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Real Estate, Healthcare, and Your 2013 Taxes – Some Surprises Waiting for You?

Posted on by Frank Gallinelli

Champagne, funny hats, and the ball-drop in Times Square might not be the only significant events to mark the New Year in 2013. If you are a real estate investor or a home-seller, you could have a couple of surprises lurking in your federal taxes.

The Medicare Tax

One of those surprises found its way into the Health Care and Reconciliation Act of 2010 at the last minute. If, as the the National Association of Realtors® states, it was added to the legislation at the last minute, then one has to wonder just how carefully our elected officials studied this before passing it.

What It Is Not

There has been a lot of talk and many email blasts, claiming that this is a sales tax on real estate. It is not. It doesn’t apply to every real estate transaction, and it doesn’t get tacked on at the point of sale, the way a sales tax would. That much is clear.

What It Is, Sort Of

The details may seem a bit daunting, but let’s try to summarize:

  • It is a 3.8% surtax on “net investment income,” which appears to include rental income, capital gains on the sale of investments (and to a limited extent on the sale of a personal residence), interest, dividends, royalties, and annuities, all net of the expenses to achieve that income.
  • It does not apply to withdrawals from IRAs and 401ks, or from veterans benefit,  life-insurance proceeds and several other types of income. (For a further discussion, see this article in Forbes.)
  • But wait, it can actually get even more complicated. According to an article in SmartMoney (no longer found on their site), there is an exception for income from sources that come from business activities. Presumably this would mean that if you derive your livelihood solely from operating rental property or from flipping houses then your rental income or capital gain from those activities is business- and not investment-related; hence it doesn’t go into the bucket of items subject to the Medicare surtax. But that same article notes an “exception to the exception” if the income is from a “passive business activity.”
  • It will never apply (should we ever say never?) if your adjusted gross income is less than $200,000 as an individual or $250,000 for a married couple filing jointly. Fire up your spreadsheet now, because there is a further test: The tax applies to the lesser of your total net investment income or the excess of your Modified Adjusted Gross Income over the $200,000 (single) or $250,000 (joint return) thresholds. (MAGI is the same as AGI for most taxpayers.) Keep in mind a couple of potential “gotchas” in regard to these thresholds. Even though your conventional (not Roth) IRA or 401k withdrawal is not considered investment income for the purpose of this law, it’s still income and could potentially push you over the threshold. Likewise, the gain from the sale of an investment property could catapult you over the line.
  • If you are selling your personal residence, you will continue to get the $250,000 exclusion for individuals, or $500,000 for a married couples filing jointly, so it is only your gain over that amount that is in play. As before you still have to pay the capital gains tax on your profit in excess of those exclusions. More about capital gains in a moment.
  • Congress did not learn its lesson from the Alternative Minimum Tax debacle, because there does not appear to be any provision to index the threshold amounts for inflation, so the tax may affect more people as time goes on.

For more information about this tax, you can refer to the articles noted above as well as a PDF summary put out by the National Association of Realtors®. You’ll find a link to that PDF here.

Capital Gains and the Fiscal Cliff

Another sobering New Year’s Day adventure is what is being called the “fiscal cliff.” Part of the wild ride into the abyss is the scheduled expiration of the Bush-era tax cuts on January 1, 2013. Here, in brief, is what it means for those of us in real estate:

  • If you sell your real estate investment property for a profit, that profit is taxed at the capital gains rate. Currently that capital gains tax rate is 15%, but if we go over the fiscal cliff on January 1, 2013, the rate will go to 20% with the potential to add the 3.8% Medicare tax to part of the gain.
  • If you sell your home for a profit and if you have a gain that exceeds the $250,000 or $500,000 exclusion (not an unrealistic possibility, especially for older homeowners who bought several decades ago – especially in what are now the more costly markets on the coasts like Fairfield County, Connecticut where I live) you may be faced with a similarly higher tax on that gain.

