free into your plan. Then, you could sell your prior home and use the cash as above. Of course, your corporation could buy your home and sell it for cash if you find you have to move fast to avoid losing your capital gains. You can use the sale proceeds from the corporation plus the cash proceeds from its sale via a loan to buy properties which might be dumped by panicky investors who don't have these remedies.
What about high interest rate properties you now own? Suppose you sold only the improvements and retained the underlying land? You could set a low price near your basis, and leave the profit in the land, charging a lease equal to the interest. The buyer would buy at bargain prices since he would only be buying the shelter. You'd only be giving up depreciation, which over 40 years wouldn't be too thrilling. When the house is sold in the future, you can either participate in the profits by selling your land too, or continue to rent with indexed lease payments to subsequent owners. Of course, you'd be wise to buy Options on replacement houses which wouldn't carry interest payments. In this instance, your investment position would provide income from rents, cash from the sale itself, and an inflation hedge both in the land lease and in any replacement option. This would be a technique for getting out of property which was highly leveraged and for which high interest costs would no longer be deductible.
In my Options course, I've often made the statement that Options offer great flexibility in any real estate situation, and often are the best of all possible approaches. If you had a house that you had to sell quickly, you could offer a bargain price and carry back either a remainder interest which would take effect in a number of years, or your profit could be in the form of an option to purchase the property at some point in the future at a price and under terms which would be equitable to both parties. Certainly, in the future, if the Bradley/Gephart bill passes, Options will offer the best way in which to invest in real estate, especially in conjunction with cash-flow lease sandwich positions. But, as a matter of fact, they're pretty hard to beat now, aren't they?
Sellers who will no longer be able to obtain capital gains under the new law may favor lease/option techniques over sales under certain circumstances. Suppose you were to buy the property of someone in a relatively high bracket now, but who would be retiring in 9 years. You could option his house first, with an option to lease it at a stated rental any time he might vacate the premises. If he transferred, you'd be able to rent from him at one price and to rent the premises to someone else at a higher rent. In this way, you'd be earning an income while awaiting the end of the option period. And at the end of the 9 years, you could either buy the property yourself, sell the property, sell the option, or re-negotiate with the original seller. Of course, you could either sell a leasehold position to someone who might want to take over your cash flow lease position, or sell the option prior to the 9 years and retain the leasehold, or both.
If there's a message to be gleaned from this month's letter, it's this: no matter what the news brings, there's probably some good and some bad in it. Keeping a sense of proportion and maintaining a willingness to adapt to changing conditions is the hallmark of successful investing. Bear in mind that next year's opportunities are in their gestation period right now. As FHA and VA interest rates are increased .5%, all the 26,000 buyers who won't be able to qualify will become tenants, and an equal number of sellers will be willing to offer you terms under which you can buy their houses. It remains for you to stay informed about opportunities and ways in which to capitalize on them.
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