Real estate investing is a long-term commitment, but a day will come when you'll need to decide how you'll exit the investment. Having a real estate exit strategy will help you maximize the total return on your investment when that time comes.
Why you need an exit strategy
When you invest in income-generating real estate, you receive a return on your money: You put your money into the real estate, and the real estate pays you. At some point, however, you may want to get your money back out of it -- hopefully with some additional equity and a capital gain. You'll need an exit strategy to make this happen.
In this article, we're going to focus on exit strategies for investors who own income properties. These exit strategies are ways to move on from a specific investment property, whether it's commercial real estate or a rental property.
Whether you just want to take your money and walk away, or you're looking to move into another investment, you need to figure out the exit plan that's best suited for your particular investment strategy as a real estate investor.
Types of exit strategies
These are the most common real estate exit strategies:
- Sell and walk away.
- Seller financing.
- Lease option.
- 1031 into another investment property.
- Cash-out refinance.
- Pass it on to heirs.
Let's discuss each of these in more detail.
Sell and walk away
This strategy seems obvious, but it still needs to be discussed. There are things you should do ahead of time to prepare for your exit in order to maximize your total return. You want to get every dollar you can out of the property without leaving anything on the table.
Keep in mind that you'll be looking at capital gains taxes most likely. You'll have a lower basis on the property if you've been taking advantage of the depreciation tax benefit. You'll have depreciation recapture as well as gains on any appreciation you've realized since purchasing the property.
This isn't necessarily a bad thing, though. In most cases, capital gains tax is lower than income tax. Of course, that depends on your tax bracket. Your certified public accountant (CPA) will be the best person to help you determine what your taxes will look like when you sell your property.
You'll want to start the process a while before you need to sell. Investors who wait until they need to sell the property often end up having to sell at a discount just to move it. Having time to plan will allow you to make any repairs or improvements to the property to maximize the value.
You can also be more patient when marketing the property so you're able to wait for a potential buyer willing to pay a fair price. There's no reason to leave any money on the table.
It's a good idea to talk to a real estate agent about what you can expect to get for the property and whether there are any improvements that would help you get a higher sale price.
Another option to consider when selling the property is to offer seller financing. A buyer may be willing to pay more, and you'll continue to receive a monthly payment with interest.
Most owner financing deals include a down payment of at least 30% and a balloon payment at a set date. This is usually anywhere from two to five years. A little bonus to this is that you only pay capital gains tax on the money you receive each year, and that's only on the principal.
Of course, there's always the risk that the buyer will default on the payments and you'll be forced to take the property back. You may even have to take it back vacant and in need of repairs.
A lease option is beneficial when a tenant wants to buy the property. This works by giving the tenant an option to buy the real estate at the end of their lease. In many cases, the property owner will apply a portion of the rent payment to the total purchase price if the tenant exercises their option.
This option works well if you're not in a hurry but know that you'll want to exit your real estate investment in the near future. You'll also have to be prepared for your tenant to not buy the property when you expect them to.
1031 into another investment
An exit strategy isn't just for walking away from real estate. There are many reasons you might want to move on from a particular property. A 1031 exchange is a great strategy if your goal is to move into a larger real estate investment, one in a different market, or one that's more in line with the rest of your investment portfolio.
A 1031 exchange will allow you to defer your capital gains tax, leaving you with more money to put into the next investment opportunity. There are even some options to do a 1031 into a passive investment, such as a Delaware Statutory Trust (DST) or an UPREIT. This allows you to continue receiving passive income until it's time for the DST to liquidate or you sell your shares in the real estate investment trust (REIT).
Your real estate exit strategy doesn't necessarily mean you have to get rid of the property. If you want to cash out, but don't necessarily want to give up the monthly cash flow, you can get a loan on the equity of the property.
You'll want to make sure the cash flow from the property is enough to cover the new loan payment, or else you'll end up putting that money right back into it every month. In fact, the lender will most likely make sure the rental income will be enough to cover the debt service and still have money left over every month. A lender will usually want to see a debt-service coverage ratio (DSCR) of at least 1.25.
If you want to cash out and get rid of the landlord responsibilities and the tenant phone calls, you can hire a property management company to take over the day-to-day operations while you still receive a check every month.
A property manager will charge a percentage of the total rent collected, so there will have to be enough cash flow to cover the management fees on top of the new debt service. However, some investors find that hiring the right management company will actually be able to increase tenant rents and lower expenses. This could add quite a bit of cash to your bottom line.
This exit strategy still leaves you exposed to risk, and probably even more than you had before. The new loan payments will leave you with less cash at the end of the day to cover any unexpected expenses, and it increases your overall liability.
If done properly, you can likely take the cash out from the refinance without paying taxes since you'll still be paying your income tax each year on the net income. You'll want to talk with your CPA before moving forward with this option.
Pass it on to an heir
A lot of investors buy real estate to build a legacy for their family. They want to have something to pass on to their children or other heirs.
This option usually involves putting the property into a trust and having a well-prepared will. Using an attorney to set this up properly will help to prevent any later disputes and will ensure the property is easily transferred to your heirs.
Even if your heirs don't want to take over the properties, it still might be a better option for them to inherit the properties and sell them instead of you selling them to leave behind the cash. When real estate is inherited, the cost basis is reset to the current fair market value. While you would have to pay capital gains tax, they most likely wouldn't.
Choosing the best exit strategy for yourself
There isn't an overall best exit strategy I can give you. The one that's best for you depends on what exactly you want to accomplish. At this point, you might not know exactly which way you want to go, and that's fine. It's still good to know your options.
Consider what your long-term goals are and how each real estate exit strategy will affect them. An important part of that is considering the tax consequences of each. Too many investors have chosen an exit strategy without first determining what their tax liability would be. This results in an unexpected and disappointing surprise when tax time comes.
Now that you know what some of the most common real estate exit strategies are, you should consider these when you're buying your next investment property. Knowing ahead of time how you want to handle your exit can influence the market you invest in, the loan terms you'll look for, and the improvements you'll make to the property. As always, discuss your specific scenario with a tax advisor and real estate attorney before making a final decision.