Many of the aspects of buying
an income property are also important when selling one. One just views
things from the other side of the transaction. We won't, in this
lesson, try to deal with every issue from the other side because it should
be obvious what the other side is of all issues discussed in the previous
lessons, but we will discuss some of the more important ones.
Why Sell It?
There are, in general, two possibilities. First,
because you have to do it and second, because you want to do it.
By "have to" we mean you need
to sell because of health or some other reason that limits your ability
to pick the market conditions in which to sell. "Want to" covers
all cases other than "have to" no matter what the reason, be it that
you're tired of the business, want to retire with the freedom to travel,
or want to utilize your equities to enjoy the lifestyle of the rich and
famous. The major difference from "have to" is that you have more
flexibility as to when you do it.
When To Do It
Like many other things in life, timing the disposal
of your property is important. The time to dispose of property is when
it's a seller's market, that is when the the demand is higher than the supply. Unfortunately,
real estate investors must often dispose of property under less than ideal circumstances
for reasons of health, divorce, or general financial condition. However,
even when you "have to" dispose of property, following the correct procedures
will help you realize the highest possible return.
How To Do It
You have several options regarding getting rid
of a property. You can give it away, you can sell it, or you can trade
(exchange) it. There are also two other ways. One is to stop paying
your loan payment or your property taxes and have it taken away, but this option
doesn't require instructions. The other is to die and leave it to your
heirs, and, while no instruction is usually necessary for the dying part, proper
estate planning is recommended.
Gift It
There are several reasons why you might consider giving
it away. One would be to gift it to a family member or friend. Gifting
to relatives or other individuals or entities (other than charities) can have
an impact on overall estate planning Another would be to donate it to a
charity. There are even ways to put a property into a charitable trust
that allow you to retain control even as to future use long after your demise. All
of these possibilities have tax consequences and require that you seek competence
legal help. Timing of a gift can be important because the stepped up basis for
the recipient is related to the value at the time that the gift is made. If
gifting to a tax-exempt organization timing has no tax consequence, but there
could be other issues.
Charitable Trust
Since the charitable trust is probably less well-known
than are gifting to a family member or donating directly to a charity, we'll
discuss it further.
The happy thought of selling a rental property
for cash can be easily squelched by the unhappy reality of capital gains and
depreciation recapture taxes, which often take up to 35% of the cash received
from a sale. On a $100,000 rental house, a landlord is often faced with a choice: “Would
I rather have a $100,000 rental house that drives me crazy or $65,000 in cash?” It's
a painful choice. What every landlord would really like is to have $100,000 of
hassle-free cash. After all, cash doesn't call you at 2 o'clock in the morning
to say the furnace isn't working! To avoid the taxes on a sale, many landlords
have utilized the 1031 exchange program over the years. The problem is that a
1031 exchange puts you into more property, not into cash (you are taxes on any
cash taken out). More property means more ongoing real estate management
issues. So why isn't there a simple way to sell the property and receive
tax-free cash? Actually, there is. A charitable trust is an easy
way to sell the property, keep the cash, and skip the tax. What is a charitable
trust? It's a very simple type of trust that basically says, "While I am
alive, this trust money belongs to me. When I die, a charity can have whatever
is left over."
