4 Common Misconceptions About Condo Investments
Investing in condos is an attractive option for young real estate investors looking to break into a big-city market — particularly one as diverse, and with as much potential, as New York City.
Yet caveats abound where one might not expect to find them. Robert Gilman, partner and co-practice leader of Anchin, Block & Anchin's Real Estate Industry Group, spoke with us about four of the most common misconceptions developers encounter as they embark on their initial investments.
1) Whether condos are subject to ordinary tax rates
It is understandable why one would think they are not. Selling rental property allows the seller to benefit from capital gains tax rates. For condos, this is not true; the sale of a condo is taxed at the regular rate, which is approximately 20% more than the capital gains tax. Condo sales are sales of inventory, meaning that sellers are subject to the highest ordinary income tax rate — in many cases, as much as 39.6% for higher income brackets.
2) You will have enough money to pay taxes, especially in the first few years.
More often than not, property development is funded through bank loans. Agreements usually stipulate that the bank receives money before investors can begin receiving distributions. If the investor sells units during the year, there is a financial gain expected from the units sold. However, if the banks reclaim the money until the loans are paid off, the investor receives no money, but will have taxable income from the units sold. They would be required to pay the taxes on units sold.
When negotiating the loan with banks, clients must be prepared to demand retention of tax dollars — even though the bank retains the first dollars when revenue starts flowing in.
"A lot of banks understand that you need money to pay off these taxes, so they allow it," Gilman said. "But it's critical to go in and negotiate at the beginning. You can't ask for it later."
In addition to the tax at the individual level, the entity itself can also retain a tax that developers sometimes overlook. Sales of New York City condos are subject to the city's 4% unincorporated business tax rate,and many developers do not think to put aside enough money to pay off these taxes.
3) Whether you can allocate most of the costs to the first units sold.
You must use a reasonable methodology when you allocate costs. Many owners incorrectly attempt to allocate all or most of their costs to the first few units sold. This leaves little to no gain on earlier units sold. They often try to recognize the gains on the last units sold.
"You have to allocate the cost that you incur from the units, and can't just allocate all the costs to the first units being sold," Gilman said.
Accountants can assist with this step, helping the developers to craft the best strategy for cost allocation by examining both the current year's sales and the timeline for when the rest of the condos will sell.
Simply being aware of the costs is often half the battle.
4) Misinterpreting the requirements when pursuing a better tax rate.
This ties back into misconception No. 1. We know that condo units are subject to ordinary tax rates. If some of the units are converted to rental properties they can eventually qualify for long-term capital gains rates. Many dealers think they just need to wait a year to get the capital gains rates.
Investors and developers may not realize that after converting condos into rental apartments, they must hold the unit for five years before they can benefit from the capital gains tax rate.
“I see many developers selling after a year and a day, thinking that they have a long-term capital gain,” Gilman said. “This isn't the case. While there are various tax-planning ideas to still sell the condo prior to the [end of the] five-year holding period, these factors must be considered when planning what to do with all the units of a condo project."
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