July 1985
Vol 7 No 10
When Kenny Rodgers made that song famous, he was referring to a gambling game in which the rules were firmly established. Certain combinations of cards comprised a winning hand. Other combinations weren't worth betting on. We should be so lucky! In our rough and tumble world of investment, it's more complicated. Not only do the rules change with each hand, but the value of our cards change constantly. In May Ronald Reagan unveiled 'TREASURY II'. Suddenly, we have a whole new game with a new set of winners and losers. The trick will be to figure out what we should be doing next.
Let's see where we stand under the Reagan proposal – and remember folks, it's only a proposal. It has a long way to go before it becomes law! 1986 will be the year it takes effect! We may have a little time left before then. We might call this the Real Estate Revenge Law. It will drastically restructure our markets. We lose deductions for expenses associated with 2nd homes and/or resort property that we use. Credit card consumers will be in for a nasty surprise when their interest is no longer deductible. For that matter, no consumer interest will be deductible excluding mortgage interest on your principal residence. Investment interest limitation, presently at $10,000, will be phased downward commencing in 1988 until it reaches $5000 over the sum of all net income from investments. How does this affect you? Look at your 1984 tax return. Add back in all the deductions for interest on loans to buy appliances, furnishings, cars, boats, personal loans, and investment loan interest which exceeded investment income by $10,000. Now, recompute your return to see what your new taxable income will be. What will you owe?
But there's more. Neither would your property taxes be deductible! Assume you're paying $1000 per year on each house. That's $3000. And if you decided to take depreciation, first of all, you'd have to sign your Notes with FULL RECOURSE. Then when you sold the property, you'd have to pay ordinary income taxes on any profit. The only way to obtain long term capital gains would be if you didn't depreciate the property. Even then, capital gains wouldn't be indexed to inflation until 1991. There will be strict guidelines as to what does and does not qualify for capital gains treatment.
There are other features of the law that offend everyone. Since sales and state/local income taxes wouldn't be deductible, people in high tax states like New York, Wisconsin, Massachusetts, Michigan, Minnesota, California would pay more than residents in lower taxed states. Tax rates would be compressed into 3 brackets: 15%, 25% and 35%. Many personal deductions would be eliminated but the zero bracket amount would be raised to $4000 for married couples plus personal exemptions for taxpayer, spouse and dependents would be increased to $2000. Income averaging would be eliminated, hurting those whose incomes were subject to wide fluctuations – like salespeople and businessmen. Investment tax credits would be eliminated. Corporate profits of $75,000 or more would be taxed at 33%, 25% between $50,000 and $75,000, 18% from $25,000 to $50,000, and 15% on $25,00 or less.
The hue and cry has already started. The overall effect of the tax plan shifts about 3% of the tax burden from the individual onto corporations. But it doesn't stop there. The secondary effects will be more than anyone bargained for. Since Oil and Gas still retain a lot of tax benefits, the smart money will move in that direction until those loopholes are closed. Real estate syndicators will lose business to the extent they are pushing tax shelter rather than economic advantages. Capital, investment in smoke stack industries will be reduced at a time when it's crucial that we rebuild capacity to be able to compete with lower cost foreign goods. Businesses will move out of the high tax states, thereby reducing the tax base in areas where social costs are historically the highest. Unemployment in the industrial areas will continue to be the highest in the nation. The capital markets will also be deprived of Bond revenues as industrial bonds lose their tax exempt status under the new bill. Credit markets will be starved in many areas – particularly in the farm belt states.
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The retail area will suffer too. As the shrinking tax base drives up sales taxes, consumers, no longer able to deduct them, will see this as a form of price rise. Particularly hard hit will be 'fringe benefit' industries such as hotel, rental car, airlines, restaurant, bar, resort and recreational area business. Don't forget seminars. Costs to the consumers will be going up as revenues to the vendor go down. Wonderful.
Let's talk real estate. Sure, you'll have lower tax brackets, but you'll be taxed on more non-deductible income. And you'll be paying ordinary income taxes, not capital gains. You'll lose property tax deductions. Maybe some interest deductions. Investment tax credit. What will you do? Sell? To whom? What lender would be foolish enough to offer financing when values are falling. And what about all those reverse amortization loans we've been warning you about these past few years? What will happen to all those loans where the balance owed exceeds the value of the property? What will happen to all those clever lenders who find their loans without any security or recourse? Ohio and Maryland have experienced only a tiny sample of what a real run on the system could bring about!
