Mar Salkin Team Real Estate / email us at realproperty@marksalkin.com
Mark Salkin, Esquire / Kristen Moss, Transaction Coordinator
Newsletter for July, 2007 Volume I / Issue 4 / a four page update
Contents this issue:
Market Update – Why Buyers Aren’t
1031 Exchange Regulations Overdue
Income Tax Disadvantages of a Short Sale
Intro: I’ve been saving this newsletter because I wanted to give you something of value, not something re-digested from what others say. Our goal is to keep you informed and thinking about real estate with critical information of value. We’d love to hear from any of you with questions or information on trends in your area.
Market Update: I simply think that both the pundits and the clients are misinformed when it comes to their assessment of the market. I believe the reason that prices are depressed is what I learned when I first studied the stock market: prices go down when people stop buying, and they go up when people buy. Right now, on a national level, people aren’t buying. And though sales continue at modest upturns in Los Angeles, sales are still down here. Why?
One answer that seems to continue is the lemming factor (a perversion of the greed factor). Buyers are following, and since no one is leading they are simply parroting what they learn from the news media. People read the market is slow and declining, so they hold their buying power and wait. They are waiting for the market to reach it’s low so they will not overpay and for fear they will pay too much. And this is proven out statistically from the results of a survey undertaken by in this month’s Worth Magazine.
In the Worth survey (365 affluent homeowners, broken down into three groups of net worth between $1M - $10M, $10M - $20M and over $20M), it was revealed that the lower two groups place a larger value on their homes as investments than do the highest net worth individuals. Because of this concern for value, the lower two groups own less real estate than their counterparts, have a higher concern for whether the value in their homes will stay at current levels (or decline), are spending less on home improvements due to these beliefs (ie., that they may not get their money out of their investment) and do not expect to buy another residence within the next three years. The opposite is true of the higher net worth group: they are still buying, building and pay little attention to their homes as a substantial portion of their net worth.
So we have this large group (2/3ds of the higher net worth types) not buying for fear their investments won’t work versus the high end net worth types who continue buying, building and adding to their portfolios. What does this say?
That’s easy: it says that for most people, and this is true (if not more so) of entry level buyers too, their homes are a large stake in their financial future. Unless they perceive value, or that value will increase, they simply aren’t going to buy. Yet this flies in the face of reality and the less than economic, but often more real, values that homes provide.
First, people still need a place to live. And as any competent agent knows, owning a home versus renting one provides intangible benefits that simply can’t be measured by money. Peaceful quiet enjoyment, pride of ownership, security in occupying one’s castle, the access to neighborhoods for schools and other civil services and numerous tax breaks are all intangible values of home ownership. Second, the equity in one’s home is often an illusory value: it’s not liquid and only qualified real estate professionals know best how to get at that equity to turn it into a useful commodity. Thus no matter whether an up or down market, the value of a home over time is irrelevant to one’s lifestyle except when they need to tap that equity.
What should be, and apparently isn’t, more important is home affordability. It an owner has the money and can buy, he should. Interest rates are rising faster than home prices are leveling, especially on the Los Angeles Westside. This translates to a loss, one that most buyers don’t see.
And so the buyers continue on the sidelines while being manipulated by creative agents doing their jobs: here in Los Angeles, the trend is to purposefully undervalue homes (our inventory is still not yet at “normal” levels and we continue in a seller’s market) in order to drive interest and obtain multiple offers. Several sweet entry level homes have fallen into escrow this way recently while the overpriced leftovers from those who got into the market late now sit empty. This pricing reflects the buyers perceived value such that they write offers on what they see is a bargain, only to end up at the appropriate price level due to the number of offers. And please don’t cry at the agents who use this tool, their job is to obtain the highest price for the seller, not to worry about buyers and their perception of value. It’s only after the price has been bid up and factored into the statistics that the market reflects the truth: prices in Southern California, in selected areas including the Westside, are still on the rise.
As always, education and a sophisticated reading of the market is what it takes to motivate buyers. All the scripts in the world used by agents are going to be hard pressed to overcome what the buyers perceive until the truth dawns: it’s still a good time to buy, interest rates are still close to all time lows and, at least in Southern California appreciation rates are higher than bank rates. Unless and until they create more land, the people waiting on the sidelines are going to wait themselves into a lesser quality neighborhood or a lesser quality home. Given all of the truth, it seems a buyer would be hard pressed to make the case that he’s waiting for the market to hit bottom. In fact, it already has and we are on the upswing.
