Don't Sell - Refinance!
Selling your rental property is the big payday you dreamed of when you bought the building years ago.
Alas, there is a lot more to selling than just finding a buyer. It’s expensive. You already know about real estate commissions, doc stamps, title insurance, legal fees, etc. But do you realize how much the IRS is going to take?
Depending on how long you've owned the property, Federal taxes can be a real gut punch! In fact, many investors regret selling after they see the tax bill.
Veteran real estate investors almost never sell their rental property. Instead they borrow against the equity, that's tax free cash, plus they get to keep the property (Asset Leveraging). Then, if they want to give up their landlord responsibilities, hire a management company.
It really is that simple. Below, we’ve laid out the elements which make up these transactions. Plus, there's a spreadsheet attached so you can run your own test cases.
Finally, here is a link (Click Here) to a YouTube video by ProPublica titled: “Buy, Borrow, Die". It’s a terrible title but they do a good job of laying out the pros and cons.
Read on.
SELLING RENTAL PROPERTY - The Costs
Real Estate Agent Fees
If you use a Real Estate Agent to sell, the commission is typically 3% to 6% of the selling price.
Closing Costs
Including title insurance, legal fees, escrow fees, transfer taxes, etc.
Capital Gains Tax
If the selling price exceeds the original purchase price you'll owe between 15% and 20% (depending on your tax bracket) Capital Gains Tax on the difference.
Depreciation Recapture
Each year IRS calculates depreciation of your residential rental property evenly over a period of 27.5 years. When you no longer own the property, through sale or loss, all of this Depreciation is "recaptured" and taxed at a rate of 25%.
Net Investment Income Tax (NITT)
If your family's adjusted gross income is greater than $250,000 in the year the property is sold, you must pay Net Investment Income Tax (NITT) which is currently 3.8% of the selling price.
Other Potential Costs
Like repairs needed to sell the property and mortgage payoff, etc.
REFINANCE & HOLD
(See Example Below)
Tax-Free Cash
By refinancing, you put the proceeds of the loan in your pocket. There are no taxes to pay for those dollars - Ever!
Continued Ownership:
When you refinance, you still own the property and collect rent just like before; and, given the certainty of inflation, these rents will appreciate and provide future income. Oh, and increasing rents means the value of the property continues to increase which means you may be able to refinance again in a few years. More tax-free cash!
Management:
If you don't want to be a landlord anymore, hire a Property Management Company to take on those demands. At around 10% of rents its a bargain!
Rental Income Can Pay Debt Service:
The net income from rentals is usually enough to pay the expenses of ongoing rental operations including the new mortgage.
Long-term
The property will continue to produce income in perpetuity.
Stepped-Up Basis at Death:
At your death, the property's tax basis is "stepped up" to its current market value. This means your heirs inherit the property at this new, higher basis which means, if they want, they can immediately sell and avoid capital gains tax and recaptured depreciation tax.
Example Analysis
Sell Rental Property Vs. Refinance and Maintain Ownership
OPTION 1 - SELL
ORIGIONAL BASIS
Original purchase Price Minus Land Value ..............$150,000
Improvements Over 20 Years.............................$ 15,000
Adjusted Basis (Purchase Price + Improvements).........$165,000
DEPRECIATION
Ownership Period....................................... 20 Yrs
Annual Depreciation ($165,000 divided by 27.5).........$ 6,000
Accumulated Depreciation ($6,000 x 20 yrs).............$120,000
ADJUSTED BASIS
Purchase + Improvements - Depreciation.................$ 45,000
TAX CALCULATION
Selling Price..........................................$300,000
Less Adjusted Basis....................................$ 45,000
Capital Gain (Sale Price Less Adjusted Basis)..........$255.000
ESTIMATED FEDERAL TAXES
Capital Gains (15%)....................................$ 38,250
Recaptured Depreciation (25% of Accum Depreciation)....$ 30,000
Total Estimated Federal Tax............................$ 68,250
Note: Net Investment Income Tax (NITT) is 3.8% of
selling price ($11,400) if your adjusted gross income
exceeds $250,000 in the year sold. Not included here.
ESTIMATED SELLING EXPENSES
Sales Commission (6%) .................................$ 18,000
Title Insurance........................................$ 2,250
Doc Stamps.............................................$ 2,100
Other Closing Costs....................................$ 1,000
Total Selling Expenses.................................$ 23,350
PROFIT
Proceeds from Sale.....................................$300,000
Less Selling Expenses..................................$ 23,350-
Less Estimated Federal Taxes...........................$ 68,250-
Total Expense & Tax....................................$ 91,600-
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NET CASH AT SALE.......................................$208,400
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OPTION 2 - Refinance & Hold
REFI
Tax Free Cash(Mortgage)(75% of Market Value)...........$225,000
CONTINUING OPERATIONS
RENTAL PROFIT & LOSS
Monthly Rent...........................................$ 2,100
Monthly loan payment (30 yrs @6.2%)....................$ 1,368-
Estimated Monthly Property Tax.........................$ 275-
Estimated Monthly Insurance Expense....................$ 170-
Estimated Monthly Vacancy Rate.........................$ 105-
Estimated Monthly Management Cost......................$ 250-
Estimated Monthly Maintenance Cost.....................$ 200-
Total Expense..........................................$ 2,368-
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Net Monthly Cash Flow .................................$ 268-
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CONCLUSION
In this example, you receive $208,400 after expenses and taxes when you sell the property. By refinancing, you receive $225,000 tax-free while retaining the property and receive net income from operations for the rest of your life with the likelihood of refinancing again as equity grows.
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