The Good Old Days — Negative Cash Flow Sometimes Golden

preacher
My dad, grandpa, great-grandpa, and two uncles were ministers. Because saying grace took so long, I was in high school before I knew what a hot Thanksgiving meal was. :) Being a PK (preacher’s kid) I know for a fact that none of the 10 commandments say anything one way or the other about real estate investments (income property) having negative cash flow. I double checked to make sure. There’s some talk about who invested some of their master’s cash for the best return, but nothing, nada, zilch is said about negative cash flow. Come to think of it, there’s nothing said about positive cash flow either.

I bring this up because I promised yesterday to write about how, sometimes, in a time far, far away, negative cash flow was the best way for certain investors to go. It wasn’t even a close call. Of course, the tax laws back then were, in many ways, far more attractive from an investor’s viewpoint than now.

Allow me an illustration from the BawldGuy files of yesteryear.

no forks

A client came to me with two problems he wanted solved. First, depending on the year, he was paying $35-55K a year in state and federal income taxes. Ouch. Second, he had nothing going financially with the exception of a pretty impressive income, and his home. He was self employed, was incorporated, and by today’s standards he made pretty good coin. By 1980′s standards he was drowning in 100-dollar bills. His first comment to me upon meeting at my office was that the tax man was close to sticking a fork in him. He wanted to stop underwriting three government programs all by himself, and get some investments going — simultaneously if I could work that out for him.

Today, real estate investors are limited, with certain exceptions, to a maximum of $25K depreciation which can be applied to their ordinary (job) income. Back then, (to the best of my memory) there was no limit. Also, to sweeten the pot, investors could use what was known then as ACRS, for their depreciation schedule. What it amounted to was a 15 year period, instead of the current 27.5 years. Quite a difference? You betcha. A ginormous advantage for an investor.

My client had enough cash available to acquire about $1.4Mil in income property — with 10% down. The total cash flow from all properties was a negative $25K the first year, and less as time went on. Between his $75K in yearly depreciation and negative cash flow, he was able to virtually eliminate his income tax bill entirely. His corporate tax bill that year was about $3k, which I could do nothing about as it was, as you might suspect, detached from his personal investments.

Why would a rational person choose to acquire properties guaranteed to drain his wallet?

black hole

It’s simple. He could continue to write checks for, what in some years was over $50K in income taxes — which went into a black hole, disappearing forever. Or, he could create a Purposeful Plan which would result in negative cash flow of about half or less what his income taxes had been. With a significant amount of depreciation available, he now had $100K in losses his first year of ownership. ($25K in negative cash flow + $75K depreciation) According to his CPA at the time, this resulted in an overall tax savings of 90% over the previous year.

He was still shelling out thousands a year like before. However, instead of shoveling all of it into a black hole, he was now putting it into appreciating assets. In the late 80′s when we successfully executed a 1031 ( tax deferred) exchange for him, (all three original props included) his negative cash flow was only a memory. His net profit after sales/exchange costs was well over half a million bucks.

During those first five years his income taxes were successfully tamed. He was enjoying positive cash flow by the end of the third year. That turnaround remains one of my fondest memories. He entered the 1990′s with significant cash flow. By the end of the S & L crisis he was poised to really wreak some havoc. Alas, on a trip to Europe he fell ill, and passed away within a week. It was a real shock. Apparently his heart couldn’t survive a freak infection.

Our Plan called for him to trade again in the spring of 1997. However, his wife sold everything and moved back to her hometown to be with her family. Had he survived, he would have been able to move well over $600K in net equity into a market that would’ve rocketed his net worth literally into the stratosphere. There’s no way he wouldn’t be worth at least $3-5Mil by now. He was a joy to work with, a very decent man.

If he’d have come to me today instead of 24 years ago, the outcome would be far different. Instead of being allowed to use all $75K in depreciation against his ordinary income, he’d be shaking his head as I told him about the current IRS rules. First, the depreciation figure itself wouldn’t be close to $75K. It would be just over $40K — barely over half. And he’d only be allowed to use $25K a year against his ordinary income. The rest would have to be carried forward as unused depreciation. Oops — because he makes way to much ordinary income, I’d have to tell him he couldn’t use any of his depreciation. Ouch. At least today’s interest rates would’ve put a smile on his face. All three of his first investments began with much of the debt at double digit rates.

I shudder to think how much he would have made in Phoenix and Boise. Wow.

Ah, the good old days.

This entry was posted in 1031 Exchanges, Purposeful Planning, Real Estate Investing on by .

About BawldGuy

I'm second generation real estate, first licensed in fall of 1969. Having been mentored by several iconic brokers, I'm also CCIM trained, having completed all 200 hours back in 1980. Have successfully executed well over 200 tax deferred exchanges, many of which have been multi-state in nature. Strong points are analysis and the creation and real world application of Purposeful Plans employing several strategies synergistically. The idea is to arrive at retirement with the most after tax income possible, backed by the largest net worth.

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6 thoughts on “The Good Old Days — Negative Cash Flow Sometimes Golden

  1. BawldGuy

    True – and for folks who want and have a bunch of cash flow, that’s pretty nice. If however, growth is what’s for dinner, all that depreciation remains on the shelf like a book on the discount table at Barnes & Noble. :)

    Reply
  2. Rob Beland

    Great Post…

    I was actually making an argument just the other day to my wife about a vacant property I own.

    I shell out about $1,000/month to carry a vacant property that happens to sit across the street from a newly built Wal-Mart. The market is such that the development potential for my property is a few years away from making real money but I can wait.

    The way I explain my willingness to dump $12,000/year into the property not including taxes, insurance, etc…which brings the total annual investment to $20,000 +/- is that I could either do what I’m doing or actually pay taxes with the $20K. Why not put my money into my own property and ultimately back into my own pocket rather into Uncle Sam’s pocket?

    Rob Beland

    The Real Estate TrendMill

    Reply
  3. bawldguy Post author

    Rob – I have to assume your potential profit on this puppy is in the six figure range. If you make $1-200K profit, your wife won’t be too upset with 30-50K in holding costs – minus your tax savings.

    Of course, my question would be how much is it worth now? And is it possible you can find a buyer with the same confidence in it? If so, 2-3 years of leveraged, break-even property in a growth region might not only be better for profits in the long run, but for depreciation.

    There’s always peace in our time at home too. :)

    Thanks for stopping by – please come back.

    Reply
  4. Rob Beland

    Quickly…yes…the potential profit is upwards of $100K and if things go the way I plan, the profit will reach $200K after a few years…

    I am always considering dumping the property for a quick gain but I’ve always wanted to be the guy who owns the high profile property on the corner at the lighted intersection…

    Rob Beland

    The Real Estate TrendMill

    Reply
  5. bawldguy Post author

    As long as you know what it might really be costing you, your decision appears to be fully informed.

    Sometimes we just have to please ourselves, don’t we? I know, I’ve been there too. Good luck.

    Reply

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