WHEN YOU CAN KEEP YOUR HEAD WHEN ALL ABOUT YOU ARE LOSING THEIRS.
Ronald Reagan has pulled off a masterful P.R. job. He's stolen the whole tax issue of fairness from the Democrats, going directly to the poor tax paying middle class with a plea for for REVOLUTION against the unfair tax laws. He even has the gall to do this while some are still struggling with their tax bills from the 1984 tax bill he signed. That's political genius. He knows the Democrats are going to chew his new tax plan up in committee. He'll be able to blame them for failing to come up with a fair tax proposal. And he'll force them to pass a tax increase to meet budget deficiencies in 1986. It could cost them a lot of votes in the House where they're strongest. Meanwhile he'll be above the fray ready to take credit for any good that's accomplished while being able to veto any act he doesn't like. But all the time the American public will have its attention diverted from little things like a $50 billion budget overrun, balance of payments problems, leap frogging deficits, military and security scandals. And he's got Congressmen Jim Wright and Rosty Rostenkowski wrangling over Tip O'Neill's seat while the other 533 Representatives scramble for position under the heaviest lobbying barrage ever.
We shouldn't get any more excited over this proposal than over the last one. It has little chance of passage in its present form. We should take heed of the trend though! The walls are closing in on real estate's privileged position. Almost three years ago I said you'd better de-finance your properties, get them into positive income positions or sell them off. That's still good advice. The money you generate will serve you well in the event a real estate panic develops in your area – or your lenders decide to sell off their foreclosed real estate at distress sale prices. Either way you win.
The best and easiest way I know to reduce mortgages is to offer real estate for debt relief. You won't be able to make much headway with your institutional lenders, but private lenders are a different matter. That's why we've consistently recommended that you not use institutional lenders when buying properties. Here's why. Go to your lender and commiserate about how he's stuck with 'iffy' collateral for his loan, but that you'll give him another property at wholesale value if he'll agree to renegotiate your loan. To the extent you can trade off equity for income, you're on the right track.
Let's assume that you learn how to get your creditors to accept EQUITY in return for DEBT. Then the next step is to negotiate profits while doing this. Suppose you were able to consistently buy 20% under the market, then exchange the property at full retail, you'd be making a 20% profit every time you used such a property to pay off a debt. Why would the lender be willing to make such a deal? You might offer inducements. For example, you might guarantee to lease back the property so the lender would have both passive income plus any future appreciation. You might offer a 'kicker' in the form of a small advance payment of cash, building lots, etc. I've made this deal by throwing in a used car. The point is, that you're trying to reduce interest costs and to build up the equity, safety and desirability of your income property while divesting yourself of potentially non-deductible interest and property tax expense on marginal properties.
WE'RE GOING TO SEE THE 'REAL' PUT BACK INTO REAL ESTATE – OR ELSE . . .
In the movie, 'The Towering Inferno' which came out a decade or so ago, a group of people on the top floor were unconcerned that a fire was raging out of control on a lower floor. Ultimately, many of them lost their lives because they'd failed to take any remedial action while they still had time. It's time to get back to earth with your real estate investments while you can. Whether or not the provisions of this particular tax bill are made law or not doesn't change the long term trend. The government is broke! Uncle Sam has already mortgaged the future of the next 3 or 4 generations and shows no signs of slowing down. The tax break currently being enjoyed by real estate investors is just too fat a plum to leave hanging. Here's what we'll have to start to do:
1. Start buying rental property based upon its cash flow and amortization rather than for the tax benefits and appreciation. While I firmly believe we'll reap a pre-tax profit from our houses simply because of the inflation built into our economy, I can't be certain that the government will allow me to keep that profit after taxes.
2. Reduce interest expense to the minimum. Be willing to trade off price in order to obtain lower payments and lower interest. Historically, AMORTIZATION has been the primary benefit in owning real estate, After the loans are retired, INCOME takes over and provides the cash flow from the investment. And cash flow is the bottom line.
3. Managers are going to be able to write their own tickets. When investors lose their deductions, their only recourse will be to wring more income from their properties while reducing expenditures. Turnover, Vacancy, Maintenance, Collections, Tenant Supervision, Promotion will be essential to investment survival in real estate. Land speculation will be ruinous with taxes and interest non-deductible. Only managers will be able to pass the costs of this tax increase along to the tenants. Passive investors who can't do this will bear the costs.
