March 1987
Vol 10 No 5
Think about that for a moment. Who'd sell it to you? What would they rather have than the gold itself for currency? Why would you give gold that had already been mined in exchange for gold that had yet to be mined? The same principle is true of advice on getting rich quick! If the people who gave it could use it, they wouldn't sell it on TV would they? Over the past year I've been building a file of nationally known gurus who are being charged with fraud, filing for protection either personally or in the name of their corporations under the Bankruptcy statutes, being sought by the authorities for a variety of transgressions, or who have suddenly switched to different lines of work. They all shared a common flaw: they sold an eager, unsuspecting public a map to a gold mine.
Oh, it wasn't exactly that, but it was close. They presented real estate as a sure road to wealth for anyone with the price of a set of tapes. Easy! No risk! No need for any expertise, education, experience! All the mark needed was the secret formula which was contained in the magic tape/book set. And there was absolutely NO DOWNSIDE RISK. Is it any wonder that these hucksters are now in hiding? If you don't believe that, try to get one of them on the telephone.
What's the point? There are several: (1) There's nothing easy about making and keeping money. The money game is getting a lot rougher and only those who are dedicated to learning and maintaining their knowledge of the rules will succeed. (2) Past success doing one thing is no harbinger of future success doing the same thing. (3) Keeping wealth is lots harder than making it in the first place. (4) Greed, envy, corruption, taxes, computer crime, market manipulation, economic uncertainties are on the rise at a time when standards and values of society, personal responsibility, moral leadership, and the work ethic are on the wane. Pyramiding your assets is going to require a steady hand on the tiller and the till.
THE GREED/FEAR INDEX IS MOVING TOWARD GREED . . .
Anytime logic must compete with greed, greed usually wins. Look at the stock market. Don't I wish I'd had every dime I could borrow in it for the past year. Don't you? Through the use of Options, I could have multiplied my assets 10 times over. But I didn't. Why? Because I was afraid when the market was at 1500 and I'm still afraid at 2200. My fear overcame my greed. And I don't want to contemplate what will happen after foreigners with cheap dollars decide to bail out once the dollar grows stronger or the companies they've invested in fail to produce a return.
My problem is that I try to use real estate logic on non-real estate investments. For example, today I might be seeking a gross cash return around 10% based upon my rents as compared to invested cash-AFTER PAYING THE MORTGAGE PAYMENTS. And I don't like excessive leverage because I understand how fast my equities could be wiped out in a down turn when they've been leveraged too much. Yet, right now, FASB accounting guidelines contemplate forcing many of the biggest gainers in the market to start including the debt of subsidiaries on their balance sheets. Up to now they've just been showing the profit – but not the debt! American corporations are leveraged at higher levels than at any other time since the 20's. As I recall, the market also had quite a run-up then too – for a while – before it crashed. I'm more comfortable where accountants aren't cooking the books to make managers look good, where computers aren't controlling massive shifts in prices, where fickle foreign money isn't determining how well I do with my investments. But IF I were a SPECULATOR, I don't know . . .
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THE NEW TAXES ARE ALREADY CHANGING MARKETS . . .
Single family house sales seem to be continuing at about the same level as they were in 1986. Recent cuts in mortgage interest rates are helping this to sustain momentum. In some areas, the rush of corporations to liquidate, terminate retirement plans, merge and adjust operations to the new tax realities has caused layoffs, but overall, employment is at the highest levels in history and there seems to be some strengthening in the rental market. Investment real estate is seeing a somewhat different scenario.
I attend marketing meetings on a more or less regular basis at which larger parcels of land, apartment complexes, office buildings, condominiums are presented for sale or for exchange. Prior to the passage of the new tax act, these were routinely presented at a price which was justified by the 'beauty' of the property, the 'potential' in the hands of the buyer after cosmetic work to make it 'beautiful', the inflation profits (AFTER prices rise), the tax shelter. Income was rarely even considered or described except in general terms. Now that's changed.
First of all, prices have been adjusted downward. Physical attributes of the properties are not emphasized, but cash flow is. And the intangibles of appreciation, tax shelter, location are also being down-played. The market has stopped respecting these and is focused much more sharply on the cash-on-cash yields. Extremism, whether directed toward 'beauty' and 'potential' last year, or toward 'cash-on-cash' return this year can be costly.
As a buyer, you should start with INCOME. Don't believe anything you hear or see that's presented by the seller. Never ask your barber if you need a haircut – and don't expect the seller to tell you the truth, the whole truth, and nothing but the truth. In many instances, he just doesn't know. In others, he knows, and that's why he's selling. You need to do your own audits of income. Start by establishing comparable rents in comparable properties. Usually a ratio of rents to square feet in similarly located buildings with approximately the same amenities – landscaping, janitorial services, utilities, interior and exterior cosmetics, extras, parking, etc. Once you establish rents per square foot per year, then you can establish vacancy rates, maintenance, licenses, fees, MANAGEMENT, accounting, common area utilities, insurance, taxes, reserves for replacement of carpeting, roofs, paved areas, pools, sprinkler systems. Don't forget liability, property damage, loss of rents, tenant mischief insurance. And look at surrounding economic conditions. It does you little good to buy a property at 50% of value if there's no chance to find paying tenants to use it.
