Long-term Minneapolis and St Paul duplex owners often come to an age and time in their life when the hands-on management of owning investment property becomes less and less appealing.
The solution would appear to be obvious and easy: sell.
The trouble is, when you’ve owned an investment property a very long time, taken all of the depreciation and it’s gone up in value, selling it becomes an expensive proposition. That’s because the IRS would like to recapture some of the depreciation tax benefits you’ve received, as well as like a piece of your profit in the form of capital gains tax.
For many would-be investment property sellers, that is where any thought of selling ends. The costs are simply too great to outweigh the benefits of ending the property management headache.
That’s too bad because there are several win-win sale strategies out there that allow s reluctant sellers to retain the cash flow of owning rental property while relieving themselves of the burdens brought by property ownership.
Below are 8 ways to help you avoid taxes when you sell your investment property.
1.Contract for Deed or Land Contract: Under this arrangement, the Seller of the property acts as the bank for the Buyer. Typically the seller retains ownership of the property until the contract is fulfilled. However, the buyer gets the right to claim the property tax credit. All terms of the contract for deed are negotiable, including the length of the contract, the down payment, and the interest rate. While most are amortized over a length of time equivalent to what a bank may offer, most also have a balloon payment several years into the contract. When the balloon payment comes due, the Buyer simply refinances the property, giving the Seller the final lump sum owed.
Contract for deeds offer sellers the advantages of continuing to receive monthly income while removing day to day managerial responsibilities. Further, they give a Seller a chance to strategize with his or her tax professional as to what may be the best way to maximize tax savings and retain as much equity as possible.
The downside of selling this way is the Buyer could potentially default and the Seller gets the duplex back. Of course, this could, in fact, be a great thing if the property values have increased. The Seller would not only be entitled to retain all payments made by the first Buyer, but also to sell it all over again at a higher value.
2. Master Lease with an Option To Buy – Under this arrangement, the eventual buyer pays the duplex owner a fixed amount of rent. Some or all of that amount may be credited toward an eventual down payment on the property. The buyer or “master tenant” of the then takes over management. He or she may keep whatever amount of rent collected above and beyond expenses and the payment to the seller. Capital improvements – things like roofs, boilers or furnaces and updating kitchens are usually paid for by the seller. If the buyer chooses to take this cost upon themselves, he/she does so at the risk of losing that money.
3. 1031 Exchange – Rather than taking proceeds from closing, investment property sellers may choose to buy a replacement property. The new property does not have to the same kind as the relinquished property. There are strict rules and deadlines to this process, so it’s important to work with a Realtor who is familiar with investment property and investment property sales. Just remember, any time you touch the proceeds of the sale of an investment property, it’s a taxable event.
Many would-be duplex sellers I speak with have no interest in taking on the managerial duties of a new property through an Exchange. What they fail to understand is there are a number of exchange opportunities that provide little to no management.
4. 1031 Exchange into Property for Heirs – Believe it or not, your heirs may not want to inherit your rental property. They may see it as a distraction from or burden to their lives, not believe in real estate as in investment, or even if they do, want to select their own investment property, not yours.
So why not sell an invesment property and exchange into property heirs actually do want?
For example, one may want to buy a bigger house for a growing family. Another may want to acquire an investment property that’s either bigger or closer to home. Why not exchange into those properties, then “sell” it to the heirs on either a contract for deed or even rent it to them? This not only gives the Seller continued cash flow, but also the opportunity to offer guidance to the heir and experience the joy of giving the inheritance.
5. 1031 Exchange into a Vacation Home – A 1031 exchange doesn’t to be limited to a multifamily property. You can exchange it into almost any kind of real estate. Have you always dreamed of spending winters in Florida or Arizona? Why not exchange into a vacation home in a warmer climate and rent it out when you’re not there?
6. 1031 Exchange into a Triple Net Property – One type of commercial property that typically requires very little hands-on management is called a triple net or NNN property. In these properties, the tenant typically handles most of the repair and maintenance obligations or directly pays the owner a monthly amount earmarked for those repairs and common area maintenance expenses. The most commonly known examples of NNN properties include Walgreen’s and CVS stores, but there are countless others as well.
7. 1031 Exchange into a Delaware Statutory Trusts (DSTs) – Available only to accredited investors (those with a net worth of more than $1 million excluding the value of their home), DSTs give smaller investors a chance to own a fraction of a large, high quality and professionally managed property. Each owner receives their share of the property’s cash flow, tax benefits and appreciation of the whole property. This typically results in cash on cash returns in the 5-7% range. The downside is, funds are typically tied up for the length of time the investors have agreed upfront to hold the property. If at that time, however, the Seller wishes to 1031 exchange into another piece of real estate or DST, he or she may do so.
8. 1031 Exchange in a UPREITs – short for Umbrella Partnership Real Estate Investment Trust. Similar to a DST, the investment property Seller completes a 1031 Exchange. Rather than identifying a suitable replacement property, however, the investor identifies and aquires a fraction interest in real estate a REIT has already designated. After holding the property for 12 to 24 months, the investor receives an interest in the operating partership in exchange for his or her contribution of the real estate ownership. The Investor is now part of the REIT itself.
The first step is selling the relinquished property and structuring a 1031 Exchange. However, instead of searching for suitable replacement property the investor would identify and acquire a fractional interest (tenant-in-common interest) in real estate that the REIT has already designated. This completes the 1031 Exchange portion of the transaction.
The second step is to contribute the fractional interest into the operating partnership after a holding period of 12 to 24 months as part of a 721 Exchange (tax-deferred contribution into a partnership). The investor receives an interest in the operating partnership in exchange for his or her contribution of real estate ownership and is now effectively part of the REIT. REIT investments are considered securities.
The advantages of an upREIT are similar to a DST in that the investor has no managerial responsibilities and receives monthly cash flow. However, because the REIT is completely in charge, if they choose to liquidate the investment, the investor cannot exchange because he or she now owns securities rather than the real estate itself.
If you’re a long-term investment property owner trying to come up with an exit strategy, it’s important to work with a Realtor who can not only get you the most money, but is also knowledgable in the specificities of selling investment property.
Give me a call.