Friday, September 9, 2016

Starker-type deferred exchanges and Real Estate buying no-nos.

Buying a house is a big decision.  Deciding what house to buy based on the paint color is idiotic.

A reader noted in response to my previous posting that I could do a Starker-type deferred exchange on my condo and thus defer taxes.  This may be true, but I want to spend the money at this point in my life and get out of the Real Estate business for good.  So I will have to pay capital gains taxes.  I could structure the sale in installments or take back a mortgage and thus profit two ways (and take advantage of the installment provisions of the tax laws) but since it is slated to be bulldozed, those options may be limited.

I wrote about Starker-type exchanges before and how they work.  It is one of those "loopholes" you hear politicians railing about, but of course, no one wants to close it.    If you buy an investment property in Chicago and then decide to move to New York, you might want to sell the Chicago property and buy a similar property in New York.   Is this a "realization event" (see my posting on that) or merely transferring funds from point A to point B?   Mr. Starker seemed to think not, and thanks to his court case, the law has been changed to allow such transfers.

Your equity in the original property is transferred to the new one, tax-free.   There are rules and limits to this, of course - consult a tax adviser for details.   We did this back in the 2000's, selling a duplex and buying two condos in Florida.   The duplex had doubled in value during the crazy days of the 2000's and we bought the condos with the proceeds, transferring our basis in the property to those condos.

We then decided to sell one condo, after it doubled in value from its purchase price.  We had to pay tax on that.  The other we made our principal residence for three years and then sold it, tax-free, as you don't pay taxes on the sale of your principal residence.   Neat trick if you can swing it.

Others "roll over" gains to larger and larger properties and then leave them to their children, who get a "stepped-up basis" in the property (meaning their basis is the market value at the time of death of the parent) and thus get the property tax-free and once again the tax man is cheated.

Well, not cheated per se as it is the law - just a law that favors real estate investors.   Ah, the neat stuff you learn in law school - like how the rich get richer.

But why is a personal residence not taxed?  Again, we covered this before - you don't really make money on the house you live in, it generally appreciates at a rate equal to inflation.  And when you factor in how much you spent on the house to maintain it, well, it is a zero-sum game at best.   You might get a big paycheck at the end, but it is equal to all the money you spent over the years on the house - in most cases.  Again, see my posting on that subject.   So the law recognizes this and doesn't tax personal residences.

But you can convert a rental property you own into your personal residence and then (if you live there for three years or so) not pay taxes on the sale.   Pretty odd law.   But it illustrates how laws - like Obamacare - can be oddly crafted to produce unintended results.

Three recent events in my life occurred which made me think about home buying.  First was an article the Chicago Tribune (I think) saying that mini-mansions are hard to sell these days.   Some guy bought one in 2005 for 2.5 million and had to take a $600,000 loss on it (which is NOT deductible!) in order to sell it.  The styles of the 2000's and colors are not as salable today and new home can be bought for less.

The second thing was I found the first season of Glee! at a garage sale for $1 and was watching it.  The part about "Sheets and Things" (where Mark worked briefly) was spot-on, as was the scene where the young couple is looking to buy a house - more concerned about features and appearances than real value of the home.

The third thing was my Brother-in-Law telling me about showing houses to a millenial couple.   They turned down solid houses at decent prices because they didn't like the color of the interior paint which of course is idiotic.

It got me to thinking though, that a lot of people make huge mistakes in home buying based on appearances and other superficial things and end up broke as a result.  A former secretary of mine turned away free-standing houses that were a good value to buy a "brand new" townhome that ended up being a PEX plumbing nightmare (as well as roofing problem) that resulted in a lawsuit against the builder.   Like the lady in Glee! she said she didn't want to buy a "used home" - as if houses were the same as cars.

Paint can be changed.  So can appliances and cabinets - once they wear out after 10-15 years.   But many people choose a home based on the color of the walls, the type of cabinets and flooring, and the appliances.   It is pretty stupid.   When we bought our last house (in every sense of the word) it came with white appliances and Corian countertops.   Maybe not my first choice, but it was all brand-new.   Rather than ripping it out for granite and stainless steel, we decided to live with it, and frankly, it works very well.

In our former vacation home (see my posting about the kitchen "remodel") we were faced with the same problem - black appliances and drab walls.   New hammered knobs on the cabinets, hardwood flooring, and a color change made the place look like a new kitchen for very little money.

