Apartment Seller Asks About Tax Exemption
QUESTION: About 12 years ago, I inherited a four-unit apartment building where I live in a two-bedroom unit.
My nephew and his wife have made me a very good offer to buy the building at a price that will give me over $200,000 profit. The question is can I use that $125,000 old folks tax exemption you often write about?
ANSWER: Yes and no. You appear to qualify for the “over 55 rule” $125,000 home sale tax exemption, as to the profit on the sale of your personal residence apartment. However, this tax break does not apply to your profit on the three rental apartments.
To qualify for the $125,000 home sale exemption you must be 55 or older on the day of sale, have owned and lived in your principal residence any three of the five years before sale and must never have used this tax break of Internal Revenue Code 121 before.
For example, if you live in the best and largest apartment, you can probably allocate more than one-fourth of the sales price and profit to your personal residence unit. Perhaps $80,000 of that $200,000 profit can be attributed to your apartment and the remaining $120,000 profit applies to the other three units.
Using your $125,000 exemption it will shelter $80,000 of profit from taxation, but you will owe tax on the remaining $120,000 profit. Incidentally, you cannot save the unused $45,000 of your exemption in this example for future use. Please consult your tax adviser for more details.
Rental Houses a Good Way to Beat Inflation
Q: We own our home, which has proven to be a great investment as well as a good place to live. Since our home has done so well, we’re thinking of buying one or two rental houses. Do you think they would be good inflation hedges?
A: Although many real estate markets are stagnant now, over the long term, real estate market values usually keep pace with or exceed the inflation rate. If the annual inflation rate stays around 5%, in 10 years property values will need to increase 50% just to stay even with inflation.
But you can do better if you use leverage to maximize your profit per dollar invested. To illustrate, suppose you make a $10,000 down payment to buy a $100,000 house that appreciates just 5% in market value during the next year. That $5,000 increased value is a 50% return on your $10,000 leveraged investment. Yes, I think rental houses can be great inflation hedges.
Leasing Your Home and Renting Can Pay
Q: I was fascinated by the recent question and answer in your column about renting out your personal residence and moving into a rental house. My CPA fully agrees it makes sense from a tax viewpoint. But my wife won’t accept the idea of living in a home we don’t own. However, we agreed to think about this concept and possibly move into a rental house next June after school is out. Are there any precautions to take?
A: For readers who haven’t the slightest idea what we are discussing, previously another reader wrote about the concept she heard about moving to a rental house and renting her residence to tenants. I agreed it was a wise thing to do, considering the income tax advantages.
By moving out of your home, you can rent it to tenants and depreciate the lower of its adjusted cost basis or market value on the day of conversion to rental status. This will probably result in a negative cash flow and a tax loss that you can deduct from your ordinary taxable income such as job salary, interest and dividends.
Renting a similar nearby home should be far cheaper than owning it. In fact, you may be able to rent a luxury home which you couldn’t afford to buy.
Precautions to take include obtaining as long a lease as possible, preferably two to five years, insisting on a renewal option so you won’t be forced to move out at the end of your lease, requiring a clause in the lease limiting the maximum rent increase and if possible, obtaining an option to purchase the rental house. Please consult a real estate attorney for further details.
Property Seller Liable for Misrepresentation
Q: I got swindled but am not sure what to do about it. Two months ago, I bought my first income property, a 12-unit apartment building. The realty agent told me all the tenants were on month-to-month rentals. Since the rents were very low I had planned to immediately raise the rents.
But when I gave the tenants their rent raise notices, they all surprised me by showing me their new leases, which they signed with the seller just a few days before the close of the sale. I had carefully insisted on receiving copies of the current rental agreements, but I was shown only month-to-month tenancies. The seller has left the state. Can I hold the realty agent liable for my damages?
A: The primary responsibility for the fraudulent misrepresentation falls on the seller for signing those sweetheart leases with the tenants just a few days before the sale closed. However, it is arguable that the realty agent, as agent for the seller, also had responsibility to deliver to you what was represented to you when you saw those month-to-month leases. Since the seller is now beyond your reach, that leaves the realty agent to answer for your loss. Consult a real estate attorney for details.
‘Magic’ of Leverage in Buying Property
Q: I can’t see why you encourage people to invest in rental houses, apartments and commercial buildings since they usually produce little or no positive cash flow. Although I can only earn 8% to 9% on my money at the bank, it seems to me this is better than no return at all. Please clarify.
