When going through the myriad of items in your due diligence of evaluating rental real estate to purchase, it would be a good idea to spend at least a little time thinking about what the implications of selling that same piece of property might be at some point in time down the road. Why? Because many of the decisions we make about properties early on can directly impact our options over the course of that investment. Even if we cannot change some of those implications by thinking about them ahead of time, it is always easier and more palatable to know what to expect at the outset instead of getting a surprise later that you hadn’t planned for. Let’s go over a few areas in this regard:
1. Who will be your buyer in the future?
Sometimes you might end up with a rental property that is odd in some way: an unusual location or unique design or nontraditional floor plan. This might work out to be a great rental for those very reasons, but given the opportunity to plan accordingly at the outset, those types of properties might also limit the pool of buyers you have in the future should you decide to sell your rental. Most likely, to have the best chance of selling your property at a great price you will need that property to have significant demand from renters AND buyers. That could mean a duplex close to a hospital that is a popular area for graduate students to rent or a multifamily property with a good mix of 1 and 2 bedroom apartments in an urban area that will attract students or working professionals. Whatever that looks like in the market you are considering, set yourself up for as many buyers at your exit point down the line by buying a property that will have ongoing appeal and demand in that area.
2. Consider the impact of depreciation recapture upon a sale.
One of the significant benefits of owning rental real estate is the ability to reduce taxable income by utilizing the depreciation of an asset. However, upon the sale of a property the portion of the gain on the sale that is attributable to the depreciation deduction is taxed at ordinary income tax rates compared to the rest of the gain which is subject to long term capital gains tax rates (assuming you have held the property for greater than 1 year). You do have the opportunity to offset this depreciation recapture with carryover capital losses, but you should be working with your tax advisor to make sure you are fully aware of how the gain on a sale will be taxed so you don’t end up with significantly different tax liabilities than you planned on.
3. Consider your investing goals and timeline.
The goals and timeline of each real estate investor will be different depending on so many individual factors: age, investment strategy, number of years until retirement, what retirement income levels will be, etc. All of these things should factor in to what you buy and how long you plan to hold a property. If your plan is to acquire just a few single family homes for a few hundred dollars of extra cash flow each month, hold those houses for several decades until paid off and then leave them to your children then you aren’t going to be as considered about the tax implications as if you plan to buy several properties in anticipation of selling or exchanging them in X number of years to fund another investment or goal. You will want to take into consideration what tax bracket you will likely be in at the end of the anticipated timeframe you have for holding that asset: will you be retired from your professional career and be in a different tax bracket (higher or lower)? Also, if you are investing with partners, what are the agreed upon exit strategies of the other partners and how does that impact your investing and tax strategy buying into a property with others. Again, everyone’s situation is unique but the main point is to always consider the exit strategy (preferably strategies) and your predicted life circumstances before you even buy.
4. Consider in what entity or personal name you choose to hold title to a property.
If you think you might utilize a 1031 Exchange at some point in time to defer taxes on the sale of a rental property, be aware that the name(s) of the person or entity taking title to the new property is required to be the same as the name of the person or entity selling the relinquished property. This makes sense if you think about it in terms of how things would continue to be consistent for tax purposes in regards to the person or entity’s taxpayer I.D. number as it must remain the same to roll from one property into another. For practical purposes, this means that if you hold title to a property individually as “John Doe” you will be required to take title to the new property as “John Doe” as well. Similarly, if the property is owned by “123 Main Street, LLC”, you will be taking title to the new property as “123 Main Street, LLC” as well. As with many things related to taxes, there are a few technical exceptions to these rules, but these are all things you should consult with your own tax professional on to make sure everything is tailored around your own particular situation.
5. Don’t let unplanned expenses create a situation where you need to sell a property prematurely.
Perhaps you bought a rental property because it seemed like a good deal and it was close enough to your primary residence that you knew you could handle the management, maintenance, and upkeep in your spare time. With this plan in mind you might have neglected to factor in any property management costs or maintenance and service provider expenses into your pro forma. Perhaps a few years later you end up needing to move out of state and now have to consider either hiring a property manager or selling the property. Hopefully with the additional expenses of property management and maintenance you can still generate a profit. If not, you might feel the need to sell a property before you were really ready to do so. Anytime this happens you are somewhat at the mercy of the buyers in the market or economic factors to determine what you are able to sell your property for rather than selling at a time of your choosing when conditions are optimally favorable for you. All of this to say that you should always be very thorough and as accurate as possible in running the numbers on a property so as not to create a situation where unanticipated events or expenses dictate the fate of your property.
Hopefully this has given you a few more things to consider at the outset when thinking about purchasing a property. Always have the end goal in mind and a strategy to get there! Feel free to share any other considerations you have learned about planning your exit strategy in real estate.