|Last Updated: May 14th, 2012 - 22:24:01
Trading with someone who is short of cash can often be worked out to the benefit of both parties, if you use some of the special techniques that have been developed by imaginative real estate investors.
Here’s an example. We’ll imagine you own a piece of land worth $180,000. You owe $45,000 on an assumable mortgage against it, which you’re paying off at $450 per moth. So your equity is $135,000.
But you confront two problems. Making those mortgage payments is keeping you uncomfortably short of cash. And you’ll owe a big tax bill in April unless you find some tax shelter.
A logical solution is to trade your land for income-producing property that will at least carry itself and give you a deduction for depreciation. So you advertise in the paper. You get a cal from a Mr. Short, who owns an apartment house and is interested in your land.
You look at his property. He looks at yours. Both of you are pleased. A trade will benefit both of you, if you can just work out an agreement on values and terms.
Finally, you do so. Mr. Short agrees to accept your land at its fair market value of $180,000. You agree that his apartments are worth $480,000. You both decide that you’ll get together in a few days to figure out the final details.
Mr. Short owes $360,000 on his apartments. The mortgage can be assumed. So your final problem is to balance Mr. Short’s equity of $120,000 in the apartments against your $135,000 equity in the land (its $180,000 value minus the $45,000 mortgage).
Mr. Short’s apartments are bringing in net spendable cash of $900 every month – over and above the amount needed to make the mortgage payments and cover all other expenses including maintenance, repairs, and a comfortable reserve for vacancies. This is better than you’d expected. All you were trying to do was to find a legal solution to your tax problem and escape the pinch caused by your land’s property taxes and mortgage payments. So you happily await the meeting with Mr. Short to close the trade.
But suddenly he phones you: “I’m afraid out deal is off. I still want your land and would like to trade for it on the terms we figured out. But I just can’t find any way to raise the $15,000. I’d have to pay you to make up for the difference in equities.”
You think fast. “No problem,” you say, “I’ll be glad to carry back a $15,000 purchase-money second mortgage on the land. I’ll only charge 10 percent interest, and I’ll let you pay in installments as small as $150 a month.”
Mr. Short sighs. “That’s mighty nice of you. But I’d still have to pay $450 a month n the existing land mortgage, plus the property taxes and $150 to you – and I don’t think I’ll have that much cash available every month. I should have figured this out sooner, but the cash flow from my apartments has kept me feeling prosperous, and I didn’t realize what a difference it would make not to be getting that income any more.”
In other words, his problem is similar to yours. Both of you own valuable assets but you both need more cash than you can count on.
Fighting down the impulse to hang up I disgust, you say, “Let me mull it over. Would you still be interested if I think of some way for you to acquire my land with no more cash outlay than the land taxes?”
He sure would. He knows, as you do, that your land is likely to be extremely valuable someday. So you think and you think.
You realize that you’ll have enough cash to get by if you just don’t have to make those mortgage payments on the land. That $900 monthly cash flow from Mr. Short’s apartments won’t be terribly important to you. Is there some way you can equitably divert part of it to him?
At last you find an astounding answer. Write two new mortgages instead of one!
By cleverly adjusting the terms of payment on the two mortgages, you can overcome Mr. Short’s cash flow problem. Remember that you must get $15,000 from Mr. Short to compensate for the difference in equities, and that he can neither scrape up $15,000 nor undertake to pay $450 per month on the existing land mortgage. Let’s take the solution step by step.
1. You’ll write a second mortgage for, say $30,000 in Mr. Short’s favor, with the apartment house you’ll be acquiring as collateral, on condition that –
2. He’ll give you a similar second mortgage on the land he’ll acquire from you. But this mortgage will be $15,000 bigger than yours, to balance the difference in equities.
3. You’ll make payments of $900 per month to Mr. Short on the $30,000 mortgage he’ll carry back, on condition that –
4. He’ll make monthly payments of $450 to you on the $45,000 mortgage you’ll carry back.
Of course, the net effect is that every month for the next several years Mr. Short will receive $450 more from you than he’ll be paying you. This will give him the money he needs for the $450 monthly payment on the land mortgage.
You’ll be paying off your debt to him much faster than he’ll be paying what he owes you. So the time will come when he’ll have to rely on his own resources to cover the two $450 monthly mortgage payments. You point this out to him. “That’s all right,” he answers. “A few years from now I’ll have ample cash flow from other sources.”
So you’ve solved his problem and your own problem as well. You’ll have improved your net cash flow by almost $1,000 a month, and you’ll have acquired a tax shelter in the depreciation allowance you can take on the apartments, thus increasing your net cash spendable even more.
Making money by giving it away is another strategy that millionaires use – and that you may be able to use too, even though you’re not quite in that category. It’s a good idea to keep in mind for the time when you’re tired of the fun of buying and selling and managing properties, and would like to stop work without stopping your income.
When you reach such a point, you’ll quite possibly find yourself in a high tax bracket, despite your know how in minimizing taxes. Moreover, if you start selling off your investment, you’ll be forced to pay the heavy capital gains taxes that you’ve kept deferring through tax-free exchanges.
You can postpone a good part of this tax bite by selling on the installment basis. And you can very likely make additional savings by trading down. But this would probably intensify your management problems before it would ease them.
There’s a better way. Instead of selling and paying the taxes, you can just give away some or all of your properties. Foolish? Impractical? Not at all. You can still keep the cash rolling in to you from these investments. You can even bequeath the income to your heirs for twenty years, without anyone being taxed on the capital gains you’ve piled up. It’s like giving away your cake and having it too.
You can do this by giving away the property to a charity – a youth movement, a church, a college, a fraternal order, or virtually any other organization that the Internal Revenue code recognizes as a tax-deductible charity.
You set aside property or other assets that will eventually to a designated charity, meanwhile continuing to provide yourself and/or other beneficiaries with a steady income from these assets. You’re really exchanging your property for income, even though you’re also making a charitable contribution that is income tax deductible.
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