Not that many years ago, real estate investors could boast that turning huge profits was as easy as printing money. Anyone with a few thousand dollars and the verve to get started could make a good business sniffing out value priced real estate deals and selling them at a substantial profit. While the recipe for profits used to be fairly straightforward - buy low, sell high - the current economic climate has complicated the real estate market. Participants need to be particularly cautious to avoid getting burned by this year's biggest real estate blunders. (Find out why this job more closely resembles the role of a CEO than an asset manager, in A Career In Real Estate Portfolio Management.)
IN PICTURES: 7 Tips On Buying A Home In A Down Market
Buying for the Homebuyer Tax Credits
The Worker, Homeownership and Business Assistance Act of 2009 provides tax credits up to $8,000 for qualified first-time home buyers, and up to $6,500 for qualified repeat home buyers purchasing a new home as a primary residence. As these credits are set to expire at the end of April, with no indication that they will be available again anytime soon, prospective buyers may feel pressured into signing a contract before they are truly ready.
At the very least, this pressure could lead to a premature purchase. Making such a large financial commitment on a tight deadline can cause a number of problems, including being stuck with a house that isn't exactly what you were hoping for. While lenders are stricter on the loans they are willing to dole out, you could rush into something that is "more house" than you intended to buy, which will cancel out any savings that you could have earned by claiming the tax credit.
In addition, the tax credit may have to be repaid if the home is sold or ceases to be used as the buyer's principal residence within three years of the purchase. Be sure you are planning on living in the home for more than several years. Since you have to live with this decision for at least three years, it makes sense to take the time to find your dream home - even if you might miss out on the tax credit. If you are lucky enough to have already found your ideal house - go for it. Just make sure the contract is in place by April 30th. (If you're not taking advantage of these deductions, you could be missing out on tax savings. Find out more in Tax Credits You Shouldn't Miss.)
Expecting to Flip
Flipping involves making a profit from either buying low and selling high in a rapidly-rising real estate market, or buying a house and making repairs and/or updates and selling it for a profit. Functionally obsolete homes, such as three bedroom houses with only one bathroom, can be inexpensively updated (in this case by adding a bathroom) to fetch a higher asking price.
In any economic climate, flipping can be a gamble, particularly in the event of unforeseen repairs, which eat away any anticipated profits. And while there is certainly money to be made flipping, there simply is not the pool of qualified home buyers that existed several years ago. Securing a mortgage loan has gotten tougher, following the proliferation in foreclosures. Finding someone who is willing and able to purchase your newly updated and fixed-up home may be harder than you hoped for.
Buying in a Depressed Neighborhood
You might be able to find a great deal in a depressed neighborhood, but there are some considerations. If the neighborhood is flooded with foreclosures, the area's home values may take years to recover as the large supply of foreclosed homes, which are already undervalued, take a long time to sell. The neighborhood may also be experiencing overall deterioration with nobody left to take care of the homes. Aside from being an eyesore, this can also lead to certain types of crime, like vandalism and theft.
As well, many real estate markets that are experiencing higher percentages of foreclosures are in areas where unemployment rates have skyrocketed - no job equals no mortgage payment. Unless you have a job lined up, be wary of spending money on a house - even at a greatly reduced price - if you aren't going to be able to find suitable employment.
If you are planning on hanging on to your home for many years, you may be able to ride out a depressed market and make your investment worthwhile.
If you are a real estate investor, as opposed to a home buyer or seller, the IRS views you as either an active real estate professional or a passive real estate investor. You are considered the former if you spend more than 50% of your work time actively engaged in the business of buying, selling and managing properties (this totals at least 750 hours per year). You are considered the latter if you contribute money to the purchase or upkeep of properties but do not participate in the day-to-day details. The IRS limits passive investors to $25,000 in real estate losses.
If you fall into the active real estate professional category, the IRS will further define you as a flipper or a long-term investor. While there is no exact number to differentiate between these two distinctions, if you buy and sell more than one property per year, your houses could be treated like retail inventory and taxed accordingly. If you hold on to properties for more than a year, the IRS can treat you as a long-term investor, granting you more favorable tax rates.
Tax implications need to be understood and considered prior to making real estate investments. What might seem like a great deal might not be, once taxes are taken into account.
When All is Said and Done
Being smart about buying, selling and investing in real estate in the current economy requires due diligence. Real estate market participants should thoroughly evaluate a potential transaction prior to signing on the dotted line, which means taking the time to do the math - are the tax credits, tax liabilities and future value of the home in line with your expectations? If not, you may consider stepping back and waiting for a more promising deal to come along. (Real estate investors can flip a property or use it for cash flow. Find out which will work in your neck of the woods, in Flipping Houses: Is It Better Than Buy and Hold?)
Catch up on the past week's top financial news in Water Cooler Finance.