26. Tax Angles in Selling

There are such special and unique benefits and exemptions afforded to real estate operations that it has given rise to this saying:

The tax is never a good reason for not selling real estate.

This unique advantage is not given to any other field of in­vestment. To best understand the capital gains benefits af­forded exclusively to Real Estate investment, we compare our investment with another—investment in stocks.

Note that in all that follows, we speak only of those invest­ments that you keep for a minimum of six months. These are classified on the Federal Tax level as long-term capital gains, as compared with those we keep for shorter periods. All that I say here applies only to long-term holding of property, and only to Federal Income Tax, not State.

Let us say you buy $10,000 worth of X stock, keep it for seven months, and sell it. In the sale you make a profit of $3,000. Now, says Uncle Sam, you may take one-half of the profit, or capital gain, and put that in your pocket, tax free. The other half, or $1500, you enter in the proper place on your tax return, and pay your regular tax on it.

Now suppose you sold the stock and LOST money instead. Let us assume you sold it for $6,000 for a loss of $4,000. Uncle Sam now allows you to deduct this loss on your tax return but notmore than $1000 per year, against your other income. This is limited to 5 years * and, as a result, a maximum total deduc­tion of $5000 no matter how large the loss (unless you have capital gains against which to offset the loss). The next does not apply to a "real estate dealer," one who buys and sells real estate primarily for profit. If you are a real estate operator, who buys and sells property but only incidentally to your ownership and management of it, there is a special rule which seemingly does not balance out and which is set up for your advantage in a most remarkable way.

Suppose you bought a piece of real estate and held it eight months.* Then you sold it at a profit of $5,000. In this part of the example, the profit is treated precisely as in the case of profit on stocks. You put one-half the profit in your pocket tax free and enter the other half on your return as a long-term capital gain. You must pay your income tax on this one-half. But how big a percentage you pay in tax is limited, upwards, but not downwards.

If your regular tax bracket is, let us say, 30 per cent, you will pay a tax of 30 per cent of that half. If it is 40 per cent, you will pay 40 per cent of that half. But if you should be fortunate (?) enough to be in the 70 per cent bracket, the law puts a limit on the tax for your benefit. In no case are you required to pay a Federal income tax on that half of the capital gain, of more than 50 per cent of that half*

That, of course, amounts to a net of 25 per cent tax as a limit on the entire profit on the deal. This is a very low figure, all considered. After all, the percentage of tax at this rate is very close to the lowest bracket on the list*

Now we come to the most remarkable part. Let us say you LOST $5,000 on the sale of the real estate. If the same policy that obtained in the sale of the stock applied here, you would only be permitted to deduct $1000 per year with a maximum of $5000 total. But not so in real estate losses! You enter the entire loss on your return, and you are permitted to deduct it all from your year's income. Thus you get the benefit both ways, win or lose. That most vital factor in all investment, income tax, gives that break only to real estate investors. Its effect on your progress toward your million will be a determining element therein. Besides the capital gains tax advantage previously described here, the outstanding tax benefit we have in selling real estate happens to coincide perfectly with our most advantageous plan for selling. My Certified Public Accountant, Sid Feinberg, has worked this one out with me and guided most of my moves in the tax picture. It is called the Installment Basis of selling and, of course, our best interests are served by selling on that basis.

In simple language, this is what the Installment Basis rule provides: If you sell a piece of real estate, after keeping it at least 6 months * for profit, and you receive less than 30 per cent of the sale price in the first year, you are entitled to use the In­stallment Basis for paying capital gains tax on the profit. The 30 per cent must include all principal payments you receive in that first year, too. It is clear that when you sell something on installments, it is never certain that you are going to be paid in full for it. Hence you pay taxes on that part of the principal payments that you receive as you receive it. You do not pay your tax on the entire profit you hope to make, when and if you are paid for the property.

This has a tremendous effect on your method of selling real estate. When you reach the point where you want to start selling your buildings, if,

* Now no limit. You can take it forever until absorbed indeed, you ever do decide to do so, you will want to avail yourself of the
rule, and certainly you will find that it has a salutary effect on your ability to hold on to the down payment for further investment, instead of having to pay it to the government as tax on the profit on the deal.

