Condo conversion: a mixed bag.

The real estate bubble has burst, interest rates have risen, and now it's time to decide whether the condo conversion craze of the past decade will live on indefinitely or become a vestige of a past frenzied market. There are compelling arguments for both.

Take residential condos, for example. As interest rates have risen, so too have rents. Property owners looking to sell are beginning to get more competitive offers from income buyers, or buyers that intend to continue to rent the apartments within, and that has put the squeeze on condominium converters. In fact, if two equal offers land on the desk of a property owner, one from an income buyer, the other from a converter, the owner is likely to go with the income buyer, because of the ease of closing the transaction. So will this be the end of condo conversion?

Not so fast. An argument can be made that the rapidly escalating costs of real estate over the last ten years-which fueled the rush to convert rental units into condos--was more than a simple byproduct of lower interest rates. There have been fundamental changes in buying behavior in this country. People work more, make more money, and have come to feel that owning a home is their birthright. Much of that thinking has been cultivated during the real estate bubble years, but the mindset lives on. And in space-constrained markets like New York and the surrounding areas, there are regional and economic pockets that can continue to show strong growth in condo conversion.

But perhaps the strongest growth in condo conversion is coming from the retail side of the equation. Most retailers in this country don't want to own real estate, preferring the flexibility of renting stores instead. But in some parts of the country, especially New York, retailers are kicking landlords to the curb and plunking down millions to own their own store. And developers are obliging them.

The New York Times reported that the dollar volume of retail condo transactions in the U.S. has more than quadrupled in the last two years alone. And the price for square footage has gone from an average $441 in 2001 to $995 in 2005. Investors, who once would make street level space available only for rent, even when the rest of the building was being converted into residential condos, are beginning to sell it off to eager buyers.

The condo buyers come in different stripes. Some of the retail buyers are looking to take advantage of Section 1031 of the federal tax code and defer capital gains taxes by exchanging property. But it is also not uncommon to see foreign companies eager to own their own stores, as is often the case overseas. Ascot Chang, a Hong Kong-based high-end clothing retailer, ditched its $40,000 a month lease on 57th Street and Fifth Avenue to buy 4,700 square feet at the former Intercontinental Hotel on Central Park South, for $4 million.

And then there are the real estate investors, who pay premium prices, and snap up the most desirable space. In 2005, Vornado Realty Trust set a record when it paid $6,647 a square loot for retail space on Madison Avenue and 69th street. It is not a record that is likely to stand long.

Of course, with any real estate transaction there are important tax implications. But with condo conversions, some of the tax considerations are unique. The most important is that condo developers are often seen as "dealers" in the eyes of the IRS. This means that profits get taxed as ordinary income rather than capital gains. With tax rates on capital gains at historic lows, whether you are viewed as a dealer--someone who holds the property primarily for sale rather than investment-or an investor, can have a big impact on the bottom line.

There are a number of factors the IRS looks at in making this distinction, including: the nature and purpose of the acquisition; the duration of ownership; extent of the improvements; the use of advertising to increase sales; and the extent of the efforts to sell the property. Generally speaking, the longer you hold the property, and the more passive your involvement, the stronger that case is for investor status.

The problem is, minimizing taxes and maximizing profits are often mutually exclusive propositions. But there is one solution that allows you to have both. By forming a partnership of LLC to hold the property for a year or more, it can then be sold to another entity, likely an S corporation, for development. The first entity is eligible for capital gains on the sale to the S corp., and the S corp. pays the income taxes on sales of the developed property.

Condo conversion, whether for individual or retail use, can be lucrative, given the right market conditions and timing. But to fully understand the tax ramifications, consult with an accountant before entering into any transaction.

BY MARC WIEDER, CPA 

ANCHIN, BLOCK & ANCHIN LLP