Whether we like it or not and whether we have a strategy for it or not, at some point, we are all going to exit the real estate investing game.
As a firm believer in the acquire and hold forever model, I have not spent a lot of time thinking about exit strategies. But because our exit is inevitable, it behooves us all to understand our options.
Exiting A Property
Most real estate investors are familiar with or at least have heard of the 1031 Exchange. The 1031 Exchange is a very powerful wealth building and wealth preservation tool* .
At a high level, Section 1031 of the IRS Tax Code allows people to exit a PROPERTY without incurring capital gains taxes and/or triggering depreciation recapture when they sell a property by rolling their gains into another piece of real estate.
For simple example purposes, assume you bought a $200,000 investment property 20 years ago that is now worth $500,000. You depreciated the value of the home every year as required by the IRS. Assuming you took a total of $100,000 of depreciation over the 20 years, and did not make any improvements to the property the BASIS of your property is $100,000($200,000 – $100,000).
When you sell the home for $500,000, you have a gain of $500,000 – $100,000 = $400,000. Depreciation recapture and capital gains are not taxed at the same rate and the rates will depend on your income. For this example, let’s assume the blended tax rate is 20%. That means you will owe 20% * $400,000 = $80K in taxes.
Not may people want to stroke a check to the IRS for $80K.
Now, if you take the $400,000 of gains and roll them into a new property(s) you can defer your obligation to pay this $80K. This is the beauty of the 1031 exchange.
The net result of a 1031 exchange, however, is that you are still a property owner. So while the 1031 exchange can be considered an exit strategy at the PROPERTY level, it is not an exit from being a landlord.
Exiting Property Ownership
So now let’s look at the possibilities for property owners whose tolerance for managing repair requests, HOA’s, property tax bills, insurance bills, vacancies and property improvements is approaching zero.
Below are 3 options:
1. Sell Real Estate In The Traditional Manner
In the example above you could list your $500,000 investment home and sell it on the open market.
Positives:
- Gets you out of being a rental property owner
- Turn your equity into some cash
Negatives:
- Remove tenants
- Give up ongoing stream of income (cash flow)
- Fix up/stage home to prepare it for the market ($5,000 – $50,000?)
- Pay a real estate agent between 3% and 6% ($15,000 – $30,000)
- Pay taxes of $80,000
- Net of these is your “perceived” gain of $500,000 (price you sold for) – $200,000 (price you paid) = $300,000 just turned into an actual net gain of somewhere between $140,000 – $200,000.
- Feels like a buzz-kill
2. “Refi Til You Die”
Positives:
- Borrow (home equity line of credit, home equity loan, 2nd mortgage) against the property in perpetuity and get tax free cash
- Interest paid on the amount borrowed is tax deductible
- No property sale transaction friction/risk
- Pass along the value of home/portfolio to heirs on a stepped up basis. (In essence, at passing, depreciation recapture and capital gains are wiped out)
Negatives:
- Doesn’t get you out of property ownership while you are still alive
- Portfolio/property cash flow reduced due to new debt service obligation if refinanced
- Challenging to divide home(s) among heirs and all heirs need to be well educated on related real estate and tax principles
3. 721 Exchange – Section 721 of the U.S. Internal Revenue Code allows a property owner to contribute real estate to a partnership in exchange for partnership units.
Positives:
- Gets you out of being a direct property owner – no more repair requests, HOA’s, property tax bills, insurance bills, vacancies or property improvements
- Defer paying capital gains taxes and depreciation recapture by rolling your equity into a qualified real estate fund
- Get shares in the real estate fund that offers continued cash flow and appreciation potential
- No need to pay to fix up/stage the property for sale or pay agent commissions
- Diversify your risk across multiple markets and properties
- Contribute to and become a part of a like minded community of real estate investors and tangentially stay attached to your real estate
- Permanent solution – No “next decision” stress/risk
- Shares easy to divide among heirs compared to portfolio of homes
Negatives:
- Pay onboarding fees/management fees
- Give up ability to borrow against your asset
- Lose future 1031 exchange availability
Summary
We acquire and hold real estate for the long term because it provides so many benefits including: cash flow, appreciation, return on amortization, tax sheltered income and inflation profiting. We should respect this powerful model by being aware of our options so we can optimize our inevitable exit. The traditional model of selling properties/portfolios on the open market does not come without some meaningful downside. The 721 exchange option has some very attractive qualities that allow property owners to truly exit in a lucrative and relatively friction-free way.