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.
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?
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.