What is really important about a house is not the color of the walls or the types of appliances or other superficial things but its cost, location, and structural soundness, pretty much in that order.

Real estate agents like to tout "location, location, location!" and that is a very important factor to be sure.  But the cost of the home, in terms of its affordability to your budget and whether it is overpriced for the market is far more important.   Cost is the one term never mentioned by agents or by other types of "review" sites.  But it is the factor we all consider in every purchase we make, first.   For example, a car site may say that a Toyota is a better car than a Nissan, and that may be true.  But the Toyota is more expensive and the Nissan dealer is offering discounts.   Price is a huge factor.  I bought the Nissan.

People who want the "perfect" house with the sun nook and the colors and cabinets and appliances they like may end up paying far too much and end up "house poor" or upside-down on a house and unable to sell it later on, without taking a huge loss or declaring bankruptcy and walking away from the mortgage.  It happened in 2009 and it will happen again.   In fact, the episode of Glee! mentions this, with Will arguing that so many houses on their street are in foreclosure and are good bargains.   Again, his wife responds with "I don't want a used house for our children".   An idiotic statement, but people make it in real life.

Location is a close second and closely related to pricing.   If you buy a house in an inconvenient location or a bad neighborhood, you will end up unhappy and perhaps broke.    Buying a cheap house in a crime-ridden neighborhood with poor schools, so you can have money left over to buy consumer products is an idiotic choice - but a choice millions of people make - installing alarms and fences and getting dogs to protect their "stuff".

A good location holds its value, and a location with good schools appreciates in value.   A location that is personally inconvenient (long commutes in rush hour) will end up being costly and make you unhappy.   If it is in an area that is a long commute for everybody then it will not appreciate but in fact, depreciate in value.  We saw this in the DC area where people moved further and further out to the cornfields, only to realize that no one wanted to buy a 2-hour one-way commute every day.

Structure is the third factor in the equation and one that can be costly to repair.   Shaky foundations, leaky roofs, rotting sill plates and backed-up plumbing can be expensive to fix and make a property hard to sell.  Young buyers are wow'ed by modern color choices and trendy kitchens and baths, but may overlook a serious structural issue that will make the house impossible to sell once trends change and the house is "dated" looking.   A good home inspection is key here - and you should pay more attention to that than to color choices or carpet types.

Sadly, most people are awed by superficial things and not by substantial things.   We like the flash and sizzle which is promoted on the television shows.   So many of these "improvement" and "buy and flip" shows concentrate on that and not on the real meat-and-potatoes issues.  I saw one recently while in a Hotel room, and the guy was "flipping" a house next to a junkyard by putting in trendy countertops and appliances, and a big fence between the house and the junkyard.   Granite countertops or not, a house next to a junkyard is not a good investment.  I felt bad for the buyers.

Rooms can be painted.  It isn't hard to do and needs to be done every few years or so (our house is about ready for every room to be repainted).    Appliances and cabinets last maybe 15 years.  If you are more concerned about impressing your friends and neighbors with your "designer kitchen" than with having a positive bank balance, you are headed for trouble.   And let me be clear about this - your friends and neighbors aren't going to give a shit about your designer kitchen for the simple reason that they won't spend much time there, if ever.   I've seen people blow tons of money on "look at me!" kitchens and baths, only to live lonely, impoverished lives, without even the satisfaction of intimidating their friends.

It is interesting about so-called Millennials, though.  Raised in the mini-mansion era, they probably expect that a "normal" house should have all sorts of look-at-me features.  Indeed, one of the largest growth areas in construction is in luxury student housing which makes no sense at all to me.   When I was a student, the term "student housing" meant run-down and roach-infested tenements which were overpriced but close to campus.  We sacrificed because we were getting an education.   A generation raised in McMansions perhaps has different standards.

But perhaps there is hope.  There are signs that the average size of new homes is shrinking somewhat or at least staying static.   The reasons are multiple - no one can afford huge houses anymore for starters.   No one wants to pay the property taxes on a monster house (which can exceed $10,000 a year in some jurisdictions).  No one wants to pay the utilities on a monster house or have to clean it or pay to have it cleaned.   Less is more, as I have learned.  And being a slave to a possession, including a house, makes no sense at all.

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