Utilizing this vehicle, a charitable trust is
set up, the rental property is transferred to the trust, sold tax-free, the proceeds
are invested for a good return, and the trust thereafter makes hassle-free payments
back to the landlord for as long as the landlord and his or her spouse are alive. The
landlord decides what size monthly payment to withdraw, but the IRS does have
some rules. In theory, they want you to withdraw no less than 5% annually, but
they also don't want you to withdraw so much that they believe there will be
less than 10% left for charity as a gift (for example, on a $100,000 property,
the IRS wants at least $10,000 left for charity). In practice, landlords are
able to select IRS approved trust payout rates that range from 5% up to 12%,
depending upon their age when they establish the trust. Therefore, the trust
payments from a $100,000 trust could range from $416 to $1,000 monthly, at the
landlord's discretion. That's much better than depositing $70,000 in the
bank at a 3% return to create a $175 monthly payment. Most people would agree
that, given a choice between paying up to 35% in taxes today or giving 10% to
their favorite charities at death, the charitable option makes more sense. Some
people even think this obvious benefit sounds too good to be true. So why
does the IRS permit that choice? From the IRS's point-of-view there are
only two things that can be done with charitable trust dollars—either distribute
them and pay income tax on the earnings, or die and leave it to charity. The
IRS is perfectly happy with either of these options. So a charitable trust is
a nice blend of benefits for a landlord and his or her chosen charities that
actually have the approval of the IRS.
Sell It
You can, of course sell the property,
just as you can sell your personal residence. And, just as when
selling your personal residence you want to maximize the sale price. However,
selling income property is usually more complicated and can have significantly
more tax consequences.
Selling an income property involves many
of the same issues as buying one, except from the other side of the fence, and
having completed the previous lessons, you certainly realize that that buying
can be a bit complicated.
One of the most import tax consequences is that
taxable gain will be based on sales price (less selling costs) less your basis
at the time of sale. In other words you will pay tax on all the depreciation
that you deducted during the years of ownership in addition to paying tax on
the actual increased value.
There are ways to somewhat cushion the tax
blow, for example, by structuring the sale as an installment sale, but further
details are a subject for a future e-course.
Timing is obviously important for selling a property
because you'd like to sell at the top of the market or at least not at the bottom. If
in an increasing market, you might want to delay the sale if practical and add
more dollars to your price, using that time to maximize rents and minimize expenses
where ever possible.
Exchange It
Unless you want to get out of the landlord business,
it will usually be advantageous to exchange your income property under Section
1031 of the Internal Revenue Code. The exchange also provides a means of
trading your existing real estate portfolio for one that is less management intensive
when you want to slow down, but not entirely retire from the rental business. While
this is sometimes referred to as a "tax-free' exchange, it is in reality a "tax-deferred" exchange. The
main advantage of a tax-deferred exchange is that it allows you trade up to larger
property or higher quality property after your previous property has increased
in equity in order to improve your leverage position, utilizing untaxed dollars
to do so. As indicated by the word deferred, you will eventually have to
pay the piper if you wish to cash out and retire from the landlord business. However,
there are ways to cushion the blow.
When exchanging property, timing is of only secondary
importance regarding tax consequences. One issue that can be important
in timing your exchange is that it can be more difficult to find the desired
property if supply is limited because it is a seller's market. This can
be of significant importance if you are doing a delayed exchange and can't find
the replacement after having disposed of your old property.
Addition discussion about 1031 Exchanges is included
in the next lesson of this course and even more details about Exchanges and other
possible tax strategies are subjects for another e-courses.
Marketing
Pricing
To determine what your property
is worth when it's time to sell, you follow the same procedures as when
you bought it as discussed in Lesson ? of this course or as covered in
much more detail in our Valuing
Income Property e-course.
Preparation
Take care of all physical and legal problems regarding
the property that might be considered an issue by a buyer. Having them
become an issue in the middle of a deal can result in cancellation of an escrow
or re-negotiation of the price or other terms. Physical issues include
inoperative sprinkler systems, out-of-code electrical or plumbing systems, cracked
windows, . Legal
issues include tenant disputes, building code violations, delinquent taxes, and
missing licenses or permits. On reason to take care of these issues before
even putting your property on the market is that some might suggest to a savvy
buyer or agent that you are having financial difficulties and could result in
lower offered prices.
Also consider various relatively inexpensive cosmetic
upgrades that might make a difference. Exterior painting, cosmetic landscape
improvements, re-coating of asphalt. and repairing superficial defects that make
the property look ragged can have a significant impact on potential buyer's initial
reactions even to the point of writing the offer.