The Bottom Line

I believe the significance of the Medicare tax may be not so much the money it raises – probably not very much – but rather in the anti-investor mindset it reveals. The same would seem to underlie the proposals to raise the capital gains tax. Both taxes suggest to me a policy that puts investing and risk-taking in the crosshairs, that seeks to discourage rather than encourage the activities that are essential to making an economy grow.

This writer shares the opinion of many that higher tax rates on capital gains are a bad idea generally, and a terrible idea during a struggling economy. Existing businesses need capital to grow and startups need capital to launch. If our tax structure is changed to impose a disincentive to invest, then we shouldn’t be surprised to see our economy shrink even further. This WSJ article says it well.

Those who invest and who see investing as vital to our society need to keep careful watch on every new tax proposal and to keep ourselves in the conversation about those proposals. And as this Wall Street Journal article put it: “If you’re planning to sell rental real estate or other investment property, run, don’t walk, to a trusted tax expert.”

–Frank Gallinelli

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You’re Invited: Value Hound Academy’s Webcast Interview with RealData Founder, Frank Gallinelli

Posted on by Frank Gallinelli

I want to invite you to a webcast interview that will be broadcast Wednesday Sept. 14, 2011 at 11AM PST (2 PM EST).

The folks at Value Hound Academy asked me to discuss my insights into analyzing real estate deals:
—  how to be a “financial detective” when examining a seller’s representations
—  the biggest mistakes investors make when analyzing deals
—  critical items folks overlook in renovation projects
—  and lots more

Crunching numbers is critical to your success as a real estate investor, so do sign up to hear this webcast.  It’s free.  http://www.valuehoundacademy.com/public/337.cfm

The Flavor of the Month: Apartment Investing

Posted on by Frank Gallinelli

It comes as no surprise to those of us who are a bit long in the tooth: The recent economic environment has been bad for almost everything, but it’s good for multi-family investment property.

When credit flows freely, almost anyone who can buy a house will buy a house. (Whether they can pay for it after the closing is of course another matter.) On the other hand, when credit tightens or dries up almost completely, then the subprime prospects are frozen out of the housing market, along with a sizeable group of perfectly responsible borrowers who now find they can’t clear the considerably elevated qualification standards. It doesn’t take tremendous insight to realize that most of these people are now candidates for apartment space. Remember Econ 101?  Supply, demand, etc.

If you read the financial press (or follow our tweets) then you’ve seen ample evidence lately that apartment properties are hot. The Wall Street Journal cites a Marcus and Millichap report stating the values of apartment buildings rose 16% in 2010 after falling 27% between 2006 and 2009. In that same article, WSJ says that the supply of new apartment buildings is at a two-decade low. There’s that supply and demand thing again.

Reuters  recently reported that apartment vacancies showed a steep drop in the first quarter of 2011. At the same time, Investor’s Business Daily noted that even the smallest buildings — those with four units or less — were in high demand. An advantage here for the small investor is that this kind of property can usually qualify for Fannie- or Freddie-backed financing, and perhaps on even more favorable terms if the investors lives in one of the units.

After a long period when it seemed like investors were in duck-and-cover mode, it’s good to see this resurgence of activity.

(self-serving footnote: If you’re doing an apartment deal, be sure to run the numbers first, Either the Express or Professional Edition of Real Estate Investment Analysis will do a great job with apartment buildings. If you’re raising capital from equity partners, then use the Pro Edition — it will give you presentations for individual partners.)

Recovering from the Housing and Financial Crisis

Posted on by Frank Gallinelli

Federal Reserve V.P. and senior policy advisor John Duca has just published an exceptionally lucid article that discusses the four key “shocks” suffered by the U.S. economy during the financial crisis: As he states quite succinctly, “Home construction plunged, wealth fell, credit standards tightened and financial markets seized up.”