The potential for regulation in 1031 exchanges: I have been acting for select clients as their qualified intermediary or accommodator under section 1031 of the Internal Revenue Code for some twenty years now. Nary a penny has ever been misplaced. But recently a market development occurred that may alter this most favored of tax advantages for long term investors.
In an exchange, the property owner can defer the capital gains tax treatment (a combined 25% here in California due to state laws) by selling and replacing the parcel with a new acquisition. Although very strict rules apply in order to qualify for this vehicle, many savvy investors and some not so savvy ones, know enough to realize that they would not consider a sale without this tax break. But in order to do this, the owners must contract with an entity called a “qualified intermediary” (or QI) as that term is defined by statute. And the QI, once under contract, is the only one entitled to the use and possession of the money during the term of the exchange, which can last as long as one hundred eighty days. As far as I am aware, as of the writing of this newsletter, anyone can call himself a qualified intermediary for which no licenses or government strictures apply. And there are few tax reporting requirements making this a more or less unregulated industry. Our readers should know that the intermediary is not a trustee and indeed, is hard pressed to even be considered an agent.
Recently, one of our investors sold a condo and entered into a 1031 exchange transaction. Turns out the QI he chose was a company non-resident in the state he lived, and this company was holding his money under contract awaiting instruction to buy the replacement company. During this holding period, this QI was sold to a new company, one whose principals were less inclined to hang onto their client’s money awaiting instructions. Instead, this second company, also acting as a QI, was using the money held by the first company to pay exchange obligations of others because they had depleted the money they were already holding for other non-contractual purposes (some enlightened types might call this stealing or embezzlement, but it’s not). Discovering this, many of the clients of the first company made demands to get their money back (which could potentially have destroyed the exchange anyway). In doing so, they created a run on the second company which was only beaten back when this second company filed for bankruptcy protection. The result was chaos: clients were unable to get their money from the bankruptcy estate to pay for replacement properties that were already under contract. Either these buyers had to find new money to close their contracted-for sales or default on their deposits. And the timelines were often blown due to the red tape meaning that many exchanges failed anyway.
In the case of our client, he had to close by leveraging another property or face litigation. He still had to hire a bankruptcy attorney in a foreign state and is long past his deadlines for the original exchange, so he is likely to still have to pay capital gains. The likelihood of his having to pay taxes increases by each day ad of course, he still hasn’t seen one penny of his money – his bankruptcy Proof of Claim is treating him as any other non-secured general creditor. These losses have been multiplied by all of the clients in the first company. What does this mean?
While the jury is still out, we forecast that this will come to the attention of Congress because the current statutory scheme was not intended to sort out the competing interests. Besides, there’s a lot of money at stake. (When national financial company -whose only business was acting as QI -sold a few years back, it had almost one-half of a billion dollars worth of investor funds on hand at the time). I’d have to say that Congress is likely to start regulating this previously chaste and unregulated industry to the detriment of all it was intended to serve. We feel that once Congress is aware, the likelihood of more and detailed paperwork, new government qualifications of the qualified intermediaries and increased costs are going to be the most likely resort. And of course it will also likely require some amending to the bankruptcy scheme for what is ostensibly trust funds, but is treated today as ordinary losses under contract.
Our advice is to make sure you deal with a reputable qualified intermediary. If you are unsure, you can email us at realproperty@marksalkin.com and we can give you some advice on what factors to look for in order to avoid the fate of our seller, who unfortunately chose not to use our services.
Thinking of the Benefits of a Short Sale? Don’t Forget the Income Taxes!: One not well communicated fact for those thinking of selling their holdings via a short sale is the income tax aspect. In a short sale, the owner convinces the bank that there is no likelihood of ever being able to pay the mortgage in full due to economic reverses and a poorly performing current market. So the bank agrees to cancel the debt and accept less than the full value of its mortgage, enabling the home to sell at less than mortgage or market value (this is a huge plus for the bank, more on that another day).
Problem is that any forgiveness of debt is considered income by the Internal Revenue Service. So if you sell your $500,000 home and pay the bank less than you owe, the difference will be income on which the seller must pay income tax the following year. If you don’t have the cash, you could be in for penalties as well. We suggest you consult a tax advisor anytime you make a sale for less than value to insure the planning for taxes is in hand before you close.
Thanks, your feedback is invaluable.
Mark Salkin, Esq. (310) 301 2316 DIRECT
Kristen Moss
July, 2007
Email us at realproperty@marksalkin.com
