Tag Archives: appreciation

What’s with 1031 Exchanges?

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photo by www.rentalrealities.com

US News & World Report quoted me in Why 1031 Exchange Investments Are Worth a Look. It opens,

With tax reform nearing final passage in Congress, one of the most underlooked, but potentially overpowering, tax-advantaged investment tools is the 1031 exchange, which was spared major changes in the proposed legislation.

The 1031 exchange, especially when related to real estate investments, is all about “timing and taxes” and the better you manage the two, the more money you can make.

What is a 1031 exchange? By and large, IRS Section 1031 covers “exchanges” or swaps of a specific investable asset (such as real estate) for another. The end game for the taxpayer/investor is to avoid having exchanges listed as taxable sales. But if they’re executed within the confines of a 1031 exchange, taxes are either significantly reduced or eliminated altogether.

The primary benefit of 1031 exchanges related to real estate investments is tax deferral, or avoidance of capital gains taxes on the sale of appreciated investment property, says Kevin O’Brian, a certified financial planner at Peak Financial Services, in Northborough, Massachusetts.
“If held inside owner’s estate at death, the asset would receive a step-up in cost basis to the market value, as of the date of death,” O’Brian says. “Therefore, heirs could avoid capital gains taxes, if sold after inheriting it as well.”
Others note that following IRS guidelines on Section 1031 are a must.
“1031 exchanges allow a real estate investor to sell one property that has appreciated in value and not pay capital gains tax so long as the investor buys another property,” says David Reiss, a professor at Brooklyn Law School. “This is a powerful tax deferral tool that many sophisticated real estate investors use. It is, however, somewhat complicated to pull off and involves some additional costs and planning so it is not for those looking for a quick and easy way to defer capital gains.”
What are the rules for a 1031 exchange? The rules governing 1031 exchanges have to be followed carefully and it makes sense to plan for it with an appropriate team of professional advisors and a reputable 1031 exchange company, Reiss says.
“Generally, the investor needs to sell the property that has appreciated in value; place the proceeds in escrow with an intermediary; and then use those proceeds to buy a replacement property within a certain period of time,” he says. “If the investor fails to follow the requirements for the exchange, he or she may be taxed on the full capital gain.”
Investors should also be sure to use a 1031 exchange company that meets specific criteria. “Not the least of which is that it’s properly insured to protect you in case your funds disappear from escrow,” Reiss says. “This has been known to happen.”

The Good, Bad & Ugly of Real Estate

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U.S. News & World Report quoted me in The Good, Bad and Ugly of Real Estate Investments. It reads, in part,

While many investors get a rise when it comes to the potential profits in real estate, that doesn’t mean all properties rise enough in value to justify the commitment.

“Some people buy real estate expecting it to appreciate a lot over time,” says David Reiss, a professor of law and research director of the Center for Urban Business Entrepreneurship at Brooklyn Law School. “But it can be risky – or even foolish – to pay so much for a property that you’re losing money on an operating basis just because you think it will appreciate.”

The wisdom in real estate, then, applies just as it would with stocks, commodities or any other investment class: The variables are many, the can’t-miss propositions few. So where should the savvy money go? And how does real estate fit into your overall portfolio?

Here, experts and observers weigh in on the essentials that should guide your decisions, as well as the ways to guide your financial forays toward success.

Know your market well. If you pay market price for an investment property, you probably won’t see particularly robust returns. “It will make a market return, and if you want to do better than that, you have to pound the pavement,” Reiss says. “Look for deals that are underpriced for one reason or another. And you won’t know which deals are underpriced unless you have a good sense of how properties are priced.”

*    *    *

Increase your profit potential with an investment of time. Property development, management and administration often require an army of specialists. But if you’re adept at repairs, accounting or showing a vacancy to prospective renters, you can forego the fees associated with hired help. “Depending on your availability and your skills, these could be trade-offs that are worth making for you,” Reiss says.

Salary Needed for a House in 27 Cities

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HSH.com has posted a study to answer the question — How much salary do you need to earn in order to afford the principal, interest, taxes and insurance payments on a median-priced home in your metro area? The study opens,

HSH.com took the National Association of Realtors’ fourth-quarter data for median-home prices and HSH.com’s fourth-quarter average interest rate for 30-year, fixed-rate mortgages to determine how much of your salary it would take to afford the base cost of owning a home — the principal, interest, taxes and insurance — in 27 metro areas.

We used standard 28 percent “front-end” debt ratios and a 20 percent down payment subtracted from the NAR’s median-home-price data to arrive at our figures. We’ve incorporated available information on property taxes and homeowner’s insurance costs to more accurately reflect the income needed in a given market. Read more about the methodology and inputs on the final slide of this slideshow.