He discusses the relationship between home construction and GDP, housing’s wealth effect, and the availability of credit; and concludes with a balanced assessment of what may lie ahead for both the U.S. and global economies. He cites indicators that point to recovery, but tempers those with a discussion of the downside risks that remain.

There are enough stats and charts here to satisfy number crunchers like me, but the prose is clear and readable enough to stand on its own.

10 Ways Green Construction Can Improve Your Bottom Line

Posted on by Frank Gallinelli

I had the good fortune to attend a real estate conference at my alma mater, Yale University, on April 3, 2009, where I got an opportunity to tour their new state-of-the-green-art building, Kroon Hall.

So-called “green” design and construction of commercial buildings aim to save energy and water, create healthier work environments and reduce the environmental impact of construction.  But does it make economic sense?  Conventional wisdom holds that green design currently adds about 2% to 5% to the cost of new commercial construction, although that premium is likely to decrease as both techniques and material become more mainstream.  The payback period on that investment, however, can be quite quick and the long-term economic benefits significant.  Here’s my short list of bottom-line reasons to go green:

1. Look for tax incentives:  Most states offer some sort of tax incentive to developers of energy-efficient buildings.  Check for the possibility of federal incentives as well.

2. Get a ton of publicity: Ok, maybe you didn’t choose to follow the green-brick road for the fame and glory.  Still, you’re going to want to rent or sell this building and a little profile-raising can go a long way.  One sure way to stand out is by achieving LEED certification for your project.  LEED (Leadership in Energy and Environmental Design) is a rating system developed by the U.S. Green Building Council.  It provides recognized standards for green construction, and four levels of certification — Certified, Silver, Gold, and Platinum — based on design.  Their certification is a mark of distinction worth earning.

3. Find a friendly ear at the bank:  Green construction is “sustainable,” which means it should last longer than your financing, and should give you an edge in attracting and keeping tenants.  In today’s financing markets there are no guarantees, but these are advantages that should work in your favor to find financing and secure the best terms.

4. Reduce demolition and materials costs: If you’re building on a site with existing structures, reuse some of the materials.  You’ll save on the cost of materials, carting and disposal, while at the same time reducing impact on landfills.

5. Reduce construction costs:  Passive solar heat and reduced electric lighting will generally mean you need a smaller HVAC system — less costly to install and to maintain,

6. Reduce heating costs:  Orient the building to take advantage of passive solar heat.  Windows can be recessed or otherwise configured so that they allow full sun to enter in the winter, but are shaded when the sun is higher in summer.

7. Reduce electric costs: Increase natural daylight and thus reduce the number of bulbs and amount of electricity needed to run them.  Add daylight sensors to minimize use when unneeded.  Add photovoltaics to reduce purchased power.

8. Reduce water costs by collecting rainwater and/or recycling “greywater” from dishwashers, clothes washers, etc. and use this for landscape irrigation and toilet flushing.

9. Increase rental revenue and improve tenant retention:  There is evidence to suggest that the healthier environment in green buildings improves worker productivity and reduces absenteeism.  A workplace like that can improve a business’  bottom line and hence is more attractive than a similar but not-so-green space.  Translation: The potential exists for higher rental rates from the green space, and fewer vacancies as well.

10. Increase property value: Increased revenue plus decreased operating expenses equals a higher Net Operating Income — and a higher NOI translates into a greater property value (read my books, do the math).  To sweeten the deal even a bit further, here’s a bit of speculation: Watch for the day when commercial appraisers employ a bonus reduction in cap rate for certified green buildings.

Spring Thaw for Real Estate?

Posted on by Frank Gallinelli

The first sign of of happy news, of course, was that the stock market actually went up recently more than one day in a row.

Then, on St. Patrick’s Day, Reuters reported that housing starts jumped an unexpected 22.2% in February, “the biggest percentage rise since January 1990 and the first gain since April.” It’s enough to make us want to drink green beer.

In a related article, they suggest that the economy may be showing some signs of life, and note, “Sensing that the worst may soon be over, investors have begun putting a bit more money into some of the hardest hit sectors, including retailers and home builders.”

