Taxes are inherently complicated and often drive us crazy. Each year we deal with the complications and time that preparing our tax returns requires. Why do we do it? We deal with the complications because in many cases the investments we acquire are worth the hassle.

Take your real estate investments. It would be much simpler to ignore real estate investments all together and just own stocks. The problem is that real estate, along with lending, provides a level of diversity to your portfolio that is not available at investment firms that simply trade stocks.

For proof, consider this: every one of our clients who owns a diversified portfolio of stock, real estate and lending investments outperformed the stock market – everyone. This, in a year when more than 50 percent of all stock market investors lost more than 40 percent. That alone is a compelling reason to muddle through the chore of preparing partnership tax returns, also called K-1’s, named after the IRS form used to present your tax data.

Each year we have a few clients who don’t quite understand the difference between real estate performance and the capital account balance on their tax return. However, you cannot fault an investor for being confused – taxes are confusing.

Here is a sample e-mail from a very sharp client asking about her tax report:

Dear Lakeside,

I don’t understand why I’m losing money on these real estate holdings?  I thought I was supposed to be earning money?  The losses are shocking and I need someone to explain this to me.

My response:
It is all about education. Here is a short summary:
1.    For investment purposes only, many clients care only what an investment is worth and what you have received in distributions

2.    But, for tax purposes, since you are allowed unique benefits in real estate not available in the stock market, these types of losses are beneficial.

The primary benefit is the amount of tax write-off you are allowed for depreciation on real estate. Then the write-off is deducted from the beginning value each year for tax purposes. After a few years, the tax report to your accountant will show that the real estate has very little value.

For example, if you paid $1,000,000 for a building and wrote off the building over 20 years the building would show a value of zero at the end of 20 years even though it may be worth several million.

Let me show you an actual example using our first hotel investment acquired in 2003:

The client below acquired an interest in several hotels for $100,000. From 2004 through 2008, the client received $184,537 back as the hotels were each sold - a very nice return.

Now, let’s look at what the client was seeing on their K-1 Partnership tax form each year:

What a difference, don’t you think? As you can see, the capital account balance illustrated on an IRS form has a much different purpose than an investment summary.

Taxes are a necessary evil and one that brings some complications to our daily life, especially this time of year. Lakeside has developed a unique means of communicating information directly to your tax preparer to ease some of the pain. We think you will agree that the investment opportunities make it all worthwhile.

These days we have a particularly hard time seeing the value in stock investments as the best place to allocate your money. It seems like many of the market ‘pros’ face that same challenge.

Earlier this week on CNBC, a leading stock market asset manager shared some great advice -distressed assets outside the stock market are a better choice than investing in companies with more liabilities than assets.

We feel the same way.

The story goes something like this: A company has more debts than assets and needs to raise cash to stay in business. However, the only assets that can be sold include land and buildings and unfortunately, the market is currently home to particularly low bids. With no other choice, the land or building purchaser gets a great asset at a favorable price and the seller has to take what they can get.

Now let’s play that scenario out with banks as our example. The majority of all real estate in this world has a bank loan attached to it. When times are tough, there’s a higher likelihood that property will fall into the bank’s lap.

As an investor, there’s an opportunity, but is it worth the risk?

You can buy stock in the fallen bank or buy the assets they own. It’s possible the bank stock you’re looking at is down 90 percent and in our eyes, this is not something you want to pursue.

Today, most banks run the risk that their assets are less than the liabilities they owe. When that occurs, the bank has two viable options - either raise money or risk going under.

The current situation is banks cannot raise money. Many hold on to hope that the value of their real estate asset rises before they go under. Unfortunately, the odds are stacked against them.

On the other end of the spectrum, banks have taken back real estate after borrowers found themselves at a dead end, unable to make payments.

We believe these bankers are not well equipped to manage all the real estate they’ve acquired and can’t afford to sit and hold it for years. This provides a great opportunity for savvy, cash-in-hand investors.

The reality of the situation is bankers believe investors are offering too little for the real estate on their books and investors believe the bankers are unrealistic about the true value of their holdings. This has caused a stall for more than a year. What bankers fail to realize is that real estate values may never come back to the prices quoted on 2007 appraisals.

