Strategies to Consider When Selling

1. Introduction

Now that the rental real estate market appears to be recovering from its 1990’s recession, a lot of us are once again thinking of selling.

Believe it or not, there are quite a few of us landlords out there who have had it with the rental real estate business. It seems like every day we are confronted with problems and headaches.

Flaky and/or demanding tenants; government control and interference; skyrocketing repair, maintenance and utility costs; vacancies; insurance policy modifications and/or cancellations; and lender interference are but a few of the issues that make it a frustrating business.

Unfortunately, for those of us who have owned property for a long time, selling is costly from an income tax (i.e. taxable gain) point of view.

2. Tax Table

Our taxable gain in a sale can be looked at as the difference between what we gross from the sale and what our tax basis in the property is on the date of sale. For example, if we sell a rental today for $1,000,000 that we bought eighteen years ago, our tax consequence could look like this:

Sales Price	1,000,000
Expense of Sale @ 7%	-70,000
Gross Proceeds		930,000		930,000
Purchase Price	250,000
Depreciation	-175,000
Adjusted Basis		75,000
Taxable Gain		855,000
Federal Appreciation Tax @ 20%			136,000
Federal Appreciation Tax @ 25%			43,750
California Tax @ 9.3%			79,515
Total Tax				259,265
Net Proceeds				670,735

With that much potentially going to the government, it behooves all of us to ask ... is there a better answer? The following are alternatives to an outright sale. Anyone who is fed up with their situation and cannot take it any more should review these alternatives.

3. Professional Property Management

Professional property management firms are an option worth considering. Especially if you are having trouble maximizing your rents and minimizing expenses. Today there are many experienced property management firms who can potentially help relieve you of the day-to-day aggravation of management. In many instances management firms can even improve property cash flows to more than compensate for their fees.

Unfortunately, many of us have had bad experiences with management firms. We have either seen them increase expenses to benefit their in-house maintenance operations and/or seen them neglect the property with the result of renting to bad tenants and/or letting vacancies grow.

The main reason for experiencing such bad results is that owners often neglect to do a good job in selecting management firms. Worse than that, owners forget the fact that just hiring a management firm is not the answer.

Owners have to work with their property managers. Owners have to set goals and objectives for their properties and review results from operations on a regular basis. With the right type and amount of interaction by the owner, property managers can become a valuable asset to the owner. Better yet, should the management firm solution work for you, then paying income taxes on a disposition transaction becomes a non-issue.

4. Forming a Partnership

Those of you who want to benefit from future appreciation of the property but at the same time want to increase your current return on equity as well as reduce your management responsibilities, might want to consider a partnership as a tax deferral technique. A partnership can be formed with heirs, family members, investors and/or potential buyers.

Contributing property to a partnership is typically a nontaxable event to the property owner. Such a contribution in some circumstances can be matched by cash contributions by the other partners. The sum total of all the assets (i.e. property and cash) will then generate income to its partners proportional to their ownership interest.

A family partnership is an ideal method to bring in heirs and have them take up the responsibility for the day-to-day operations. Such partnerships can be structured so that you will not have to give up control nor income until such time as you are ready. From an estate planning vantage point, such partnerships can be utilized to reduce your estate tax liabilities as well.

5. Refinancing Your Property

It may seem obvious, but sometimes doing what's obvious provides excellent results. Borrowing against the equity in a property, enables you to bail out cash tax free, even if the new loans which secure the property exceed what you originally paid for it and even if there is no personal liability on the new loan. Under our system of taxing, selling something can cost you plenty in taxes, but borrowing a large amount will not.

If your property can service a larger loan, this could be an example of having your cake and eating it too. You get cash for pleasure or other investments, keep a property you're familiar with and pay no tax. There is one caveat, however. Not all the interest on the new loan is automatically deductible. Beginning in 1987, the law requires you to “trace” the loan proceeds and to allocate the interest accordingly.

6. Options

For those of you who want to sell your property now but want to avoid recognizing any gain until a future date, granting an option (and/or a lease with an option) may be the way to go.

You see, an option is a contract entered between a prospective buyer and seller where the buyer agrees to pay the seller a sum of money for the right to purchase the property at a specific price at any time before a specified future date.

Since the buyer does not have to go through with the purchase (i.e. does not have to exercise the right), there is no sale from a tax point of view. Since there is no sale at the time the option is granted, there are no tax consequences.

In other words the consideration (i.e. the money given the seller, no matter how much!) is not taxable to the seller at that time. Is the money given ever taxable to the seller? Yes. At either the date the option is exercised or the date the option expires, whichever comes first.

Now why in the world would the buyer want to cooperate in such a transaction? For many reasons. First of all the buyer wants your property. Secondly, by way of a lease, the buyer can take control of the property and operate it for their benefit. Thirdly, the buyer gets some time before he or she has to exercise the option which means that they can plan an exchange from one of their other properties and/or the buyer can take advantage of the appreciation before they come up with the rest of their funds (i.e. leverage) or financing.

7. Tax Deferred Exchange

If you have made up your mind that you are going to sell your investment property (i.e. your rental) and reinvest the proceeds in another investment property, it is most likely that you would be better off exchanging versus selling and then buying. By better off, I mean that you might not have to pay any taxes on the gain that you realized from the sale of your original investment. By not paying any taxes on the sale, you will have more available for the subsequent purchase and thus will benefit from better cash flow or greater leverage.

