As an owner of real estate, a licensed real estate agent, former property developer and manager, I feel qualified to give a much needed piece of common sense advice.
As of late, 99% of the U.S. population has avoided buying new residential real estate. There are already new contrarians, however, advising to get into the market now, since prices are down and most people are running away. These contrarians will also reiterate the usual song and dance about how a house can be your biggest asset and how paying rent money is like throwing money out of the window. These are completely misleading statements. Let me illustrate what happens when one buys real estate, no matter what the market is doing.
Before I bought my first condo, a friend of mine from the West Coast told me about his condo, which he bought for $200,000, and sold for $300,000 two years later. He talked about how he was able to make a $100,000 profit during grad school, and that I was crazy to be renting, since I would never see any return.
For that reason, when I bought a condo for $200,000, I too was looking forward to a handsome payoff. Here is a breakdown of what actually happened:
I paid about $20,000 as a down payment with the rest covered by the bank, which I paid back via mortgage payments that came out to be around $2,000 per month (including HOA fees). I also paid a state property tax of $2,000 per year, and a county property tax of $500 per year. Even though my condo had been newly constructed, I had to pay certain maintenance fees and upkeep expenses totaling more or less $250 per year.
This was when I realized that my friend probably had more or less the same numbers that I had, so I wanted to see how his $100,000 “profit” looked after all these expenses. This is what I came up with:
| Down payment: | $20,000 | ||
| 2 years mortgage: | 24 * $2,000 = | $48,000 | |
| 2 year property tax: | 2 * $2,500 = | $5,000 | |
| 2 year maintenance: | 2* $250 = | $500 | |
| Total expenses: | $73,500 | ||
I also asked him what type of a mortgage he had. He said it was a 5 year Adjustable Rate Mortgage (ARM), similar to mine. This means that he would have been paying only interest on his loan for the first 5 years. Selling it after two years, he would have not paid down any of the principal, so he would owe the full $180,000 back to the bank at closing. Let us then remember that the government counts the difference between buying and selling price as capital gains, and will tax it accordingly (at 35%, which makes $100,000 * 35% = $35,000). We must also remember the agent’s fee, which is usually 6% or 7%, paid by the seller (6% * $ 300,000 = $18,000)
Therefore:
| Selling Price |
$300,000.00
|
| Total owed to the Bank: |
$180,000.00
|
| Total Expenses |
$73,500.00
|
| Total Taxes |
$35,000.00
|
| Agent Fee |
$18,000.00
|
| Total Profit |
$(6,500.00)
|
Aside from the down payment, all expenses continue year to year. Only after the 5th year (in this particular case) will the amount owed to the bank actually start being paid down.
Taking these points into account, there are only two cases, roughly speaking, in which an investor can truly make a profit:
- Investor Joe buys a house and he is able to procure a renter who can pay more than the mortgage payments in rent. These rental payments will then continue long enough after the principal starts being paid down to cover the down payment. The payments will also cover the property taxes and maintenance in the long term.
- Investor Jane buys a condo and she has a seller lined up right away so she can, for all practical purposes, buy and sell at the same time. If this is done through foreclosure the selling price must cover eventual code upkeep (sewage, termite inspection, etc. etc.) as well as agent fees. Another property should then be available to buy within a year in order to perform what is called a 1031 exchange (so as to avoid being taxes the 35%).
In both cases, one needs to know the ins and outs of real estate. There are several ways to do this, but I would advise taking a course of some sort – even an evening lecture costing $500 would save you money in the end. So please use your common sense before taking risks, especially with amounts like these.
Something doesn’t seem right. I believe the seller is taxed capital gains on the difference between the final sales price and the original purchase price PLUS the seller’s expenses paid to maintain and improve the property, closing costs and sales commissions paid to real estate professionals.
Please forgive me, if I’ve misunderstood – I’m neither a tax or real estate professional. But, if my understanding is correct, then your example should probably be represented more like this:
Original Purchase Price
$200,000.00
Selling Price
$300,000.00
Gross Profit
$100,000.00
Maintenance & Improvement Expenses
$73,500.00
Agent Fee (assuming 6% of sales price)
$18,000.00
Closing Costs (assuming 2% of sales price)
$6,000.00
Total Expenses
$97,500.00
Taxable Gain
$2,500.00
Total Capital Gains Taxes (assuming 35% of taxable gain)
$875.00
Total Net Profit
$1,625.00
I also believe that most people purchase their own homes (not investment property) with 30-year conventional mortgages, which apply a portion of EVERY scheduled monthly payment to pay down the principal.
Bob,
Thanks for the pointer. Truth be told I originally wrote this article in 2008, and I’m no longer a RE agent, so much has changed since then and I’m trying to remember it all. You are right that taxes should be applied on the cost basis (purchase price plus related expenses), but this does not include the mortgage payments, so it changes little in actuality.
And starting in 2011, the tax rate will also rise to 39.6%. I also did not include the closing costs encountered in the original purchase of the home, nor state taxes, nor will I. I am no longer an agent but I know there are various exemptions these days.
This would mean (if my numbers are correct):
Original Purchase Price $200,000
Selling Price $300,000
Gross profit $100,000
Expenses $500 (maintenance)
$5,000 (Property Tax)
$18,000 (Agent’s fee)
$6,000 (Closing costs)
Total Exp $29,500
Taxable gain $70,500
Mortgage $48,000
Total Capital Gains Tax (assuming 39.6%) $27,918.00
Profit (Loss) $(5,418)
However, even if we used your numbers it would be quite telling that when someone tells you they made $100,000 on a sale they actually made $1,625 in net profit.