4. Sandwich leases whereby an entrepreneur guarantees a gross return on rental property then sub-leases it at a profit will grow in importance with each passing year. This is the fastest and easiest way for good managers to build their estates! It's the natural evolution for the Manager who starts working for himself rather than others.
5. Options are virtually impervious to the new tax law! Because they afforded no tax benefits, they had little to lose. Once purchased, they aren't taxed at any level. They are inflation hedged. They offer the maximum safe leverage at the lowest cost. In combination with sandwich lease positions, they comprise a devastating strategy for the estate builder with lots of energy and ability and little cash or credit.
Most of the potential hazards in the proposed tax bill will affect real estate which has no economic value outside of present tax benefits. While it's possible that the new law won't affect things purchased during 1985, those who would succeed will have to demonstrate that their's is INCOME /vs/ INVESTMENT property. That means they'll need to get into the real estate BUSINESS for profit. Corporate strategy could be important.
CORPORATE ASSETS ARE BUSINESS ASSETS . . .
The new tax law exempts home mortgage interest from restrictions on interest deductions. It limits investment interest as explained before. Businesses can still deduct operating costs, and interest is an operating cost! Under the new tax bill, 33% is the top corporate tax rate while 35% is the top individual rate. Because you can elect the FISCAL year your corporation operates under, you can control the time period in which you declare profits so that you get the benefit in the CALENDAR year in which corporate taxes might be lower. Suppose you'd normally pay at the top 46% rate in 1985 (50% personal tax rate), but that your new corporation's tax year ended in January 1986. That could put its income and your salary into a lower taxed year, saving as much as 13% to the corporation on any retained earnings and 15% on your personal taxes. You can see that tax planning can pay big dividends.
There's a catch to the corporation game. You have to make money! But that money can still reap the benefit of business deductions and special corporate tax breaks. First of all, under the tax bill, earnings retained inside the corporation will be taxed at a lower rate and in a more advantageous year as explained above. And this year can be manipulated somewhat by legitimate multi-year inter-corporate transfers. Next, you'll be able to deduct operating costs which include both property taxes and interest under the right circumstances. And you'll be able to deduct employee expenses to a certain extent. These could include salaries, workman's comp, FICA, medical and life insurance for key personnel, local franchise taxes and licensing fees, equipment leasing expenses, (or, conversely, fast depreciation and investment tax credit on equipment you lease to others which you purchase in 1985 and offset against 1986 income), pension plan costs and contributions. You even get to deduct 10% of the value of dividends distributed to stockholders. In some states, a one-man corporation would let you be owner and employee!
Corporations are the legal residents of states where they are incorporated. This means that you'll be able to shift intangible assets and profits into lower taxed states while continuing to do business and earn the profits in other areas. For instance, rental property can be leased to a local manager, or a leasehold interest can be sold to him for a period of time. Your corporation isn't doing business in that state, it merely owns property there. The local manager is 'doing business'. He'll pay for all costs of operation under the terms of his agreement, passing them along to the tenants in the form of higher rents. Your profits will come into your corporation in the lower taxed state. And when you die, your estate will be probated in the state in which you hold legal residence – presumably one that has the lowest estate taxes. Or it may never be probated if you've established a well conceived plan through the use of Trusts and other devices.
IF THEY HAND YOU LEMONS, MAKE LEMONADE!
Small businesses have always been the easiest to attack, but the hardest to hit. It's like trying to swat flies with a sledge hammer. Now that the President has telegraphed his punch, we can block it. ADAPT! Load 1985 with as many expenses as you can. Make certain all interest and property taxes are paid this year along with any deferred maintenance. Unload marginal properties. De-fang loans. Tighten management. Put off as much income as possible until 1986. Get liquid. Accrue as much cash as you can. If you're going to mortgage something, do it before the lenders get nervous and/or interest rates go higher. Renegotiate private loans to reduce interest in return for higher prices or payments. Get rid of Balloon Notes. Leverage as much as possible using non-recourse loans while they still count. Buy any needed business equipment in 1985 and take I.T.C. Buy for the LONG TERM and start your depreciation while ACRS still allows 18 years. If you plan on using a Clifford Trust to shelter income, start it in 1985. And, surely, you should take any seminars that involve a lot of travel in 1985. Say RENO?