Once you've subtracted the expenses YOU'LL have from the income YOU think YOU can generate in the property under your ownership, then compare it to the owners'. Generally, it is difficult to find any property which produces a true NET OPERATING INCOME after expenses over 50% of the GROSS SCHEDULED INCOME – that which you think you'd be able to produce if the property were 100% occupied at market rents. Net Operating Income is what you'll have left to pay your payments with, so take a hard look at the financing. Beware, there are lots of traps for the new owner. Some loans are non-assumable, some are indexed, some have balloons, some call for periodic extra payments of principal. Read the ORIGINAL Note and Mortgage or Trust Deed to find out exactly what your obligations will be, especially with regard to the interest rate, payment, impounds for taxes and insurance, late charges, grace periods, etc.
By subtracting payments from net operating income, you'll arrive at cash income. This is what you should compare to the cash you're putting into the transaction to arrive at your return. If it's at variance with the owner's income statement, question every item to verify its accuracy. Drive by the property when the occupants would normally be there and determine what the true occupancy rate is. Question tenants to be certain they haven't received 'incentives' to occupy the premises. If cash receipts are involved, check with the suppliers and sales tax collectors to verify that sales are as high as have been represented. Remember, the money you save is your own. You can't be too careful on larger properties. When a lender has taken back a vacant property, you'll have to buy it based upon your best estimate of what you'll be able to accomplish. Try to negotiate a moratorium on payments until you get it filled to the point of being able to make payments, or you've sold it.
CONTRACTOR vs. EMPLOYEE – IT MAKES A DIFFERENCE . . .
In 1987 the IRS is going to re-examine the relationships between those who hire others and those who are hired. Both have something to gain and to lose depending upon their personal circumstances, so it pays to understand the differences before they're explained by your friendly auditor. Let's take a look and see where we stand.
Employees are people who are paid according to how well they perform what is asked of them by their Employer. Usually, their compensation is based upon the TIME they spend, the QUANTITY of what they produce and the QUALITY of what they do. Hence, these are CONTROLLED to some extent by the Employer. They give up a certain amount of their personal freedom and initiative in return for PROMOTION, SALARIES, RAISES, PENSIONS, VACATIONS, SICK LEAVE, and payments by their Employer into SOCIAL SECURITY, WORKMAN'S COMPENSATION, UNEMPLOYMENT COMPENSATION. Sometimes they belong to a UNION with a COLLECTIVE BARGAINING AGREEMENT and pre-agreed upon WAGE STANDARDS, WORKING CONDITIONS, MEDICAL AND LEGAL PLANS, GROUP INSURANCE, CREDIT UNIONS, DISCOUNT PURCHASE PLANS, STOCK OPTIONS, BONUSES. Sometimes for the convenience of the Employer, Employees are required to live in close proximity to their place of work, be on call 24 hours a day, 7 days a week, be entitled to OVERTIME PAY, be provided MEALS and LODGING, have all TRAVEL and ENTERTAINMENT expenses paid for by their Employer when on company business. And they can sue their Employer if they're exposed to hazards on the job resulting in illness or injury; if they're discriminated against because of age, sex, race, creed, sexual preference, disability, marital status, national origins and in some cases, illegal residence. Their wages and salaries are reported on Form W-2.
Employers are people who CONTROL Employees, provide them with tools, a place of work, training, wages and salaries, support services etc. They are liable to a host of Federal, State, Local regulations and restrictions as to the working conditions, pay, pension and profit sharing arrangements, hiring and firing practices; Local, State and Federal Taxes; safety, development of standard operating procedures, supervisory control, personnel administration policies and records keeping systems to document that they've met all their obligations under the various laws and statutes. They are liable for any failure to do these.
CONTRACTORS are different. They work under a CONTRACT to produce a product or a service. They aren't accountable for their time, materials, work records, sub-contractors, costs or efficiency to anyone who contracts their services. They are NOT UNDER THE CONTROL of the person or company that contracts for their services/product. They pay their own taxes and insurance, pension plans, wages and salaries. And they provide their own places of work, tools, equipment, training, materials. They are responsible only to the limits of their contract as to quality, quantity, date of delivery of the finished job and agreed upon price. To the extent they are paid more than $600, their earnings are reported on a 1099 Misc. form. They work for many different people and/or companies rather than just for one.
