While 2020 and 2021 have been a red-hot seller’s market on the residential side, supply has been extremely short on the multi-family and commercial side, too. Never in my career have I ever seen multiple offers on an apartment complex days after it has come onto the market. With many properties selling for above the asking price, the sellers are fully in control of the real estate market. New home builders are working to increase the supply of single-family homes. However, very few builders are building new apartment complexes. While many small landlords are choosing to sell their rental homes to cash-out in this market, it’s creating a supply and demand crisis in the rental world, as well. Too many tenants chasing after too few properties. The good news for landlords is that it has become easier to choose the best tenants from a large pool of applicants.
The big question for landlords today is whether to sell or hold. No doubt that even a property that has only been modestly maintained will fetch a significantly higher price than it would have several years ago. Let’s look at a few options owners have available to decide whether selling or holding will be the right option for your rental portfolio in this market.
If you’re looking to sell an investment property and you expect to have a gain, expect to put some money aside to pay capital gains tax. Hopefully you’ve owned the property for more than a year, so you would be taxed at 0, 15, or 20% of your gain on the federal level. In addition to that, you will also have to pay the recapture tax, which is a tax on the depreciation you were able to take over the course of your ownership (the taxman giveth and the taxman taketh away). The recapture tax is taxed at a taxpayer’s ordinary income rate up to a maximum of 25%. If you’re looking to liquidate now to have cash available, this could be your best option. But let’s look at two alternatives when selling.
The first option when an investor is looking to sell a property is a 1031 exchange. This allows a taxpayer to defer paying capital gains taxes and recapture taxes by rolling them into a new property. 1031 exchanges are a great wealth-building strategy, but there are some very strict rules that need to be followed. The one rule that needs to be emphasize here is that within 45 days from the sale of your old property, you MUST identify up to three properties that you would plan to buy. Furthermore, you MUST settle on one of those three properties within 180 days from when your original property sold. 45 days and 180 days sounds like plenty of time, but I assure you they are not. With minimal inventory, high prices, and low cap rates, a 1031 exchange is just too risky for many people today.
The second option is to offer seller financing on the property. This allows a seller to spread their gain over multiple years, while commanding absolute top dollar for their property. No appraisal is needed, so buyer and seller could come up with very creative terms to strike a deal. Raise the price $50,000 and offer financing at 0%? No problem. Take title to the buyer’s hunting cabin in lieu of a down payment. Sure, why not? Opportunities abound for sellers who don’t need a lump sum of cash at the sale of their property. This strategy works best on a property with no mortgage or with a small mortgage that can be paid off with the down payment from the buyer, otherwise, you risk running afoul of the bank’s Due On Sale clause.
But what if you want to hold onto the property for a while longer? Maybe you have a great long-term tenant in place or the property is a cash cow. There are several options to take advantage of the current economic state we’re in. If you have a commercial mortgage that has a fixed rate for three or five years, many times the lender will allow you to relock at today’s rate for only a few hundred dollars. From the lower interest rate, your breakeven point would likely be less than a year.
If you have a residential mortgage or are looking to get some cash out of the property, a refinance will be your best option. Closing costs will likely be several thousand dollars, which means a longer breakeven period. If you stay with your current lender, the costs might be less if you can simply modify the loan to update the interest rate. The lender has all your paperwork, so the processing will be significantly less. Be aware that if you do a cash-out refi on a rental property, you will have to adhere to the IRS tracing rules. This means that even though the cash you received is secured by the property, it is not deductible against the property. Instead, you must track where the cash is being used to determine how it can be deducted. Cash used to start a new business? It’s deducted against the business. Used to purchase more real estate? It’s deducted against the new real estate. Used to pay off personal debt or take the family to Hawaii? Sorry, not deductible because it’s used for personal expenses.
With any of the above strategies, speak to your CPA before moving forward to make sure it is the best option for you. It will be much easier for an account to guide you before you do something than to try to fix a mistake that has already been done.