Disposing of Income Property Part 1 Of 3
Disposing of Income Property
The Basics
Many of the aspects of buying an income property are also important when selling one. One just views things from the other side of the transaction. We won’t, in this article, try to discuss every issue from the other side. However, we will discuss some of the more important issues.
Why Do It?
There are, in general, two possibilities. First, because you have to do it. Second, because you want to do it. By “have to” we mean you need to sell because of health, financial, or other issue that limits your ability to pick the market conditions in which to sell. “Want to” covers all cases other than “have to” no matter what the reason. It might be that you’re tired of dealing with tenants, want to retire with the freedom to travel, or want to utilize your equities to enjoy the lifestyle of the rich and famous. The major difference from “have to” is that you have more flexibility as to when you do it.
When to Do It
Like many other things in life, timing the disposal of your property is important. The time to dispose of property is when it’s a seller’s market – that is, when the demand is higher than the supply. Unfortunately, real estate investors must often dispose of property under less than ideal circumstances for reasons of health, divorce, or general financial condition. However, even when you “have to” dispose of property, following the correct procedures will help you realize the highest possible return.
How to Do It
You have several options regarding getting rid of a property. You can give it away, you can sell it, or you can trade (exchange) it. There are also two other ways. One is to stop paying your loan payment or your property taxes and have it taken away, but this option doesn’t require instructions. The other is to die and leave it to your heirs, and, while no instruction is usually necessary for the dying part, proper estate planning is highly recommended.
Gift It
There are several reasons why you might consider giving it away. One would be to gift it to a family member or friend. Gifting to relatives or other individuals or entities (other than charities) can have an impact on overall estate planning. Another would be to donate it to a charity. There are even ways to put a property into a charitable trust that allow you to retain control even as to future use long after your demise. All of these possibilities have tax consequences and require that you seek competent professional help. Timing of a gift can be important because the stepped up basis for the recipient is related to the value at the time that the gift is made. Lesson 32 of our “Buying & Selling Income Properties” eCourse includes a discussion about charitable trusts.
Sell It
You can, of course sell the property, just as you can sell your personal residence. And, just as when selling your personal residence, you want to maximize the sale price. However, selling income property is usually more complicated and can have significantly more tax consequences.
Arguably, the most important tax consequence is that taxable gain will be based on sales price (less selling costs) less your basis at the time of sale. And, your basis is usually the net purchase price plus amounts added to basis during the period of ownership minus depreciation taken during the period of ownership. In other words you will pay tax on all the depreciation that you deducted during the years of ownership in addition to paying tax on the actual increased value, where there may be a difference in tax rates between the two. There are ways to somewhat cushion the tax blow, for example, by structuring the sale as an installment sale.
Timing is obviously important for selling a property because you’d like to sell at the top of the market or at least not at the bottom. If in an increasing market, you might want to delay the sale if practical and add more dollars to your price, using that time to maximize rents and minimize expenses where possible.
Exchange It
Unless you want to get out of the landlord business, it will usually be advantageous to exchange your income property under Section 1031 of the Internal Revenue Code. Section 1031 provides a way to exchange one property for another without paying income tax on gain and depreciation recapture on the property being exchanged from at the time of the exchange.
Although sometimes referred to as “tax-free” exchanges, remember that there is no such thing as a free anything. Section1031 provides a deferment of taxation rather than a waiver of it. However, if you die before selling a particular property, your heirs may receive a stepped up basis that makes the deferment permanent, depending on tax laws at the time of death.
Currently (2010), the Internal Revenue Code allows owners of certain types of like kind “real” and “personal” property to exchange like kind property without paying the capital gains tax. The Code lays out in detail the procedure for turning a sale and purchase type transaction into an exchange.
In general, no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
Section 1031 provides a means of trading your existing real estate portfolio for one that is less management intensive when you want to slow down, but not entirely retire from the rental business. The main advantage of a tax-deferred exchange is that it allows you to trade up to larger property or higher quality property after your previous property has increased in equity in order to improve your leverage position, utilizing untaxed dollars to do so. As indicated by the word deferred, you will eventually have to pay the piper if you wish to cash out and retire from the landlord business.
Additional Information
Additional discussions regarding several issues related to disposing of income properties will be provided in future articles. Currently, significantly more detailed discussions regarding a wide range of issues can be found in our “Buying & Selling Income Properties” eCourse.