Rental property is often an attractive investment. Whether you are a hands-on, do-it-yourself owner with a handful of properties or prefer to outsource the details to a property manager, owning rental homes can be a great experience. Still, you may decide to sell a rental unit for several reasons. You might be ready to cash out the appreciation, move into a different property type, or even transition to passive income options. No matter what motivates the sale, you want to maximize the gain and minimize the pain when you decide to sell.
Consider the tax liability before moving forward.
While owning a rental property can be a tax advantage, selling an appreciated property offers potential tax pitfalls. That’s no reason to hold on to a property you want to dispose of, but it's an excellent reason to plan ahead.
Suppose you are motivated to sell by a desire to transition into passive ownership options or change either geography or sector. In that case, you may consider selling the asset using a 1031 exchange. The 1031 exchange is a helpful tool for investors that allows you to defer the capital gains taxes as well as the recapture of any depreciation that would be due.
You can use a 1031 exchange to move from rental property to another type of investment asset, like office, industrial, retail, or specialty properties. You can also employ a 1031 exchange to exit direct ownership and move into DSTs (Delaware Statutory Trusts), which provides some of the tax benefits of real estate investment without ongoing involvement.
If you need cash from the proceeds for other purposes, you may still be able to defer capital gains taxes by reinvesting the gain into a QOZ (Qualified Opportunity Zone) project. Each of these potential tools is complex, so be sure that you discuss the options with an advisor.
Getting ready to sell.
Whether selling and reinvesting or selling for cash, you can enhance your potential gain by carefully preparing the property for sale. First, make sure that all maintenance items are current. Your rental home will be easier to sell if small things like leaky faucets are fixed, the lighting is adequate, and the landscaping is appealing. If you have a tenant in the home, consider paying for cleaning and touch-up items like decluttering.
Selling with a tenant in place can complicate the effort, but a steady tenant is also an incentive for the buyer if they plan to continue using the rental as an investment. If your tenant has a lease, the buyer must agree to honor it in many states. The tenant will need to accommodate access for viewing, but you may want to offer incentives for them to cooperate.
Selling from a distance.
It’s certainly easier to prepare a home for sale if you are in the immediate vicinity. That makes repairs, showings, and inspections much more straightforward. If you are selling a property that is far away, you will probably need more help, either from a professional or from a trusted associate. Still, don’t overlook the importance of curb appeal, either for someone who plans to live in the home or a buyer who wants to continue using the property as an investment.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
