As I began my investing career, I had unknowingly happened onto a formula called "piggy backing" which is borrowing on an existing asset to acquire the next.  This formula worked too well because it is one that should seldom be used alone.  The effect of using half the formula was a very heavy negative cash flow after buying my first six rental houses in this fashion.  I later learned that I had created the Pal half of the "Pigs and Pals" formula.  I had become expert in creating Passive Activity Losses (Pals).  The counter part that is used to prevent eventual bankruptcy is acquiring Passive Income Generators (Pigs).  A Passive Income Generator is an investment whose sole purpose is to produce unearned income.  Examples would be stocks, bonds, T-bills, notes and deeds of trust as well as several advanced types of options and lease hold interests.  We will cover some of these concepts at a later time. 

The reason that Pals alone are only half the equation is that passive income will exacerbate (amplify) the tax problem that most prudent investors are working to diminish. The most effective tool for the ordinary investor to minimize the tax bite is depreciation.  Depreciation is the only tax deduction for which you do not write a check.   Depreciation, being a book entry, has the ability to offset dollar for dollar, earned income.  Most depreciation deductions apply to business assets and are passive business expenses  which may be subject to loss limitations imposed by the IRS.  The only way to exceed that imposed limit is to have enough passive income to cover the excess depreciation deductions.  For instance, if you have a passive loss total of $37,000 and it is subject to a limitation of $25,000, the only way to claim the $12,000 excess depreciation is by having $12,000 of passive income.  These two together will have the net effect of meeting the $25,000 limit.  In most cases, without the offsetting passive income, the $12,000 excess depreciation must be carried forward to a future tax year in which the investor has not reached the maximum allowable loss limit. Due to affect of inflation, this deduction is worth far less in a future year than it would be today.

I repeated the "Pals" portion of the "Pigs and Pals" formula until I found myself working twelve hours a day, seven days a week, and playing music, my "hobby" five nights a week. Many times I woke up in my car in front of my garage door not remembering the drive home. This schedule was not greed or drive, simply desperation. 

In retrospect, I could have named this course "A little knowledge is a very dangerous thing!"  I'm sure many people have found themselves in the same type of situation and like me, had to work their way out armed only with the knowledge at their disposal.  Most people adopt a position statement based on the negative experience. Some of the more common ones addressing this problem are; 1) I do not accept negative cash flow. 2)  I do not invest in real estate for fear of negative cash flow. 3) If I take on a negative cash flow I set aside a six month safety net of reserves. 4) I don't know why this always happens to me!

Here are the problems with each of these positions. 

Not accepting negative cash flow ; this philosophy means the investor is either putting too much money down which ruins leverage, is purchasing with a variable interest rate, which is a negative cash flow waiting to be born, or is purchasing only one steal deal instead of 10 good ones.

In doing nothing at all; you are in fact accepting a negative cash flow.  Each year that passes without acquiring appreciated investments your earned dollar devalues by the extent of inflation, which means your income dollar buys less in products, goods and services each year than it did before.

The safety net; every dollar held in low producing reserves has effectively killed a high producing investment dollar. This weakens the overall value of the investment portfolio.  When an investor holds out for only "steals", the investor ends up making fewer purchases, thereby amplifying the effect of a single mistake.  If an investor has 10 assets and one "loser", only 10 percent of their portfolio is producing badly.  If an investor has 2 assets and one goes south, 50 percent of his portfolio is at risk. 

Why does this happen to me? Except for the people you meet and the books you read you will be the same person five years from now that you are today. Without different input, your knowledge and experience will lead you down the same path again and again obtaining the same results. Become a student and learn from those who have succeeded in doing what you wish to do, then do it!

What I recommend to my clients is what I concluded from my graduate studies at Hard Knocks U, which is, when one is in a position of risk, buy insurance.  Buy more good investments with maximum leverage.  Calculate the amount of down payment that would be required to make the property break even and calculate the difference between that down payment and the down payment actually used.  Acquire a discounted note and deed of trust at a yield sufficient to eliminate the negative cash flow on the new real estate purchase. My personal position statement is as follows: "Take Your Real Estate Agent to Lunch and Buy Your Pal a Pig".