House prices in 2009 may not be showing much movement upward in places like California, Nevada, and Florida, but they are starting to stabilize too. That, along with a special first-time home buyer (courtesy of the Federal stimulus package), may mean it’s a good time to look at buying a home. Even if you don’t live in these areas, some great deals can be obtained through investing in home foreclosures, which are at a record high. Just be sure you understand that this isn’t an investment without a downside. There can be some substantial risks, as well as benefits, when you choose to invest in a foreclosed home.
Risks
The first obvious risk is that the market may not have bottomed out. However, this can be offset by the fact that you can receive up to $8,000 credit on a first home through the stimulus package. If you buy the foreclosed home as a rental, rather than a primary home, you will not be able to take advantage of that credit. Be sure to understand what it takes to qualify so that the money you spend is not later eaten up in lost equity, should prices take another dive.
A foreclosed home cannot be guaranteed to be in good condition. If you don’t understand the market, the neighborhood, or the signs of a poor buy, it’s best to leave that to someone who does. It’s a very easy thing to swoop in a think that buying a home at $1,000 is going to make you rich. Instead, it could land you with unpaid back taxes, city fines, outrageous repair or replacement bills, and more. Don’t just buy because the price is right. Make sure to do your due diligence.
Benefits
If you are confident and experienced enough to take advantage of the fallen house market prices, you can stand to make a small fortune. Even if you don’t sell right away, if you buy in a good neighborhood, you can rent out the homes until the market improves, generating a positive cash flow from a small down payment.
What can you learn from these graphs? Actually, almost everything that there is to learn about investments—and I will explain these facts in great detail soon.
• The history indicates that stocks offered higher average rates of return than bonds, which in turn offered higher average rates of return than “cash.” However, keep in mind that this was only on average. In any given year, the relationship might have been reversed. For example in 2002, stock investors lost 22% of their wealth, while cash investors gained about 1.7%.
• Although stocks did well (on average), you could have lost your shirt investing in them, especially if you had bet on just one individual stock. For example, if you had invested $1 into United Airlines in 1970, you would have had only 22 cents left in 2002—and nothing the following year.
• Cash was the safest investment—its distribution is tightly centered around its mean, so there were no years with negative returns. Bonds were riskier. Stocks were riskier, yet. (Sometimes, stocks are called “noisy,” because it is really difficult to predict what they will turn out to offer.)
• There was some sort of relationship between risk and reward: the riskiest investments tended to have higher mean rates of return. (However, the risk has to be looked at “in context.” Thus, please do not overread the simple relationship between the mean and the standard deviation here.)
• Large portfolios consisting of many stocks tended to have less risk than individual stocks. The S&P500 fund had a risk of 17%, much less than the risk of most individual stocks. (This is due to diversification.)
• A positive average rate of return usually, but not always, translates into a positive com- pound holding rate of return. United Airlines had a positive average rate of return, despite having lost all investors’ money.
(You already know why: A stock that doubles and then halves has rates of return of +100% and –50%. It would have earned you a 0% total compound rate of return. But the average rate of return would have been positive, [100% + (−50%)]/2 = +25%.)
• Stocks tend to move together. For example, if you look at 2001–2002, not only did the S&P500 go down, but the individual stocks also tended to go down. In 1998, on the other hand, most tended to go up (or at least not down much). The mid-1990s were good to all stocks. And so on. In contrast, money market returns had little to do with the stock market. Long-term bonds were in between.
On annual frequency, the correlation between cash and the stock market (the S&P500) was about zero; between long-term bond returns and stock market around 30%; and between our individual stocks and the stock market around 40% to 70%. The fact that investment rates of return tend to move together will be important.
Sale and gift can sometimes be effectively combined. In fact, if property is sold at a low price, the difference between the market price and the selling price is considered a gift. If the gift is large enough, federal gift taxes will be due.
Reduced purchase price, low interest rates, and easy terms could be considered in the nature of a gift. In some cases, these are designed to offset the child’s contribution to the farm business. Lower than market interest rates may result in unfavorable income tax results. The differences between the rate used and I.R.S. rates may be treated as income to the buyer with no deduction to the seller.