In order for you to totally defer your tax in an exchange, you need to follow a simple rule. Namely, as long as you reinvest all the cash you net from the sale in the subsequent purchase(s), and as long as the debt that you are obligated for before the exchange is not reduced in the subsequent purchase(s), then you will have a totally tax deferred exchange. Please note that an exchange can involve multiple properties sold and/or bought. The net numbers are what’s important.

By the way, an exchange can be structured in one of three ways. A simultaneous exchange is one where you sell and buy at the same time. A delayed exchange is one where you sell first and complete a buy within six months. A reverse exchange is one where you buy your replacement property first and then sell (at any time in the future) your original property.

Exchange rules are still quite liberal in that they allow you to sell out of a management intensive property like an apartment building and buy into a relatively management free property like a triple-net shopping center.

8. Installment Sale

If you are planning on investing the proceeds of the sale in interest bearing accounts (ex: Certificate of Deposits), that is put your money in the bank and live off the interest, then you should very seriously consider the installment sale alternative. As you know, real estate is very rarely purchased outright for cash. In most cases the buyer will put up a cash down payment and finance the balance of the purchase by borrowing that sum from a lending institution. An installment sale occurs when you, the seller, agree to act as the lending institution.

There are two primary benefits to an installment sale to the seller. The first, and typically the most important benefit for the seller is that you do not have to pay any tax at the time of the sale on the amount that you finance (i.e. on the amount you agree to lend to the buyer). The second, and typically not given its proper consideration, is the fact that you can demand from the buyer a larger interest rate than you would ever be paid by a bank on the money. When you combine these two benefits you will see that an installment sale lets you earn more money on more money!

The installment sale is a tax deferral planning technique. By that we mean that as the buyer pays you off on the principal amount of the loan, the tax will become due.

9. Capital Gains Bypass Trust

For those of you who want out of the real estate business and want to benefit from all the equity you have in your property but are hesitant to structure an installment sale, then the bypass trust may be a viable strategy. For those of you who have amassed a very large net worth in real estate and thus have an estate tax problem, the bypass trust is also a very important estate planning vehicle.

A bypass trust is a “fancy” and “friendly”way of referring to a charitable remainder trust (CRT). The basic operation of this tax avoidance technique is that by gifting your property into trust for the eventual benefit (its for your benefit while you and your spouse are alive) of qualified charity(s), the government allows you to avoid paying any capital gains taxes!

Once in the trust, you as trustee can sell the property and convert the proceeds into any form of investment. The income generated by the investments is yours! In fact, in most situations where such a trust makes sense, not only do you get to avoid capital gains and derive the income from the property and/or proceeds from the sale, but you also get a sizable charitable deduction now for making this future donation! Those of you who are concerned about wanting to leave the money to your heirs will be pleasantly surprised by the many ways available to do that as well.

10. Private Annuity Trust

A Private Annuity Trust (PAT) in some ways is very similar to the Bypass Trust described above. Title to your property is transferred to an irrevocable non-grantor PAT which enjoys an immediate step-up in basis for capital gains tax deferral purposes. The PAT in turn can sell the property tax free. The PAT is then obligated to provide you an annuity income of earnings and principal for the rest of your life or for a term certain. The annuity income is based on the equity in the property and your life expectancy.

The advantage a PAT has over the Bypass Trust (CRT) is that not all the income derived by you from the PAT is taxable. A proportion is characterized for tax purposes as a return of capital. In addition, unlike a CRT, the remains in a PAT pass to the beneficiaries of the PAT income and estate tax free at your death. The major disadvantage to a PAT is that the income generated by the PAT on its investments is taxable to the PAT during its existence (not for a CRT) while the distributions to you of the annuity payment are not deductible.

11. UPREITs

With the tremendous returns generated by the stock market within the past decade or so, many investors have looked towards moving their monies out of banks and investing in the stock market. Those living on fixed income have in the past looked at utility company stocks for their investment. Today these same investors are choosing Real Estate Investment Trusts (REITs) for their fixed income investments due to the higher rates of return generated by these REITs.

Most REITs invest in large residential rental and/or commercial properties. If you have such a property, you can perhaps form a direct partnership with a REIT. Such a partnership would be very beneficial to both you and the REIT. You would be relieved of the day-to-day management and benefit from the cashflow. If your property is not suitable for a REIT, then you can do a 1031 tax deferred exchange into suitable property.

UPREITs are becoming more popular now due to their ability to provide you, the seller/exchanger, an opportunity to convert your active real estate investment into a passive investment that is not only tax deferred but offers tremendous liquidity to you and your heirs.

12. Combinations of the Above

As you can see, there are many avenues for those of us who are anxious to get out of the direct day-to-day rental business. The good news is that there are many strategies we can utilize to better our situation. Some of these strategies can be utilized in combinations.

As mentioned above, we can refinance our current holding, invest the net proceeds in conventional money markets and/or securities for greater return, and simultaneously hire professional management. We can sell our property on the installment basis and exchange the down payment on a tax deferred basis. We can contribute a partial interest into a Bypass Trust and cash out on the rest. We can partner with a REIT or our heirs. In fact we can utilize as many of these techniques as are practical.

RealTax professionals have the competence and experience to provide you with an in-depth analysis of your exit strategy options and their respective tax consequences. 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.