Four Important Sets of Exit Strategy Issues

1. Introduction

There are a number of exit strategy options that exist for the rental real estate owner/investor. These options include:

Outright sale of the property
Turning over the property to professional management
Exchanging for new properties
Considering refinancing
Considering doing an installment sale
Perhaps considering contributing the property to a capital gains bypass trust (i.e. a Charitable Remainder Trust)
Creating a private annuity trust
Potentially exchanging into an UPREIT
Combining any or all of the above options.

With all of those various options available to the rental real estate investor, how does one go about deciding which is best for them? The following article will address some of the main factors or issues that one needs to identify when they are considering exiting out of a specific real estate investment.

In our discussion of the exit strategy factors we are going to group these factors into four groupings. The first grouping that we will address is titled “Personal Issues.” This will deal with the individual’s age and health status.

Secondly we will consider the individual investor’s “Family Issues” (i.e. their marital status); their designated beneficiaries (heirs to their estate); their income needs; their net worth; their tax bracket (both income and estate); as well as their philanthropic tendencies.

Thirdly we will address the prevailing “Economic Issues”, specifically current interest rates; capital gains tax rates; local market conditions; as well as remote market conditions. Fourthly we will take a look at the specific “Property Issues”; namely the investor’s tax basis in the property, the location of the property, the condition as well as its financial performance.

2. Personal Issues

It appears that for most people the time of reckoning (i.e. deciding whether they want to continue owning rental real estate investments, rental property or income property) is very closely associated to their age and health.

a. Age

At some point in time in our lives we start realizing the we are not getting any younger. We realize that real estate, especially rental income property, is a very demanding investment asset in contrast to financial instruments such as stocks and bonds and CD’s.

With this realization we start thinking about the fact that we don’t want to do this for much longer. When each of us reaches that point in time, we should look at various options for exit strategy purposes.

Probably the first thing we should consider is relinquishing our day to day involvement with the property to professional property management. If property management is out of the question, based on the specific property, then typically we will consider an outright sale as the second alternative. We usually get to that point when we say to ourselves we’ve had enough and it's time to get out.

b. Health

Like age, health is also a determining factor in our desire and motivation to continue owning and operating income property. Similarly, our health, or lack thereof, forces us to consider either professional property management and or an outright sale.

3. Family Issues

Our family situation presents a set of factors that we must take into consideration whenever we are thinking of exiting or getting out of a rental real estate business. Our spouse's and our kids' existence, expectations and abilities must play a key role in determining which exit strategy will be right for us.

a. Marital Status

If we are married and both are elderly, then we need to consider each other’s longevity. If one spouse is in engaged in the day to day management of the property(s) and the other spouse is not, then we have to question or take into consideration what happens should the actively managing spouse get sick or die. In such times, the survivor can potentially be left with more of a problem than an opportunity.

On the flip side, if we are considering an outright sale, but decide against it based on the tax consequences, then another reason the marital status is an important consideration is due to the fact that upon the death of the first spouse, there will typically be a full stepped up basis in the cost basis of the property.

This step-up in basis will result in a zero taxable gain upon the subsequent sale of the property. This later consideration sometimes is a very important consideration especially if the marital couple are elderly seniors.

b. Heirs

The question of your heirs or beneficiaries of your estate is an important consideration. Sometimes we have expectations that our kids or grand kids will take over our estate and run it the way we have been running it. Sometimes our heirs or beneficiaries have expectations that they will inherit the properties and will be able to convert their parent’s or grandparent’s wealth into their own wealth and grow it from there.

It is very important for the present owners to consider their heirs or beneficiaries or to take them into consideration as to which exit strategy avenue to take. The reason being is that not everyone is qualified or capable of running rental properties.

If the parents or grandparents wish to leave properties to their children or grandchildren, then it behooves the parents or grandparents to get the kids or the grand kids involved in the day to day operation as early as possible.

This way the kids or grand kids can demonstrate up front whether they are capable of managing the properties effectively. If they learn and are motivated then it perhaps behooves to continue ownership of the properties and have the kids or grand kids get actively engaged or involved right now.

If that is the case, then forming a partnership (family limited partnership) or using a private annuity trust may be good exit strategies. If it becomes apparent that the heirs are not motivated or are incapable of running the properties effectively, then perhaps the present owner should consider the other options, namely selling the property or using the charitable trust or private annuity trust.

c. Income Needs

Owning real estate can be a mixed blessing. Properties are either run well or due to various circumstances do not perform. If we own rental real estate with a lot of equity and the equity is not producing a fair return, then we should seriously consider investment alternatives.

If the return on equity under the present property situation is not comparable to financial instrument return on investments, then we may consider exchanging the property from rental real estate to perhaps triple net real estate.

Our income needs will also determine whether we want to perhaps form a charitable trust so that we can avoid capital gains on the sale and convert our equity into financial investments that will generate higher yields.

Our income needs may also force us to consider perhaps doing an installment sale where we can demand a more attractive rate of return on our equity by carrying paper, i.e. seller-carry-back financing.

d. Net Worth

If we are very wealthy and have lots of resources, then we can have greater flexibility and more choices to consider with regards to the various exit strategies.