The theme during the fourth quarter was increased affordability.

Home prices declined from the third to the fourth quarter in all of the metro areas on our list but one. But on a year-over-year basis, home prices have continued to trend upward.

“Home prices in metro areas throughout the country continue to show solid price growth, up 25 percent over the past three years on average,” said Lawrence Yun, NAR chief economist.

Along with affordable home prices, mortgage rates fell across the board which caused the required salaries for our metro areas to decline (again, except for one).

“Low interest rates helped preserve affordability last quarter, but it’ll take stronger income gains and more housing supply to help meet the pent-up demand for buying,” said Yun.

On a national scale, with 20 percent down, a buyer would need to earn a salary of $48,603.82 to afford the median-priced home. However, it’s possible to buy a home with less than a 20 percent down payment. Of course, the larger loan amount when financing 90 percent of the property price, plus the need for Private Mortgage Insurance (PMI), raises the income needed considerably. In the national example above, a purchase of a median-priced home with only 10 percent down (and including the cost of PMI) increases the income needed to $56,140.44 – just over $7,500 more.

This sounds like a pretty reasonable methodology, but there are a lot of assumptions built into the ultimate conclusions. They are generally conservative assumptions — buyers will get a 30 year fixed rate mortgage instead of an ARM, buyers will have 28% debt ratios. I would have liked to see some accounting for location affordability, because transportation costs can vary quite a bit among metro areas, but you can’t have everything.

As always, I am particularly interested in NYC, the 24th most expensive of the 27 cities.  NYC requires an income of $87,535.60 to buy a median home for  $390,000. By way of of contrast, the cheapest metro is Pittsburgh, which requires an income of $31,716.32 to buy a median home for $135,000 and the most expensive was San Francisco, which requires an income of $142,448.33 to buy a median home for $742,900.

Reiss on Rising Interest Rates

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ABC News quoted me in Small Interest Rate Changes Mean Big Money for Home Buyers.  The story reads in part,

As the economy continues to recover from the worst recession since the 1930s, mortgage interest rates remain at historically low levels.

The Primary Mortgage Market Survey, produced by Freddie Mac, reported in mid-March the average rate for 30-year fixed-rate mortgages was 4.32 percent; 15-year fixed-rate mortgages averaged 3.32 percent and interest rates 5-year Treasury-indexed hybrid adjustable rate mortgages averaged 3.02 percent. Nonetheless, Frank Nothaft, chief economist for Freddie Mac, speculated the Fed’s gradual tapering of its stimulus efforts may prompt a rise in mortgage interest rates.

If mortgage interest rates do rise significantly in the future, what, if any effect will there be on the home buying market? According to Steve Calk, chairman and Chief Executive Officer of The Federal Savings Bank, interest rates have never been the deciding factor for whether potential home buyers actually purchase a home.

“Whether interest rates are 5.5 percent or 7.5 percent, when people are ready to buy, they’ll buy a home,” Calk said.

Price, location, size, appreciation value – these are factors many would-be homeowners consider long before mortgage interest rates enter into the picture. However, once they begin actively searching for a home, interest rates often play a role in their ultimate buying decision.

This is especially the case when interest rates are high, according to David Reiss, Professor of Law at Brooklyn Law School.

“When people think about buying houses, they think about the price of the house. But what they really should be thinking of are the monthly costs. The average 25-year-old might not think about housing rates until they go to a mortgage broker.
“Then they discover that 8 percent interest may mean that instead of a $200,000 home they can only afford a $160,000 home,” Reiss said.

*     *      *

Tight credit and persistent high unemployment have almost certainly played a role in depressing home buying figures during the recovery, as has the large numbers of home owners who perhaps bought homes at the height of the bubble who now find themselves underwater on their mortgages. However, many underwater homeowners could be missing out on a unique opportunity presented by the present financial climate. In a housing market where prices are depressed and borrowing is cheap, home buyers with solid incomes and good credit can find lenders willing to extend credit on favorable terms, ultimately putting them ahead financially, even if they sell their present homes at a loss, according to Reiss.

“Many people feel stuck in place because they are underwater or the market is bad. But although it may be counterintuitive, it could actually be a smart move to sell in a bad market. It’s a bit more sophisticated strategy, but you could move out of a cheap home into a better home for not that much money,” Reiss said.

*     *     *

Education and due diligence in maintaining good credit are the most potent tools that potential home buyers can employ, whether they are seeking their first home, a larger home or are scaling down to smaller quarters as empty nesters. Obtaining prequalification can provide home seekers with a better idea of precisely how much house they can afford, Reiss said.

