Tuesday, February 25, 2014

Capital Gains and Capital Losses on Real Estate Sales

The Series 65 and Series 66 exams might ask a question or two about the tax implications of selling real estate, so let's look at some key issues here. First, if you sell your primary residence at a loss, you get no tax benefit whatsoever. Therefore, if your house is so underwater at this point that you will never sell it for a gain, you might consider turning it into a rental property and finding other digs. This way, you can take depreciation on the property, which will cancel out some or all of the rent you receive for tax purposes. And, when you sell at a loss, you can use that to offset taxable income. I'm not saying that would be cause for a case of Dom Perignon, but it might turn a bad situation into something a little more beneficial.
On the other hand, if you have a house that will sell for a capital gain, you might be able to avoid paying any tax on it at all. But, you have to be able to go back 5 years from the date of sale and show that you both owned the house for any 2 years during that period and used the house for any 2 years during that period. These 2-year periods do not have to be continuous and they do not have to happen at the same time. For example, I'm sitting on a house with some real equity at the moment. While I have used the house for two years at this point, starting as a renter, I have only owned it since last November 1st. Therefore, to turn any capital gain into a tax-free gain, I need to own the place for another 21 months. That means I can either live here for 21 months, or rent the place out for some or all of that time.
Either way, if I sell a year from this coming November and realize, say, a $75,000 capital gain it will all be tax-free. If I didn't establish the two-year ownership period going forward and sold for a $75,000 capital gain, on the other hand, the IRS would tax it at either 15% or 20%, meaning I would keep only $63,750 if taxed at 15% or just $60,000 if taxed at 20%.
There are ways around having to both own and use a residence for 2 of the previous 5 years and still get the tax-free capital gain, but I don't qualify for any of them. If interested, check out www.irs.gov "selling your house". pass your series 65 NOW!

Wednesday, February 12, 2014

Shark Tank and The Profit

To understand different investment approaches, one could watch two "reality TV" shows, both of which I caught last night: Shark Tank, and The Profit. In the Shark Tank, venture capitalists listen to start-up companies make pitches for capital in exchange for a percentage of equity in the business. Usually, the venture capitalists--the "sharks"--invest somewhere between $50,000 and $500,000 for a minority interest in the company. They are only interested in businesses that are already doing well, where the entrepreneur is kicking butt and seems able to adapt and solve problems without melting down. The companies have an interesting brand that either solves a problem or fills a niche, and their sales are growing. The best ways to turn off the spigot of capital from the sharks is to do any of the following individually or in any combination: fudge on your numbers, report either small or shrinking sales, reveal that after 10 years of hard struggle your business still makes no profit. The "sharks" are venture capitalists who invest in businesses long before any thought of an IPO to public investors, so whatever "growth investors" in public equities are looking for, so are the sharks--only more so. They are looking for a great idea, a great founder, and a business model that can easily be duplicated and scaled with a little bit of help from their rather large wallets. If they have to pay a little premium to get in, so be it. What's a few thousand bucks when we're clearly about to make millions here?
On the other hand, in The Profit, we see an investor named Marcus Lemonis who wants to take an equity stake in businesses that used to be great or could be great if only someone could come in and do some key fix-ups. See, growth investors like the sharks are out as soon as they hear even one problem, while turnaround specialists are investors interested only in companies with problems.
If Marcus, the turnaround specialist, sees, say, a pizza restaurant doing $2 million in sales yet still managing to lose $400,000 a year, he's probably interested already. When he takes a closer look, maybe he finds a pretty decent staff of waitresses and pizza chefs, but sees immediately that the delivery personnel and the store manager are weak. There is no advertising, the restaurant looks tired and dated, and no one can even see the sign from the highway that passes by the place. While the sharks don't have time to fix all these problems, the turnaround specialist now sees his opportunity. As he loves to remind the viewer, he only focuses on the three P's--product, process, and people. The product must be great to do $2 million in revenue, so that's probably not the issue. As far as the process, Marcus probably quickly invests in new pizza ovens that crank out more pies in less time, and then either re-trains the delivery drivers, equips them with GPS, or both. The first two p's (product and process) are easy--he then has to deal with the scary part, the people.
He's only in charge for one week, so he has to either turn a currently lousy employee into an asset or replace him quickly. Many currently lousy managers are just being human--they don't communicate well; they don't handle constructive criticism; they like to fudge the numbers and then get defensive about it, etc.. Unlike a therapist, who would use a gradual soft-sell approach, Marcus confronts the current problem  head-on, usually with as much rudeness as one can get by with without getting punched. After the tears (if female) or threats of violence (if male) the entrepreneur usually comes to recognize that he or she is actually part of the problem and is going to have to listen to the rich guy driving the flashy red sports car if they want to hang onto the business without dragging down the employees and the mom who foolishly took out the second mortgage to keep the thing afloat.
So, Marcus is taking on much more risk than what we call a "value investor," like Warren Buffett. Warren Buffett would not invest money with any of the shifty, defensive people that Marcus routinely works with. For Mr. Buffett, the business is already doing well and is being run by people he trusts implicitly. How much hands-on management does he then do in the acquired companies?
None. If he had to go in and shape things up, he wouldn't be investing in the first place. Warren Buffett doesn't refer to himself as a "value investor," actually--he just likes to buy great companies at currently marked-down prices. That tends to rule out growth stocks, as they simply can't be purchased at an attractive price. But it doesn't mean he sits there with a stock screener pouncing when price-to-book or price-to-cash-flow ratios drop to a certain pre-set multiple.
In any case, every investor mentioned above is doing about $3 billion better than I am, so let me get back to my little Simple IRA and see what I can do to boost my total return for the year. Sign Up for Online Classes That Make Sense