I’m frequently asked by investors if they should sell their current rental properties. There are a lot of factors that go into the decision. The most important is, are you still enjoying owning and running it? (Running it might be a limited scope of work with a great property manager that you trust).
If you have ten properties, you likely have one that just always seems to have maintenance problems or attracts problem tenants. Regardless of the economics, that’s probably the one you should dispose of first. Your spouse will thank you!
Alternatively, you might be less fascinated with tenant requests than you were in the beginning, and you’re daydreaming about TRUE passive income, vs. being an active landlord. Even if you have a property manager, there are still plenty of decisions to make and headaches to manage.
Once you decide to sell a property, you can talk to your CPA to find out what the tax impact will be. You’ll have some capital gains (generally your net proceeds after sales costs, less your purchase price, less any renovation work). And you’ll have something mysteriously called “depreciation recapture.”
You can depreciate part of your property each year, and it can shield you from the tax liability from the cashflow your rental(s) generated. You can think of this as an interest-free loan from the IRS. Even though you never wrote a check to anyone for this depreciation, the IRS let you reduce your income each year…saving you some tax. When you sell, you have to pay this back.
Your total tax liability when you sell is both the capital gain and the depreciation recapture. You can legally postpone the payment of both if you do a 1031 exchange. The 1031 name comes from the section of the tax code where Congress set out the rules of how it works.
The paperwork is not hard to do. Finding a replacement property you like is by far the most important and difficult task.
If you don’t find a replacement property, or if you want to become a truly passive investor, the idea of buying a larger replacement property may not be exciting to you (and your family). If so, your options are to:
1. Use a 1031 exchange and invest in a DST.
2. Pay the tax and use the money for anything you want.
3. Invest in something that will defer some/all your gains without a 1031 exchange.
Let’s explore your options one by one.
OPTION 1 – DST
The Delaware Statutory Trust (DST) will work with most 1031 exchanges. The benefits are you can defer the payment of your capital gains tax. The downside is there are a lot of fees and expenses, and there is a limited selection of investments that are configured as a DST. Getting out of a DST can be difficult. Finally, most DSTs invest with limited (or no) leverage in very, very conservative investments. For example, the DST might purchase a Home Depot. It’s leased to a great company, but the return on investment will be low, and the annual rent increases are usually very small in retail triple-net properties like this. You might make 5-9% year, overall.
OPTION 2 – SELL AND PAY TAX
While it seems very counterintuitive, over a ten-year period, most investors will come out ahead by investing in a truly passive real estate investment that delivers 17-20% a year AFTER tax, vs. investing in a DST that pays 5-9% per year WITHOUT tax. Ironton Capital offers several funds that offer returns in this range. They are all entirely passive, so it’s effortless for you.
OPTION 3 – SELL, DEFER SOME / ALL TAX
Our National Diversified Fund (NDF) has two share classes to address the needs of two of our different types of investors. Class A shares get a slightly higher preferred return but does not get any depreciation. This works well for IRA investors, for example. The other share type, Class B, gets a slightly lower preferred return but gets ALL the depreciation.
Let’s imagine the NDF fund buys an older apartment building at a discount that needs a lot of work. The rents are $500/month below market. We’ll renovate the building, raise the rents, then sell it.
Without anything special, for residential property, you can write off the improvements (not the land) over 27.5 years.
Here’s how that tax write-off calculation would work:
24% of your investment in Class B shares would be written off each year (talk to your CPA for your unique situation). This can offset some/most of your capital gain from the sale of your old rental.
But we can do even better.
Usually about 50% of a NDF fund is a remodel of old assets that need a full remodel (the other half invests in new development, which doesn’t generate depreciation for a few years). We hire a specialized accounting firm to do a cost segregation study. Normally, the CPA will say the entire value of the apartment is $4,000,000, the land is $750,000, and we’ll just assume we write off all $3,250,000 of improvements over 27.5 years, or $118,000 per year.
In the segregation study, the CPA breaks the $3,250,000 into many categories. For example, $300,000 might be assigned to the roof, which is in poor condition and only has a three-year life. We can accelerate the depreciation for this part of the building. Similarly, some value is assigned to kitchens, baths, paint, and carpet, which might all be torn out and fully replaced as part of the remodel plan. Rather than those assets being written off over 27.5 years, they can be written off much faster.
Let’s imagine that the study finds that 5% of the value (usually its higher) can be written off immediately. Here’s how things change for the first year write off:
Now the $500,000 investment in the class B depreciation shares gets $318,000 of write off in year 1. Again, talk to your CPA for your situation, but often this may be sufficient to offset most or all your gain when you sell the old property. You can win by getting a truly passive investment and win by legally deferring your taxes, too.
And if Ironton Capital can be of service to you sorting out these 3 paths, then reach out to us at https://irontoncapital.com/myreview and choose your best time to talk.
