The Tax Code Playbook. Learn the Rules and Thrive

Donald Trump's $750 tax bill has been the topic of debate recently. My reaction is probably different than the majority of people. I see the $750 figure and think "what! bad tax planning, sir. That should be $0." Any who...I do not want to use any of my platforms to discuss politics. I only want to discuss wealth creation and personal prosperity. Below is an article written by one of my investors about how to use real estate to lower an individual's tax burden. Luckily it mentions families on both sides of the aisle, so hopefully everyone can read this and maintain a balanced view of the topic.

Trump’s $750 Tax Bill & $400 Million in Debt.

By Donald R. Hoke, Ph.D.

News reports and the vice-presidential debate informed us that Donald Trump paid $750 in taxes one year and has $400 million in debt. Is this good or bad? Right or wrong? Understanding Trump’s taxes and debt begins with his book, The Art of the Deal. Donald Trump is a real estate investor. So is Paul Pelosi, whose net worth is reported to be some $120 million, $25 million of which is apparently in real estate. Donald and Paul and I have a lot in common. I too am a real estate investor, not on their scale, but we all play by the same laws passed by Congress and enforced by the IRS.

I have no interest in reviewing Trump’s taxes or Pelosi’s real estate portfolio, so I’ll use my own experience to explain how all three of us invest in real estate. The “secret” to real estate investing is using “other people’s money” to leverage a particular investment. This is where our respective debts come in. We are encouraged by a Congressional tax code first passed in 1921. Here is a grossly simplified illustration.

My real estate agent offers me a badly deteriorated house in a nice, middle class, working family community. The aging couple did no maintenance for 15 years and owned 25 cats. The heir wants rid of the place ASAP and sells it to me for $100,000. Well-maintained houses in this neighborhood sell for $200,000 and rent for $1,500 per month. I go into debt by using my personal residence to borrow a $20,000 home equity loan as the down payment. A private lender provides $80,000 in a short-term, high-interest rate loan to complete the purchase. I am now $100,000 in debt. After I spend $55,000 in more home equity loan money (more debt!) on rehab, the house is worth $200,000 and I rent it. I am now $155,000 in debt.

The house is now worth $200,000 and with an appraisal in hand and a reputable renter in the house, I refinance the house with a conventional bank loan of $160,000 and pay off my $155,000 debt. The $1,500 rent covers my principal, interest, taxes, and insurance, leaving me with $400 in positive cash flow per month or $3,600 annual retirement income. My personal assets are now $200,000 higher than they were three months ago. I am also now $160,000 in debt, which is “other people’s money.” I leveraged my personal residence with a home equity loan to create an asset that generates retirement income.

With the deal finished, here is what Donald and Paul and I do tax-wise. The newly rehabbed home is now a business asset and is starting to deteriorate. The IRS tells me I can depreciate my $200,000 asset over 27½ years, or $7,273 per year as an expense. My $3,600 income is less than the $7,273 depreciation, so I pay no current income tax on that $3,600.

My renter, with his family of four, is delighted to pay $1,500 to rent a newly rehabbed house and live in a nice safe neighborhood. The workers who rehabbed the house earned two months wages and paid income and SSI taxes. My banker is thrilled that I make regular monthly loan payments, and the city is thankful that a rat-infested eyesore is now producing much more real estate tax income. The neighbors are ecstatic. Capitalism at work! Everyone gained and is happy.

A friend owns some twenty-five single family rent houses to fund his retirement. Assuming each house is identical to the example above, he is $4,000,000 in debt, but he has $5,000,000 in assets and earns $90,000.

I suspect Donald Trump’s $400 million debt is secured by real estate worth far more than his loans. My sample rent house is worth $200,000 against my loan of $160,000. Yes, I am in debt, as is every intelligent real estate investor, but so, I suspect, are Donald Trump and Paul Pelosi. This is how the real estate business works. There is good debt and bad debt. A rent house debt is good debt. Debt to take a vacation or buy a big screen TV is bad debt.

When I sell the house in the future, the IRS will collect taxes based on the recaptured depreciation, currently 25%. It will collect capital gains taxes on the appreciated value of the house, currently 21%. To encourage real estate investors to continue to invest, Congress created section 1031, which allows an investor to delay his taxes if he reinvests the proceeds of a sale into more real estate within 180 days. The IRS will eventually get its taxes, but not until the asset is ultimately sold.

This law is a tremendous benefit to both commercial renters and residential renters as well as the investors. Investors use Congressional tax incentives to create more homes and more retail space. This meets the needs of a growing population and an expanding business sector by creating competition and keeping prices down.

Congress designed real estate tax incentives to grow the economic pie. Whichever party occupies the White House in 2021 must understand how Congress designed existing real estate laws to keep expanding affordable housing and retail space. Real estate values, including private residences, will decline significantly if Congress does away with depreciation and treats capital gains as regular income. Investors will no longer invest in real estate because they cannot make money. They will invest their capital elsewhere, perhaps overseas. The iron economic law of supply and demand always holds true.

Donald Hoke is a Recovering Museum Director[TM] living in Dallas.