It was the Installment Basis rule that permitted me to sell the Collonnades Block. Without it, neither could I have sold it, nor would it have been practical to sell it, even had I been able to find a buyer who could make a large enough down payment.

The Collonnades Block consisted of a long block of brick buildings that ran from corner to corner, on Washington Street, Brookline. There were nine stores, including the post office, and 12 offices and 26 apartments on the second, thirdand fourth floors. Around the corner on Station Street, was a stor­age warehouse that formed part of the deal.

I bought the entire parcel for $115,000 in 1947. This was the big deal that occupied my attention while the little duplex deal

was distracting it. As soon as I had signed the agreement with the seller, I advertised the warehouse for sale or rent. I had no experience with warehouses and wanted only the front block for my holdings. A few days later an elderly gentleman phoned me and asked if he could sell the warehouse for me. I agreed and quoted $100,000. How he went about it is an amusing little story.

He opened the Yellow Pages of the phone directory to "ware­houses" and proceeded to phone each one of them. He would ask, "Do you know anyone who wants to buy a storage ware­house?" Sometimes the party would hang up. Other times he got a polite answer. But he persisted. After he had gone through the A's and B's, and as he worked on the C's he struck pay dirt. This warehouseman was overcrowded and needed more space. The outcome was that I signed up to sell the warehouse for $75,000 to this warehouseman, and arranged to pass papers and the deed simultaneously with my purchase of the entire parcel.

When it came time to consummate the deal, I was hard put to keep the parties apart. Of course, I did not want the seller to know how much I was getting for the warehouse part of the parcel, not that there was much he could do about it then, as he had to go through with it anyway. So I hopped from office to office, signing one thing, delivering another, receiving a deed here, giving one there, until the entire transaction was finished and I heaved a sigh. Now I owned Collonnades at a net cost of $43,750, which included the commission I paid the elderly broker. When I had time to think, I felt stupid for not selling the warehouse myself, but you can't have everything. Soon I placed a new mortgage on it for $58,000.

Now when I was ready to sell Collonnades under the new plan, the thing would have been impossible without the Install­ment Basis rule.

The package I offered included a price of $185,000 (yes, that's what I sold it for) and a down payment of $20,000, with a first mortgage to me for $165,000. As usual, I had tested pack­age after package to see how much the income would carry and .still leave the buyer a fat return on his investment. When I reached $185,000, I found it to be the virtual limit.

However, I had been taking depreciation during the time I held the building, and in the language of the tax experts, the cost to me at this time was $35,000. I stood to make $150,000. If I were forced to pay even the one-half-of-one-half, that is 25 per cent of the profit as tax, all in one year, the down pay­ment would not cover the tax of $37,500.

But all I received of the purchase price, including the pay­ments in the first year, amounted to less than $23,000. Of this, a little over 4/5was gain. I was allowed to put half that profit into my pocket, tax free. The other half was subject to my reg­ular tax bracket, but in no case, would I have to pay more than 50 per cent tax on this half, even though my tax bracket for the year was greater than 50 per cent.

As the payments come in each month, the part that is prin­cipal is recorded in my little book, and the part that is interest in a separate column. One-twelfth of the annual taxes is de­posited by each of my buyers with me each month. When the tax bill comes, we square up the balance and I forward the money to the town treasurer. The receipted bills are sent back to the buyers.