If a combination of sale and gift is used, the agreement should be carefully worded in writing. This may prevent misunderstandings between the farming child and the other children.
Parents in position to do so may, if they wish, transfer property to the younger generation by gift. When the gift is made early in life, the knowledge of ownership usually results in added enthusiasm and energy in developing the property by the donee and learning to care for it under the guidance and advice of the donor.
Transfer of the property at an early age is usually restricted by economic considerations and by the reluctance of parents to part too early with worldly goods. The economic reason is, of course, the most important. In many cases, the parents need all of their property to provide income in later years.
A gift is very easy to make. Land may be given by a deed properly signed, acknowledged, and delivered. Delivery of the deed is very important. Personal property can be given by handing over the property with the apparent intention of making the recipient the present owner. There must be a manual transfer of the property itself or of something symbolic of it. It is best, however, to evidence the intention of the donor by written instrument.
Most gifts are made inter vivos – that is, by a person who may be in no immediate expectation of death. Ownership of property transferred by gift inter vivos vests absolutely and at the time the transfer is made.
A gift made by a donor in expectation that he will die of some immediate threat of death is known as a gift causa mortis. Such a gift is frequently conditional so that if the donor does not die as expected, the transfer of ownership is nullified. The courts generally hold that ownership passes at the time of the gift to the donee, but that it reverts to the donor if he does not die as he expected. That is, the donor can recover the property if he survives the peril that caused him to make a gift causa mortis.
Advantages
• A gift can be given at any age and provides ownership security for the recipient.
• Knowledge of ownership may encourage development of the property under the guidance of the donor.
• A gift may reduce net income taxes. A younger person may be in a lower tax bracket; thus he would retain more of the earnings from the asset.
• A gift may help to reduce estate taxes by removing assets from the estate and by establishing the value of the assets at the time the gift was made, thus avoiding the effects of inflation.
• Individuals may make gifts of up to $12,000 per recipient per year without any federal gift tax consequence.
• Oklahoma imposes no state gift taxes while state inheritance taxes are imposed on estate transfers above a certain amount.
Disadvantages
• Unless the parents have other income, a large gift may work a hardship on them later in life. Loss of purchasing power through inflation should be kept in mind.
• Transfer by gift may result in family disagreements.
• Gifts may be subject to federal gift taxes if larger than $12,000 per recipient per year.
• If assets are declining in value, gift taxes today may be higher than estate taxes would be later.
• In some cases, the donee may not have sufficient maturity to manage the assets wisely.
• If the child is having financial problems and the gift is not sufficiently large to pay the creditors, the creditors may attach the gift property and the family inheritance may be lost.
The parents can deed a remainder interest to the child and reserve to themselves a life estate. This is a method of assuring lifetime income for the parents. The child actually owns an interest in the land, but the right to use the land belongs to the parents during their lifetime. The parents, if they so desire, could give a lifetime lease to the child. The property is still subject to estate taxes when the parents have retained a life estate and have deeded a remainder interest to a child but the property is not subject to regular probate.
Advantages
• The child is assured of having the farm and the parents are entitled to income during their lifetime.
• If the parents have no other property, no regular probate proceeding will be necessary to determine fact of death and terminate the life estate. In this procedure, an estate tax return is prepared and a certificate of tax clearance is obtained from the tax commission. The cost of this shorter probate procedure is much less than the cost of a regular probate proceeding.
Disadvantages
• Conflicts regarding management of the property may arise between the life tenants and remaindermen.
• The child could sell his remainder interest to an uncooperative person. The parents could prevent this by inserting a clause in the deed that states, “if the child transferred his rights during the lifetime of either parent, the remainder interest would revert to the parents.”
• It is hard to value what the child is getting.
• The laws are unclear regarding how mineral interests are handled in a life estate.
• Once the life estate is created, parents cannot change their mind about how the property will be distributed at their death. Thus flexibility to handle changing circumstances is cancelled.
• Creditors of the child may be able to reach the child’s remainder interest and if the child has financial difficulties, his inheritance may be lost.