Still more: The Federal Reserve took the financial markets by surprise with a plan to pump about $1 trillion into the economy by buying treasuries and mortgage-backed securities. Whatever else we may think about this plan’s effect on the dollar and future inflation, it is likely to drive mortgage rates down just in time for what would usually be the springtime home-buying season. Just one day before the announcement, pundits were saying that mortgages rates had surely gone as low as they could; now they’re saying 4% is not unthinkable.

And — back in January, an article in Forbes saw incipient signs of a “resurrection in real estate.”

All this doesn’t exactly add up to the return of a roaring bull-market economy, but at least it’s a relief from the relentless drumbeat of bad news to which we’ve become accustomed. It’s food for thought, and worthwhile reading.

Like winter, recessions eventually end. It would be nice to say good-bye to both.

This post is an excerpt from our March, 2009 RealData Dispatch newsletter. Subscribe to our newsletter using the signup form in the right sidebar >>

Making the Case for Your Commercial Refinance

Posted on by Frank Gallinelli

Many of you surely have commercial property loans that are coming up for refinance during 2009.  We have a new article (actually, the first installment of a two-part piece) on realdata.com that we think you’ll find helpful.

In Part One of “Making the Case for Your Commercial Re-Finance,” we tell you what information you must gather before you apply for the loan. We help you understand the loan underwriting process as the lender sees it, and show you how to estimate the maximum amount of financing you can reasonably expect to get.

In Part Two, we’ll demonstrate the process of building a presentation that you can use to make a strong case for your commercial refi.

To view this article, go to realdata.com and click on the “Learn” tab.  You’ll find a link to this and a whole library of articles for investors and developers.

Is Now the Time To Buy Real Estate for Investment?

Posted on by Frank Gallinelli

“Give me a one-armed economist!”  That’s what Harry Truman said as he grew weary of economic advisors who seemingly could never give a straight-out recommendation without adding, “…but on the other hand….”

I believe serious investors understand that they can succeed in both good economies and in bad. They also know that they may have to adjust their approach to fit the circumstances.   Has anyone seen Warren Buffet hiding under a rock?

Income-producing real estate – that is, rental properties – offer investors an excellent opportunity to build wealth over the long term.  It’s important to understand that the value of a typical income property doesn’t necessarily rise and fall in step with the home market.  Investment properties are bought and sold for their ability to produce net income.  So, if you buy a property at a sensible price relative to its income and you manage it well, you should enjoy a good return over the long term.

Everyone expects their investments to succeed in a hot market, but what about now, when the economy is struggling?  It’s not uncommon to see apartment properties do well at times like this.  When money is tight and it’s difficult for buyers to come up with down payments and to afford mortgage terms, demand for apartments typically rises.

Take a look at the medical office buildings in your market.  Health care doesn’t go out of fashion, and with boomers getting older, there’s a good chance that demand will rise.  Look also at university towns.  The turnover of students and faculty typically translates into high demand.

I’ll say more about these and perhaps some other areas of opportunity in future posts.

And finally, what about that one-armed economist?  Is there a, “…but on the other hand?”  As much as we would like every decision to be unambiguous, all investments involve risk.  Otherwise there would be no reward.  So what are the caution flags?

First, remember that all real estate is local.  Your local job market, for example, may be atypically strong, with new employers moving in; or especially weak, with important job sources shutting down.  View all generalities through the prism of your local market.

Remember that cash is king, especially in a weak economy.  It’s all right to try to acquire a property using as little of your own cash as possible (provided, of course, that the deal works on those terms).  But there’s a big difference between using very little cash and having very little cash.  If you have nothing in reserve to fall back on, the risk of a highly leveraged investment may be greater than you can deal with.

This may not be the time to buy with no cash and flip for a profit tomorrow, but it can be an excellent time to buy for the long term.  Do your homework, run the numbers, and prosper.

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