Steve Kent's October 2006 Newsletter

Page 6

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Coping With A Changing
Mortgage Market

By Broderick Perkins
      After rising all year, interest rates recently fell for six consecutive weeks to their lowest point since July. Less than a year ago, experts everywhere, from the Federal Bureau of Investigations to the Federal Reserve, questioned appraised values of homes. Now, as the boom wanes, lenders are more certain mortgages are backed by accurately valued collateral.
      That doesn't mean lenders aren't still going gangbusters on riskier, high-leverage loans for those who qualify even if income, employment and asset documentation aren't checked.
      Along with housing market change comes mortgage market change in a symbiotic -- sometimes nightmarish -- relationship of ebbs and flows that can leave consumers tossing and turning at night. Fortunately, for home owners and those looking to buy, the fundamentals still apply.
      Here are some timely mortgage tips to sooth your worries and to help you sleep more soundly.
  • Pull your credit report. Before you shop for any credit, pull your credit report from the only federally sanctioned free service, AnnualCreditReport.com. You don't have time for surprises. Know what the lender will know before the lender knows. You may need to make changes to your credit report, housing budget or timing, depending upon what you find.
  • Mortgage money shop. Shop several or more lenders and loan programs, as well as title and escrow fees, online and off to get the best deal. To make the best comparison, compare all loan costs whenever possible including rates, points, brokers fees, originating fees, yield spread premiums, recording feeds, title and escrow costs, everything that will wind up on the HUD-1 Settlement Statement.
  • Mortgage rate locks, for home buys, refinancing and equity taps, are always wise, especially during market shifts. Right now, they are crucial because experts expect the upward trend in interest rates to resume.
          A rate lock takes the uncertainty out of which way rates are moving or even where they are, because it's a lender's guarantee your mortgage will come with a specific interest rate, points and other terms. Get the lock in writing and lock in as many costs and terms as possible, including the lock's effective date, expiration
    		• date and any post-lock options, should the lock expire before the deal is done.
  • A preapproved mortgage goes hand in hand with the rate lock. Get preapproved with a bona fide, carved-in-stone preapproval that guarantees in writing a loan amount, interest rate and as much of the other loan terms as possible. Prequalification only indicates you are creditworthy enough to obtain a loan and lets you know how much the lender is willing to lend you, which could be more than you can afford.
          With a preapproval, instead of shopping around with a nebulous loan amount, you'll be shopping for a home with a mortgage and along with personal satisfaction, it will give you a negotiating edge with the seller who'd rather not deal with slouches.
  • For current homeowners, take control of your equity and use it wisely to boost, not bust your home value. Any equity loan, by nature, is an equity depleting loan.
          Take cash out primarily for capital improvements that will help hold or improve the value of your home, especially during times of flat and falling home values. Home equity can be a real gold mine, but you don't want to drain your mother lode.
          "Taking control of your home equity means not allowing interest rates to push you into making a hasty decision," says Jim Ferriter, an executive vice president with GMAC Mortgage. "Instead, take a deep breath, contact your mortgage professional, and carefully explore your options.
          Fundamental advise is to tap your equity for well-investigated business opportunities, education and other investments that give you a return equal to or better than the cost of equity loan. Debt consolidation can be a wise use of equity provided you plan to actually pay off the debt and close, in writing, consolidated accounts.
          Consolidate debts with care and advice from MyFICO.com or other sources that can help you prevent lowering your credit score when you close too many accounts quickly.
          For emergencies -- medical, job related, child birth, deaths and the like -- consider, with determined discipline, keeping a line of credit on standby. Remember, once you are out of work, lenders are less likely to grant you a line of credit.
    •       Sometimes real estate investors get nasty little surprises at tax time. It happens when they discover they really weren't investors after all -- at least not in the eyes of the IRS. There are three different definitions the IRS uses to define taxpayers who buy, sell or hold real estate. Your tax treatment will differ based on the definition that the IRS gives you.
          These three definitions are:
  • Real Estate Dealer
  • Real Estate Developer
  • Real Estate Professional
          Now, let's look at each of these in more detail.
          A real estate dealer is someone who is in the business of buying and selling real estate for short-term profits. A real estate dealer is known by other names: wholesaler, flipper, or rehab'er. Although the person gets the label of "real estate dealer," it's a decision that's made based on each property. It's possible to be a dealer on one property, but not on another.
          The key question is whether the property was purchased to sell or purchased to hold. If you "flip' the property for a short term property, it's just the same as if you flip a burger -- you have a business. That means as a real estate dealer your income is subject to self-employment taxes and is taxed at the ordinary income tax rate. There's one more additional wrinkle, as well. Normally when you sell a property "over time" you can take what's called the "installment method" for calculating tax due. You pay tax only as you collect payments. A real estate dealer can not take the installment method. That means if you're considered a real estate dealer for a property that you sell and carry back paper on, you'll pay tax on the whole profit now -- whether you've collected any money or not.
          The second definition is real estate developer. A real estate developer is someone who renovates or changes the use of a property. It could be the person who buys an apartment building for a condo conversion, the developer who turns bare land into a trailer park or simply the person who buys a wrecked house and does extensive work before it's habitable.
          The tax challenge for a real estate developer occurs when he or she remodels or constructs a property.
    		• Costs that are incurred during the time the property is in development must be capitalized and later either expensed or amortized when the property is put in service or sold. Just imagine: You might be paying mortgage interest, property tax, construction costs, and other property related costs and not be able to deduct a dime of it.
          The tax news gets even worse still, though. As a real estate developer, you also must capitalize your "indirect costs." This includes administration, management and just the ongoing costs of running a business.
          That's what happened to Jack and Sue when they expanded their rental business to include business development. They bought a piece of land to be developed into a trailer park. They grumbled about the fact that they couldn't take a current deduction for the interest and property taxes paid for the trailer park. They even knew that they couldn't take a deduction for the costs of developments. The bad tax surprise occurred when they discovered that the cost of their rental office was now not completely deductible. Their office secretary, for example, fielded calls related to the construction. That meant part of her salary had to be capitalized into the trailer park as well. There is a cost to development and it isn't always the obvious cost of the bills you pay for the development. It also includes the additional tax burden you'll have during the development.
          The final classification is "real estate professional." Finally, we have an IRS definition that will put money in your pocket. A real estate professional is someone who is involved in real estate activities and owns 5 percent or more of his or her business. If the real estate professional is employed somewhere else, he or she needs to spend more time in real estate activities than the other employment and a minimum of 750 hours in real estate. If you're a real estate professional, you'll be able to take a full deduction for any real estate losses against your other income.
          A rose by any other name would smell as sweet, Mr. Shakespeare tells us. But a real estate investor with the wrong name could cost you big time in taxes, the taxman says.
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