The taxes that are deposited with me each month to be turned over to the tax collector in November of each year are not, of course, income. In the following figures, we consider only those sums which are sent me each month as interest and principal. The Collonnades Block

showed as profit during the time I held it                                    $46,000.00
I received down payment from buyer                                         $20,000.00
My wife and I receive payments on a                                       $165,000
mortgage at 4.5% for 30 years, $836.07 per mo.                      $300,985.20
Total proceeds from the deal                                                     $336,985.20
less what I put in                                                                         $43,750.00
Net cleared on the deal                                                              $323,235.26

Note that when I say "my wife and I" receive the income, this is because of a holding plan that you will want to emulate. You will remember that the recommended way in which you and your wife should hold title to the property was "as tenants by the entirety," or its equivalent in your state, sometimes known as "joint ownership," etc. It is also permissible for you to hold such assets as mortgages, promissory notes, bank accounts, and stocks in the same way. Thus mortgages are given to Robert W. Kent and Isabelle R. Kent, husband and wife, as tenants by the entirety. The accompanying promissory notes are likewise made out to us. The inheritance tax, probate, and other bene­fits have been described in the chapter on How to Hold the Property.

I have been asked how come the original owner of the Collon-nades parcel sold it to me? And for such a price as permitted me to turn such a quick and staggering profit?

There was absolutely nothing that I knew other than what you have learned in this book. The key to it was the method of appraisal that the seller used.

Collonnades had been owned by a former clothier who in­vested his wealth in income real estate. When he died the estate was turned over to a highly reputable agent for management. The heirs of the clothier spent most of their time on the Riviera, content to receive the monthly checks from the managing agent. In time, they married other wealth and it was decided to liquidate the real estate holdings. The agent calculated the values as he had been accustomed to do. Prices were put on the various pieces. One was offered to me for a price which my Formula indicated was not worth nearly as much. But the price of $115,000 for Collonnades was far below what the Formula said it was worth. Later developments bore this out, as we have seen.

When I sold Collonnades, there was still a mortgage of $58,000 on it. However, my buyer was not responsible for the old mortgage. I alone remained responsible for it and we made a simple contract to that effect. As usual, his attorney was puz­zled upon first meeting this arrangement, but after a careful examination, approved. The sale was consummated with a new $165,000 mortgage from the buyer to me, and he has been pay­ing punctually. The policy of giving the buyer a good MIF has paid off. It was necessary to stretch the period of the mortgage to 30 years so that the payments would be small enough to leave the buyer a good MIF. This, however, suited my pur­poses admirably.

The conclusion is inescapable. Irrespective of the size of the sale, the buyer is far more interested in the size of the payments and the resultant MIF than he is in the number of years the mortgage is to run, or the price of the building. I am firmly con­vinced that the buyer of the Collonnades would not have been interested at $100,000, if the MIF had been small. Incidentally, the buyer of Collonnades is an accountant by profession. If he doesn't understand figures, who does?

One big advantage you will achieve by selling a property oc­casionally is that you will gradually accumulate larger sums of money which will enable you to use cash as a decisive induce­ment in your purchases. I respect the ancient adage that "There is no price great enough for a thing that makes a living for you." But as soon as you have found that there are plenty of Aunt Tobys to supply your future needs, you should not be averse to selling one occasionally, if you get your price and terms. It is only if you wish to sell that you need make the terms as attrac­tive as you have learned here to do.

The sales we have described here are largely those in which the buyer was attracted by low down payment and easy terms, with resultant large MIF. You can better those terms if you sim­ply put the property up for sale, arrange a good price, and hold out for it. Your buyer must get his own mortgage, or pay you 25 per cent down, or you simply will not sell. The very fact that you are not in any hurry, that you are making more money every month you hold the parcel, is your best ally. You can wait until you get the deal you want—happily. Your own ambi­tions and objectives will decide the path you will pursue. If you want to make yourself "well-fixed at forty" as I did, with your first million made, you may choose the livelier, and perhaps riskier path I chose. You may find your situation cozy, secure and delightful when you have acquired a dozen or two Aunt Tobys, and want to stop there. It is understandable. It's a most enviable position in life.

Whichever path you choose, you need only avoid the well-meaning friend who counsels so wisely that you will go broke. Brush him into limbo with the one who declares positively that there are no more opportunities. Make the firm determination that there IS plenty of opportunity for you and that you now know how to use it, and no negative cloud will be permitted to stand in your path to your goal. Roll up your sleeves and go ahead! This is the greatest business in the world!