Will
Every day the media bombards us with
the impending implosion of the real estate market, a pretty constant theme for
at least 2 years now. You hear
expressions like ‘inventory is increasing’, ‘median home prices are up (or
down)’, ‘new home sales continue to decline’, ‘interest
rates are still low’ and on and on. Now
after the constant barrage of doomsday predictions, home and land sales are
starting to slow down a bit and in some areas prices are nudging downward. For what it’s worth here’s my take on how to
view real estate ownership and what the main reasons are for rising, falling or
stable prices.
THE TAX LAW CHANGE IN 1997
This is the one the media almost
never mentions that I believe probably effects the current market the
most. Prior to
Let’s take a look at how a primary
residential capital gains exemption could affect the entire spectrum of real
estate markets. Here are some examples
within the types of real estate investment…
Primary Residences
Instead of getting a one-time life exemption
of $125,000 only after age 55, all of a sudden you were no longer
ball-and-chained to your home no matter what your age. You could buy down, up or sideways in price
and it wouldn’t trigger capital gains, assuming you made less than the new
limits. You didn’t have to wait until
some ‘magical’ age, you could sell whenever you wanted and you could take as
long as you wanted to repurchase or never buy another home.
Under the old tax law, the work you
personally put into your home wasn’t deductible. You could only deduct the cost of bricks,
mortar and two-by-fours but when you paid tax on the capital gains, all of your
hard work wasn’t deductible. On top of
that, when you finally settled up your capital gains all you could deduct was
the cost of the improvements at their original price. The well you drilled in 1960 for $1,000
enabled you to deduct that amount despite the fact that the same well when you
sold would go for $10,000. You were
paying capital gains tax on $9,000 of purely inflated value. The $125,000 exemption was eaten up over a
lifetime, simply by inflation. Most
people rolled over their basis from one house to the next, building up years of
inflationary value in their homes, only to be hammered by the government when
they finally cashed in.
Vacation Homes
Pre-’97 was an even worse nightmare
for second homes. If you’d held a
property for say, 20 years, when you went to sell, you didn’t even get the
one-time exemption. Many, who’d recycled
cabinets from their primary residence or remodeled with their own labor, got
hit with a capital gains tax that again, ignored inflation, non-purchased value
or an owner’s ‘sweat equity’. Vacation
homes, while fun, were not particularly good investments and when you sold, if
your accountant didn’t know better, you could be taxed by your home state,
Vermont and the Feds, sometimes equal to half of the ‘gains’.
After the ’97 tax change, many look
at their vacation property as a kind of untaxed retirement fund. After you sell your primary residence with
its $250,000 to $500,000 exemption on the gains, you can move into your
vacation property for at least 2 years and sell it with the primary home
exemption. And if you have a condo in
Florida, it now makes sense to go live there for a few years prior to
selling. The primary home exemption has
become a retirement plan for many that not only doesn’t penalize for natural
inflation, it now makes sense to put time and money into improving your real
estate holdings. We are no longer
unfairly taxed on inflated values or our own hard work. The penalty of ownership is gone, so long as
it has been your primary residence within the guidelines, prior to a sale.
Commercial Investments
If the impact to primary and
secondary homes weren’t enough, consider just a few other possibilities as many
have done during this real estate boom.
Spec home builders can live in a ‘new’ house for 2 years as their
primary and sell with the $250,000 to $500,000 exemption, eliminating income
tax. Owners of 2-unit apartment buildings
can move into them as primary homes without renting for the require amount of
time and take the primary residence exemption on gains. Investors have shifted commercial assets
through 1031 exchanges into homes, rented them for the required period and then
moved into them for their primary home exemptions, not just deferring the gains
but eliminating it.
Land
Prior to 7/1/97, you had 2 years
from the sale of your primary residence, until you moved into your new home
built on recently purchased land and you had to have the combination cost equal
to or greater than your old home’s sale price.
With the new law, you can buy land anytime and add a home anytime and
just follow the simple rules for claiming it as a primary.
These are just a few examples of how the new tax code liberated real
estate as an investment again. Please
appreciate, however, that the public’s awareness of tax advantages and
‘loopholes’ and the cat-and-mouse evolution of the rules dictate that you
should always consult an accountant or attorney as some of the examples given
here may be subject to new limitations.
So what else affects the prices of
INTEREST RATES
This is the one constantly discussed
in the media, as though it was the main reason for shifting markets. From experience I’ve seen great markets with
relatively high rates and slow markets with low rates. They have an effect for sure, especially on
the starter home segment of the market and commercial development, but overall
interest rates seem to be, at the moment, overemphasized.
CONSUMER CONFIDENCE
Is the current market we’re in
caused by buyers feeling great about their job and financial future? We don’t think so. Consumer confidence has hit some real lows
during the years of the current boom.
SPECULATION
When investors start to feel like
there’s money to be made by flipping properties, speculation starts to
exacerbate market conditions. This
inflates the appearance of buyer demand and can cause quick inventory fluctuations
as investors snap up properties or dump them quickly at the appearance of a
shift. We believe there is much less
speculation in
THE STOCK MARKET & OTHER INVESTMENTS
Did the stock market’s decline
beginning with the Dot Com bust in March 2000 affect real estate sales? Inevitably, but again, the
What didn’t change after this
date? We certainly saw buyers, especially
in the aftermath of 9/11, purchase property as a potential escape place or who
took the event as a sign that it was time to look for a safer place for their
family. This ‘fear effect’ has dwindled
and without a similarly dramatic event will likely continue to be
insignificant.
LIFESTYLE DECISIONS
Whether it’s the demographics of
baby boomers looking for less congestion or a way out of the corporate cubicle,
better or safer schools, less pressure on their children, a closer proximity to
nature, less traffic or waiting on lines, liberal political climate, greater
tolerance for alternative lifestyles or any other myriad reasons, it’s apparent
to us that large numbers of these folks are taking a hard look at Vermont. Retirees are also a big part of the transplant
traffic.
AFFORDABILITY OF
Compared to urban and suburban
areas, especially the Northeast and west coast,
THE COST OF RENOVATION AND NEW CONSTRUCTION
Recent and past events from the
tsunami to Katrina have caused a dramatic increase in the material cost for
construction. The global economy has put
tremendous pressure on wood and all petrochemical based products which are just
about everything in the home. These
costs, together with rising labor and development costs will tend to keep
existing home values strong.
SATURATION
Conditions shift because few
investments or markets are linear.
People, like traffic, travel in waves.
Ever work in a retail shop? No
one will come in for 20 minutes and all of a sudden 5 people walk in at
once. Real estate markets tend to bunch
up because people think alike. It’s
either a good time to buy or a good time to sell. Rather than waiting, buyers or sellers will
push their own time frames up or back so as to optimize their timing. Oftentimes, these are the best times to do
just the opposite of the common perception.
SUMMARY
There are other reasons why price
and markets shift but these are the main ones.
So what’s it all mean and how does it affect the current ‘bubble’? We do believe the current tax code regarding
the primary home exemption will continue to affect the flexibility of real
estate as an investment. The
desirability of a