Re-read the above 3 paragraphs. Can you see that being an EMPLOYER is a lot more expensive than hiring CONTRACTORS? If you were an IRS agent, wouldn't you collect more taxes from EMPLOYERS? If you had the choice of being an EMPLOYEE or a CONTRACTOR, it's not quite so easy. If you had a large family, wanted security, needed a medical/legal insurance plan, had bought on installment sale plans and credit cards so needed a regular income, had only specialized skills oriented toward a narrow market, you might prefer to be an Employee. But if you had widely marketable skills, few debts, could operate with a low overhead, had few personal obligations which required a steady pay check, and preferred your compensation to relate more directly to your productivity rather than to the whim of company policy or union contracts, you might prefer to be a Contractor. You'd be more free, but at a price.
As one who is recasting his/her position from INVESTOR to ENTREPRENEUR, these are serious considerations to he deliberated over carefully. Of course, you could be both! Just INCORPORATE and work for your own company – presuming it can earn a profit. If you were a 1 person corporation, you can avoid many of the costs EMPLOYERS face. You'd have a captive labor force (yourself) for which you could set a variable salary. You'd avoid lots of the problems of liability and regulation. You could CONTRACT as a corporation with others, and still enjoy all the benefits of a PENSION PLAN, SALARY, BONUS, PAID VACATION, MEALS and LODGING, BUSINESS TRIP EXPENSES, TUITION ASSISTANCE, MEDICAL/LEGAL PLANS, COMPANY CAR, PLACE OF BUSINESS, TOOLS, EQUIPMENT; MATERIALS, ETC. And you'd be able to allocate your profits between the corporation and the employee to obtain the maximum advantage.
TAX TIME IS APPROACHING – IT'S TIME FOR DECISIONS . . .
In my December letter I spelled out lots of things for you to accomplish before the end of the 1986 – and the end of the prior tax law. Assuming you did some of these, you have some options concerning how you'll choose to report them. The decisions you make can have far reaching effects into the future, so you need to proceed with caution. If you haven't considered everything yet, you may decide to apply for an automatic extension of your April 15th filing date by paying your estimated tax and filing a Form 4868. This will give you until August 15th. For you people living near international boundaries, you might take a shopping trip so as to be out of the USA on April 15th. This gives you until June 15th to pay up, or you can then extend that date two more months by filing the Form 4868 and paying your taxes plus interest owed since April 15th. If you need more time, file a Form 2688 with an explanation of why you need more time. This will give you an additional 6 months if the IRS approves the request. Otherwise, you'll have to pay late fees. Bear in mind, this doesn't defer the taxes due, merely the date your TAX RETURN is due.
Having made that first decision, next you have to decide which sales/exchanges of property you want to be taxed on. The best thing to do is to lay out a spread sheet on which you list all income from 1986 and projected income for 1987 and 1988. It's not as difficult as you might expect. Just look at your financial situation NOW and put it in for those years the same way EXCEPT FOR ANY CHANGES YOU EXPECT such as increased wages/salary, promotions, sales, gains and losses, expenses. Be sure to include all FAMILY income from both spouses. Just look at the bottom line. If it's higher in 1987 than in 86 or 88, it will probably cost you more money. But to be sure, apply that bottom line income to the tax rates for each of those years to see what your projected position will be.
What you're trying to do is to lower the overall taxes for the period, and 1987 will be the highest tax year for most of us. For example, if someone were going to pay off a Note in that year from a prior purchase, you'd be taxed at a higher rate than in 1988, so you might elect NOT to report a 1986 sale on the INSTALLMENT BASIS if it were going to be paid off in 1987. Or you might decide NOT TO COMPLETE A TAX DEFERRED EXCHANGE, but rather to incur the taxes in 1986 even though it would increase your tax bill – presuming your overall taxes for the periods would be lower. Naturally, you'd want to work out the present value of being able to use that extra tax money for an additional year in contrast to being able to lower your tax bill. Like I said earlier, you may need an extension to work it out.
Next, there's the ALTERNATE MINIMUM TAX. When you've used tax preference items such as accelerated depreciation, long term capital gains rates, etc. there's another 20% tax applied to these items, TO THE EXTENT THAT YOUR ALTERNATE MINIMUM TAX INCOME exceeds YOUR PERSONAL TAX LIABILITY + $40,000 (if you're married). Suppose you have $50,000 A.M.T.I. liability, you may want to re-calculate your expenses from your rentals and CAPITALIZE THEM. Suppose you decided to add the cost of some roof repairs to the BASIS of the property and in this way GIVE UP deductible expenses in order to increase your personal income tax by $10,000 more. You'd pay the same total tax bill as before, but have INCREASED YOUR DEPRECIABLE BASIS to lower your taxes in subsequent years. This is a superior strategy to merely paying A.M.T.
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