A: I agree it is foolish to invest in real estate for the cash flow because few properties provide much cash flow without a large cash down payment.
Investors often buy income properties for the tax losses, primarily from depreciation tax shelter (now limited to $25,000 deductible against ordinary income), potential for appreciation in market value, safety of investment and the “magic” of leverage.
To illustrate, suppose you buy a break-even cash-flow $100,000 income property with a $10,000 cash down payment and $90,000 in mortgages. If this building appreciates just 5% in market value in the next 12 months, that $5,000 value increase is a 50% return on your $10,000 investment. In addition, you would get tax benefits. Now I hope you see why investors buy leveraged real estate.
Tax-Delinquent Lots Are Rarely a Bargain
Q: I notice the newspaper occasionally carries legal notices of tax-delinquent property sales. I looked over the list of properties and found most were odd vacant lots. Do you think tax-delinquent properties are bargains?
A: Although there are occasional exceptions, my experience and that of many other investors I know has been that very few bargains are available at tax delinquent property sales.
My suggestion is to go over the list of advertised properties to be sold at the tax sale. If you find one that looks interesting, contact the owner and try to buy the property before the sale from the owner. Then pay the delinquent tax so the property won’t be sold at the auction.
Some Risks of Buying Nonconforming Use
Q: I own several small neighborhood grocery stores. My stores charge higher prices than supermarkets, but are more convenient and offer special services, such as payroll check cashing.
Recently, I was offered a grocery store in a top neighborhood. The reason it is for sale is that the owner is retiring.
But the problem is the store is a nonconforming use surrounded by very fine homes. The price is right. Do you think I should buy?
A: Please be careful. Investigate thoroughly. Find out the conditions on the nonconforming use.
If the building is destroyed by fire, for example, most nonconforming uses do not allow reconstruction. Or there may be a time limit by which the property use must conform with the surrounding residential properties.
However, if you are a gambler and are willing to risk that you can earn back your investment before the nonconforming use ends, then you may wish to go ahead with the purchase.
No Profit Tax Due on Bargain Purchase
Q: I recently bought a vacant lot at a bargain price at least $25,000 below market value because the seller was about to lose it in a foreclosure sale. I plan to construct a building on the lot. Do I owe any tax now on the difference between what I paid for the lot and its market value?
A: No. If the seller earned any profit, the seller owes tax on the sale. But you don’t owe tax on your bargain purchase. However, when you eventually sell the property you will have a low basis for the lot and the result will be a higher profit than if you had paid market value for the property. Please consult your tax adviser for further details.
How Starker- Delayed Exchanges Work
Q: In a recent article about tax-deferred exchanges, you briefly mentioned Starker delayed exchanges. But I didn’t understand the explanation of having 45 days to locate another property and 180 days to close the purchase. Last year I moved away from Washington, D.C., where I own an apartment building.
It is being mismanaged by a management company, which now has several vacancies in the building where I rarely had any vacancies when I managed it. Perhaps I could use a Starker delayed exchange to sell my Washington apartments and then use the sale proceeds to acquire investment property close to my new home. Please clarify how Starker exchanges work.
A: A Starker delayed exchange, authorized by Internal Revenue Code 1031(a)(3), is perfect for your situation. The first step is to list your apartments for sale with a Washington real estate agent experienced in selling that type of property. While the property is being marketed, contact a real estate attorney or other third-party intermediary who is experienced with Starker delayed exchanges.
When an acceptable purchase offer is obtained, the offer can be accepted subject to making a tax-deferred exchange. Your exchange adviser can give you the details. After the sale of your apartments closes, the sale proceeds must be held by a third party.
Your next step is to designate within 45 days after the sale closing one or more properties you want to acquire with the sale proceeds to complete the trade. Remember, to qualify for a tax-deferred exchange, you must trade up to more valuable “like kind” property without receiving any taxable unlike kind personal property “boot” such as cash or net mortgage relief.
Examples of like kind property you can acquire include one or more apartment buildings, warehouses, office buildings, commercial properties, rental houses and vacant land. However, a personal residence and dealer property are ineligible.
After designating one or more properties to be acquired, you have 180 days from the sale date of your apartment building to complete acquisition of the property you will be receiving. During this 180-day period you must complete the purchase negotiations, arrange financing and acquire the title. The happy result will be tax deferral on your sale profit and acquisition of investment property close to your new home.
