When You-And The IRS-Flip A Condo

My friend Jimmy keeps telling me, “You can’t go broke taking profits.” And, he’s right. But it’s not what you make that counts, it’s what you keep. If you’re one of those lucky people who sold a condo almost as quickly as you bought it, I hope you thought about how much you could end up paying the IRS.

It could be a lot.

Say you bought your condo for $150,000 and sold it for $250,000 two weeks later. You made a $100,000 capital gain. But say you didn’t hold the property for more than 12 months. That makes it a short-term capital gain.

You’ll pay a federal rate of as much as 35%, not the 15% long-term capital gain that investors have been frothing about. Add a state tax, say 5%, and you now owe $40,000 in taxes on your sale.

If you buy and sell multiple properties over a short period of time, the IRS might consider you to be in the real estate trade or business. That makes all your profits ordinary income, ineligible for capital-gains treatment. In addition, that will subject you to self-employment taxes, which drains another 15.3% out of your profits. Now, from your $100,000 gain, you’ve only cleared $44,700.

Add a 6% commission on the sale, $15,000, and now you’re down to $35,700 ($44,700 less $15,000 = $29,700, plus the 40% tax savings on the $15,000 deductible commission). And, that’s before other closing costs such as transfer taxes and legal fees.

Now you’re clearly a “taxpayer.” This is proof that you really don’t have to pass a civil service exam to work for the government!

Hurt yet?

Starting to hurt? Here’s some more pain. As your income increases from short-term or long-term gains, your alternative-minimum-tax exclusion gets wiped out. That increases your exposure to the dreaded AMT.

Income that normally would have been subject to marginal rates of 10%, 15% and 25% is now smashed with a nearly flat rate of 26% to 28%. (I know; I was hit with the AMT because of a huge long-term capital gain on a property my wife sold.)

Is it too late to invest in real estate?

Flipping and its impact on your tax bill lead me to ponder a second question: Is the real-estate market too frothy?

Enter “real estate” into MSN Money’s search engine and nine of 10 hits pose the same question: “Has the real-estate market peaked?”

Here’s my take:

Nearly one quarter of all homes sold last year were bought by investors, and I think most were looking to flip them for a quick profit. An additional 13% were bought as second homes. Back in 1998, only 7% of mortgage financing went to real-estate investors. If you don’t live in the properties you own, you’re more likely to dump them at the first sign of a downturn, either to lock in profits, or minimize losses.

Think tulips, as in the Great Tulip Bubble in Holland in the early 17th century. Or, if you’re not that old, try to remember the telecom and Internet stocks you were going to retire on that crashed a few years ago. A lot of day-traders with dreams of quick wealth are now back working their old jobs.

Federal Reserve Chairman Alan Greenspan months ago warned of “speculative fervor” pushing prices to unsustainable levels. The Federal Reserve continues to boost short-term interest rates, though that has less effect on mortgage rates than you might guess. Even so, rates are back up well over 6%.

Every bump up makes buying real estate more expensive. Each increase is another pinprick in the perceived bubble.

Looks healthy to me

Frankly, I’m less than convinced that a drop from record levels is proof positive of the end of the real-estate boom. The market may be cooling from its sizzling run up. But, real estate appears to remain in healthy shape.

True, the increase in real-estate prices has been fueled by historically low interest rates. But, low interest rates haven’t been the only cause. The baby-boom generation has reached the age where second homes are an attractive alternative to money market funds earning less than 2%. Their children, Generation X, are now approaching age 40 and their prime earning years. And they’re using their increased wealth to trade up. Solid growth in employment has also contributed to the run-up in real estate demand.

Remember, only three things count when investing in real estate: location, location, and location. Some areas are going to experience a significant downturn. I wouldn’t be anxious to invest in Boston or California. But, overall, I continue to like real estate, especially as a user rather than as a speculator.

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