If bankers doubt this analysis, we encourage them to look at the stock market for examples. After more than 20 years of business, Microsoft has never lost money, yet in the past decade, company stock has seen a 75 percent decline.

What caused the decline? A fall in “multiple to earnings.”

Microsoft shares sold for 25 to 35 times earnings for most of its history. Today, Microsoft sells for eight times earnings. In real estate terms, that is similar to a “capitalization rate” - or cap rate for short - of 12 percent.

Now apply that logic to real estate and your local banker who loaned money on a four percent cap rate is going to have a hard time believing that you should buy his troubled loan for a fraction of what he lent against it.

The dilemma, we believe, is that his failure to understand his predicament will ultimately be the reason the bank fails and he is unemployed. A tragic conclusion, yes, but one he has the power to avoid.

We believe we’re years from resolving this mess. By the time it’s over and the economy is beginning to recover, more than 70 percent of all banks will be gone along with the jobs of the employees who once worked so hard for their customers.

In the meantime, the senior officers of those banks have an opportunity to survive if they take a proactive approach and ignore the staid unsuccessful strategies employed by the industry.

Today is a red-letter day, and not for good reasons.

First, today we saw the Dow fall below 7,000. Just think – 18 months ago, the Dow stood at 14,000. It certainly causes one to ponder the sheer enormity of this fall. A generation of investors are now faced with the cold reality that their investment accounts – or the investment accounts of their children – will not provide them the security they need.

Another big event today was the announcement that the Feds are pouring another $30 billion of taxpayer money AIG’s way. If AIG — or any number of major financial institutions — were allowed to fail, they would individually represent a new record for the world’s largest bankruptcy.

We offer two points, one in the rear view mirror and one moving straight ahead.

First, we are still in the “magic potion” phase of this attempted recovery, where the great minds believe that formulas can solve our dilemma. In this, by propping up the AIGs in the short-term, it will lead to a faster, broader recovery. We disagree. Lakeside firmly believes that the result of letting each of these institutions fail would not be much worse in the end.

Regardless of the path we take, we will see big job losses, and substantial equity loss.

But we don’t think the idea of letting the AIGs of the world fail is even under consideration. Why? Well, the big wheels holding CEO jobs at these organizations have big wheel friends, many of whom are the architects of these bailouts, and have all sorts of incentives to make these things happen. On the corporate side, if a company still has cash in the top drawer most chief executives will keep swinging for the fences until the cash is gone – they have nothing to lose.

Why shut the company down if you can get a paycheck for another year or two? That is the thinking they are following, and it is a shame that there isn’t a provision for this in the criminal code. We believe folks who run companies like this could benefit from a sabbatical at the Grey Bar Hotel.

Compounding our difficulty is an overabundance of MBAs who should have gone pro in something other than business.

Each week, Lakeside is fortunate to have many visitors to our offices who would like to partner with our firm, many with educational pedigrees from Stanford, Columbia, Harvard, London School of Economics, among others. While most of these people are phenomenally successful at raising money, few are successful at making money. Capital gains and big risk are their agendas.

We look at things differently. Lakeside prefers solid assets with growth potential and cash distributions while we wait out this economic maelstrom, something you can’t get when dividends are being slashed on yesterday’s blue chips. So when we meet with these potential partners, we often walk away from the meetings asking where has all the creativity gone? Where is the free-thinking advisor who questions conventional wisdom? Until we find those answers we will continue with our familiar mantra; invest in opportunities that offer the ability to grow your net worth even if the markets end the decade no higher than where they began, something we introduced way back in the ‘from our strategy’ paper from 2002.

On a side note, something upbeat:

Most of my friends own businesses, and most in areas other than finance. We’ve talked with some of our clients who say that in contrast to the broader economic conditions, many are having great years. How have they done it? They have accomplished this the old fashion way; by providing better products to buy and better service along the way. As a result, they are taking market share away from competitors. The wonderful success stories I am hearing everyday are across a vast array of fields; advertising, public relations, restaurants, art galleries. The total growth of their industries is not growing but their share of the market is. That is exactly the way capitalism is supposed to work.