Long-Term Homeownership Affordability

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Amnon Lehavi has posted Can the Resale Housing Market Be Split to Facilitate Long-Term Affordability? to SSRN.  The paper argues that

a comprehensive affordable housing policy requires the formal splitting of the homeownership market into (at least) two distinct segments: one designated for the general public and following a conventional pricing mechanism through free market supply and demand, and the other designated for eligible households and controlling both initial supply and subsequent resale of housing units through regulated affordability-oriented pricing mechanisms.

While regulation of the pricing of affordable housing units during their initial allocation is a standard feature of housing policy–whether such affordable units are produced by a public authority or a private developer–regulation of pricing upon resale to subsequent buyers has received less attention as a matter of both theory and practice, thus leaving a substantial gap in

design mechanisms aimed at promoting a sustainable affordable housing policy.(1)

This is not really a new argument, but the paper takes the position that existing efforts to regulate resales of affordable housing in the homeownership market can be scaled up significantly. The paper does not take on some of the bigger questions that this position implicates — for instance, should scarce homeownership dollars be spent on rental housing instead — but it does develop a concrete proposal:

This paper seeks to enrich policy design options by introducing two alternative cap-on-resale mechanisms for the affordable housing segment: “Mixed Indexed Cap” (MIC) and “Pure Indexed Cap” (PIC). It explains how such models could be utilized to attain a policy goal of promoting long-term social mobility, allowing multiple low- and modest-income households to engage in capital building by sequentially enjoying increments of appreciation of properties in the affordable housing segment.

In so doing, the paper addresses a series of challenges posed by the design of a cap-on-resale mechanism: Could such a mechanism ensure that the homeowner is granted a fair return upon resale, providing the owner with proper incentives to invest efficiently in the property during the tenure, while setting up a resale rate that would make the unit truly affordable for future homebuyers? (1)

New York Ciy has experimented with affordable homeownership and has not come up with an ideal solution to the problem of affordability upon resale. Given the renewed focus on affordable housing policy in NYC, this attention to affordable homeownership policy is most welcome.

A Shared Appreciation for Underwater Mortgages

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New York State’s Department of Financial Services has proposed a rule that would allow for “shared appreciation” of a property’s value if an underwater loan is refinanced. The Department states that this will provide a helpful option for underwater homeowners facing foreclosure. If a homeowner were to take a shared appreciation mortgage, he or she would get a principal reduction (and thus lower monthly payments) in exchange for giving up as much as fifty percent of the increase in the home’s value, payable when the property is sold or the mortgage is satisfied.

The precise formula for the holder of the mortgage is as follows:

The Holder’s share of the Appreciation in Market Value shall be limited to the lesser of:

1. The amount of the reduction in principal (deferred principal), plus interest on such amount calculated from the date of the Shared Appreciation       Agreement to the date of payment based on a rate that is applicable to the Modified Mortgage Loan; or

2. Fifty percent of the amount of Appreciation in Market Value. Section 82-2.6(b).

The principal balance of a shared appreciation mortgage “shall be no greater than: (i) an amount which when combined with other modification factors, such as lower interest rate or term extension, results in monthly payments that are 31% or less of the Mortgagor’s DTI; or (ii) 100% of the Appraised Value.” Section 82-2.11(i). The proposed regulation contains mandatory disclosures for the homeowner, including some examples of how a shared appreciation mortgage can work.

How does this all play out for the homeowner? We should note that similarly situated homeowners can be treated differently in a variety of ways. Here are a few examples. First, two similarly situated homeowners with different incomes can receive different principal balances because of the DTI limitation contained in section 82-2.11(i). Second, similarly situated homeowners can receive different principal balances because their houses appraise for different amounts. And third, different rates of appreciation of homes can make two similarly situated homeowners give up very different absolute dollars in appreciated value.

All of this is to say that homeowners will have to consider many variables in order to evaluate whether a share appreciation mortgage is a good option for them. They should also know that what is a good deal for one homeowner may not be a good deal for a similarly situated one. It is unlikely that the mandatory disclosures will be sufficient to explain this to them in all of its complexity. It is not even clear that loan counselors could do a great job with this either.

I am not arguing that the share appreciation mortgage is a bad innovation. But I do think that lenders will be able evaluate when offering one is a good deal for them while homeowners may have trouble evaluating when accepting one is a good deal on their end. I would guess that many may take one for non-economic reasons — I want to keep my home — and just take their chances as to how it all will play out financially.