Real estate investing involves both long-term and short-term strategies to get the most return. As a rental property owner, you earn an income from rent, which is good for the short-term, but what you're really hoping for is an increase in property value over time so that you can sell it for a good profit. But when might that time be?
As the years pass and the market fluctuates, you may have considered when is a good time -- if ever -- for selling a rental property. In addition to keeping your finger on the pulse of the real estate market, you must determine how to preserve your ROI in the face of capital gains taxes. When you were a landlord, your income was taxable, but as you're getting ready to potentially exit that role, you have other layers of taxation to deal with.
Capital gains and depreciation recapture
Capital gains is something to contend with any time a property is sold, but it's even more of a tax liability when it involves your investment property as opposed to your primary property. There are short-term capital gains, which affect owners who have the property for less than a year, and long-term capital gains for those who have owned the property for more than a year.
Short-term owners are penalized for unloading properties within a year of acquisition to the tune of getting taxed at their current income rate. Long-term owners have it better with a rate of usually 0%, 15%, or 20%. It's important to note that even if an investor is able to get the exclusion rate of 0% capital gains, the sale of the property will be considered taxable income.
Don't forget about the depreciation recapture, either. While you've been able to write off depreciation each year as a deductible expense, it's now time to pay the piper -- or the IRS, as it were. And unlike the more lenient capital gains rate, you'll be taxed at your current income tax rate.
This is why you'll want to keep your accountant apprised of your intention to sell -- so that you can retain as much of the profits as you can when Uncle Sam comes knocking in April.
Five reasons for selling your rental property
Selling your property is an important step, of course, but what comes next can be even more important for your bottom line, particularly in regard to capital gains. Consider these five scenarios as a rental real estate investor and what to do next once you've sold your rental house or building:
1. It's a hot market and you want to cash in
Good profits are the very reason you got into real estate investing in the first place. If the time is right to sell, inform your current tenants that this could be their last lease with you, then put the property on the market.
What to do next: Call your accountant and continue the discussion of the tax implications of your impending sale. While you can't avoid the capital gains tax rate on your profits, you can likely lessen the blow, depending on your tax bracket
2. You're losing money
There's always an inherent risk with real estate investing. If you're still operating with a negative cash flow on a property after owning it for a considerable amount of time, it may be the right move to cut your losses and sell before the going gets even rougher.
What to do next: Look into tax loss harvesting. If you can show a loss elsewhere on your tax return, say with your stock portfolio, you could potentially offset the loss you're facing with your rental property.
3. You can't afford the maintenance
Maybe you've been coasting along for some time with long-term tenants who were just fine with the place since the last time you renovated. But now they've moved on -- and no one else has moved in. You know it's time to renovate again, but it will be a drain on your finances. If your rental property has gone from cash cow to money pit, it's time to sell.
What to do next: Check the comps, and if you're not planning any renovations or updates, set the price for the lower end of the range. Be prepared to negotiate or make some concessions. You want to make a tidy profit, but letting your property linger on the market for too long could drive your asking price down.
4. You're looking to invest in a new niche
Diversification is key to building a robust investment portfolio. If you're looking to take your growing real estate empire in a different direction, you might need the cash to bankroll your new project if you don't have enough to make a cash offer on the new property.
What to do next: Sell quickly so you can take advantage of the 1031 exchange (or like-kind exchange). If you can't acquire the new property within 180 days -- what the 1031 exchange stipulates to avoid capital gains -- and you need the money to finance your new endeavor, consider getting a bridge loan as a short-term lending option.
5. You're through with being a landlord
You've been in the rental game for a while and now you're done. Maybe it's the current tenant situation, or a bad tenant in the past has soured you on real estate investing. Regardless of whether you're parting ways with the landlord life on good terms or on bad, you'll still have to figure out how to offset the capital gains.
What to do next: Consider selling your primary residence instead and moving into your rental property, which will then become your principal residence, in order to avoid more taxes. Then find something else to invest in. If you're truly done with being a landlord, try to find another stream of passive income. You might not have to give up the real estate game altogether, especially if you add some REITs to your portfolio.