For instance, if we own multiple buildings, then it is very easy for us to consider taking one building and setting up a charitable remainder trust so that we can sell without paying any current capital gains and then get financial rate of returns on the equity on that property.

Typically the greatest draw back to a charitable remainder trust is the fact that we lose the ability to will it to our beneficiaries. However, if our net worth is significant then there are plenty of other assets we can utilize to transfer wealth from one generation to the next generation.

e. Income Tax Bracket

If our marginal tax bracket is very high then we tend to be very sensitive to any kind of taxable event. Similarly if our tax bracket is very high then we can take significant advantage of charitable deductions. They mean a lot more to us at that point in time.

Therefore, those of us in high tax brackets should consider exit strategies that either defer taxable events like installment sales or exchanges or possibly consider charitable remainder trusts which not only avoid capital gains but also provide us with current deductions to offset income from other sources.

f. Philanthropic Tendency

If our tendency is to be charitable both while we are alive and as benefactors when we die, then we should seriously consider the charitable trust vehicle as a good vehicle for exiting out of current highly appreciated real estate holdings.

4. Economic Issues

The state of the economy plays a major role in our determination of when and how to sell real estate. The following are some basic factors that we consider.

a. Interest Rates

When interest rates are high we are presented with an opportunity to sell property on an installment sale basis and earn higher than average rates of return on our converted equity.

Similarly when interest rates are high we can fully take advantage of charitable trusts that will create very large deductions for us as well as provide us with above average rates of return for payouts.

In contrast, however, if we are considering exchanging, high interest rates will make financing less attractive and therefore make that exit strategy less workable. When interest rates are low, then the private annuity trust is a very attractive vehicle to consider.

A private annuity trust is a way of keeping the net worth in the family while still selling the property at no recognized gain. But the critical factor there is the rate of return we must provide to the estate.

b. Capital Gain Tax Rates

As most long term ownership results in recognizing primarily capital gains on the outright sale of rental holdings, the prevailing capital gain rate thus becomes a major consideration in whether we sell right now or defer the gain to a future period. With lower capital gain rates our tendency is to say “let’s just pay the tax and move on.”

When capital gain rates are high or higher than we want them to be, our tendency is to say “...let’s defer or hold off” or take advantage of charitable trusts which eliminate the tax on capital gains.

c. Local Market Conditions

When the local market is depressed and values are not commensurate with what we wish to net from the sale, then our tendency is to hold on to property. Alternatives to consider at that point in time tend to be focused strictly on property management as the exit strategy.

By that we mean that we would rather hold onto the property until the market recovers so that we can sell at a much better rate of return. Exchanges within the same market segment aren’t practical based on the fact that the market itself is depressed.

d. Remote Market Conditions

When there is a differential between the local market and a remote market, then we may consider doing exchanges as a way out. If we can get out of an overvalued marketplace and exchange into an undervalued marketplace then we can take advantage of the differential.

5. Property Issues

Obviously one of the most significant set of factors to consider is the property itself.

a. Tax Basis

If our tax basis is very high compared to the fair market value, then an outright sale is a logical conclusion. By selling we don't achieve a large gain (if any gain at all).

However if our tax basis is very low, based on prior deferred exchanges or based on the fact that we have held the property for a long time, then we have to consider the other exit strategies; such as an installment sale, a tax deferred exchange or one of the other tax deferral vehicles.

b. Location

Where the property is situated (either our current property or our proposed exchange property) is an important consideration for exit strategy planning.

Exchanging property from one area to a remote area has a lot of potential problems. Smaller properties are very difficult to manage remotely. It is only with large properties that you get to leverage off professional property management.

Similarly, if you are considering selling on an installment sale basis, or if your location of the property is in a low income or poor community, then you have to consider the potential for future repossession or foreclosure.

Then the question becomes, is it worthwhile to repossess in a depressed environment, both when the economy is depressed and the property has suffered from deferred maintenance.

c. Condition

If the condition of your property is good or excellent and your property is performing favorably compared to other properties in the local marketplace, then professional management may be the way to go.

However, if your property is in bad condition with deferred maintenance issues then professional management may be very costly and considering an exchange or some other exit strategy may be more meaningful on a long-term basis.

d. Financial Performance

If your property is located in a good area and is in relatively good condition, then it should be performing as well as other properties within the same market. If your's isn’t, then you should seriously consider professional management.

However, if your property, based on your active management, is outperforming properties within the local area, then professional management may reduce your return on investment. Therefore you may want to consider an exchange or an alternate vehicle.

As you can see, there is a lot to think about and consider when you are thinking of getting out. The good news is that you have plenty of options irrespective of your particular set of facts and circumstances. There are also a lot of resources out there to help you with your consideration.

Brokers are great sources of data on values and comparable performance both locally and remotely. Apartment associations can help you get market condition data and performance stats. Tax professionals can help you with the accounting issues. Attorneys can help you with the estate issues. Good luck.

RealTax professionals have the knowledge and expertise to help you evaluate how certain issues affect your exit strategy decision. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.