10 Tips for Selling Rental Real Estate - dummies

10 Tips for Selling Rental Real Estate

By Eric Tyson, Ray Brown

Following are some critical issues for you to consider before trying to sell your rental real estate. And, because the profitability (that is, your rental income less expenses) of your rental property has an enormous impact on the property’s worth, also provided are tips for boosting your property’s profitability well in advance of selling.

Don’t Inadvertently Convert Your House into Income Property

Suppose you list your house for sale and it sits and sits for months on end without any offers. You need to move, and because you’re not Bill Gates, you can’t afford to leave the house vacant while you’re making your mortgage payments, paying property tax and insurance payments, and simultaneously shouldering the cost of renting or buying another home. So, you decide to rent out your difficult-to-sell house for several months while it’s still on the market.

If you cease seriously trying to sell your house while renting, the IRS deems that you’ve converted your home into rental property, and you owe capital gains tax unless you buy a replacement rental property. If you have any doubts about running afoul of the tax laws, please consult with a good tax advisor.

Exercise Extra Care When You Sell Rental Property

The IRS makes a distinction between property a taxpayer lives in and property he rents out to others, even if both are within the same building. You need to understand this distinction and its tax implications.

For example, suppose you’ve owned and lived in a home for a number of years. Your house has an attached rental unit that you rent out. You’ve claimed depreciation deductions for the rental portion of your property on your annual income tax return. Suppose further that the rental unit accounts for about 25 percent of the total living space of the building. When you sell the property, the IRS treats the sale as two separate transactions — the sale of your primary residence (the 75 percent portion of the property) and the sale of a rental property (the other 25 percent portion of the property). Therefore, 75 percent of your profits are subject to the primary residence capital gains exclusion rules.

As for the profits on the rental portion of the property, you owe capital gains tax on those profits unless you buy another building with a rental unit that meets the particular requirements.

Know How to Defer Your Investment Property Profits

Taxable profits on the sale of an investment property often are much greater than on a comparable residential property. The difference is that the IRS allows you to depreciate investment property while you own it and deduct the depreciation amount from your income taxes every year. The tax break is nice, but the IRS always is careful not to give people too much of a good thing. Therefore, when you sell the property, you must factor the depreciation you took on the property into the property’s adjusted cost basis.

Suppose you buy an investment property for $250,000, and many years later you sell it for $400,000. During your years of owning the property, you claim a total of $50,000 in depreciation on your tax returns. The amount of depreciation reduces your cost basis from the original $250,000 purchase price to $200,000, thus making your “taxable profit” that much larger. You owe capital gains tax on $200,000 — the difference between the sale price of $400,000 and the adjusted cost basis of $200,000.

Fortunately, you can defer taxes on these gains by rolling over your profits into another investment property. If you simultaneously sell an investment property and buy another, that one exchange is called a 1031 exchange (1031 refers to the section of the tax laws that allows these exchanges). If the exchange isn’t simultaneous — that is, if you delay your purchase of the second property — you must meet some specific requirements (called the Starker rules, after a famous tax case).

If you’re going to do a Starker or a 1031 exchange, be sure to enlist the help of an attorney or tax advisor who’s an expert at these transactions to ensure that you do it right. You need an experienced professional to help you jump through the many legal hoops (such as filling out special tax forms like Form 8824, which tells the IRS you bought a “like kind” investment property).

Understand Your Local Market to Time Your Sale

If you own property that you hold solely for rental/investment purposes, you probably have a great deal of discretion about when you sell the property. As with other investments, you may wonder when a good time to sell is.

Surely you have some sense from watching real estate prices and rental vacancy rates whether your local market is strong, weak, or somewhere in between. Although you can’t predict future real estate prices in a given community, to help you better determine whether now is a good time to cash in your chips, examine the following factors:

  • Economic health: The vitality of the local employment market is crucial to a healthy local real estate market. What’s the unemployment rate in your local area, and how does that rate compare with prior months and years?
  • New construction: If real estate prices have been on the rise, the number of new building projects may be on the increase, which can be a sign that now is a good time to sell. As more properties come onto the market and prices spiral higher and higher, eventually the increase in construction acts like water on a fire, extinguishing future strength.
  • Available land: Housing units must be built on land; the less land that remains available for development, the more upward pressure is exerted on housing prices.
  • Housing for sale: All things being equal, the fewer properties for sale, the better the environment in which to be selling. In a strong real estate market, housing sells relatively quickly and the inventory of property for sale is in relatively short supply.
  • Rental real estate market health: Although being a renter is tough when vacancy rates are low and falling and rental rates are escalating, being the owner of rental/investment real estate is great. Rental real estate is worth more when the local rental market is strong.

You need to spend some time and energy tracking down useful information. Try these suggestions:

  • Your local Association of Realtors should be able to provide you with some historic house sales data.
  • The local Chamber of Commerce can steer you in the direction of job market data.
  • The U.S. Bureau of Labor Statistics also compiles employment data.
  • Apartment and other rental property owners also have local associations that can provide you with rental data on the local market.

Understand Opportunities for Adding Value

Before you bought your property, you should’ve taken the time to research and understand the effects of zoning or possible rezoning on your property’s use. A surprising number of real estate buyers, however, neglect this important step. Even if you did understand the zoning of the property before you bought, the mood of your local planning department, which interprets zoning laws and approves building projects, may have changed in the meantime.

So, before you consider listing your property for sale, be sure you know how you can improve its use and value. Even if you don’t want to do significant renovation or contracting work, you need to at least understand how you can further develop the property so you can sell for a higher price by promoting the opportunity to add value.

Maximize Your Property’s Rental Income

The income and resulting cash flow (income less expenses) that a property can generate drive the amount a rental property is worth. Suppose you can purchase a four-unit building in a rural area or you can buy a similar four-unit building in an upscale suburban community just a half-hour’s commute from an economically robust city.

If each unit in the rural building rented for just $650 per month whereas those near the city rented for $1,000 per month, which building do you think would be worth more money? Or, looking at it another way, which building would you prefer to buy if both buildings were for sale for the same price? Higher rents translate into a much higher property sale price.

Suppose property like yours typically sells for ten times the property’s gross annual income. For example, each unit rents for . And market value.

Suppose that, through property improvements, you can increase the unit rents by 10 percent. Now the building is worth . And market value. Thus, a mere $100 per month per unit increase results in a $48,000 increase in the building’s value.

Plan for the sale of your rental property as far in advance as possible so your rental income is maximized. If any units are coming vacant, examine what upgrades can be done to boost the rent you can charge. Also consider what enhancements you can make to the building and survey the local rental marketplace to ensure you’re not underpricing units.

Minimize Your Property’s Expenses

In addition to maximizing rental income, you can also increase a property’s cash flow by minimizing its expenses. Planning at least a couple of years in advance for the sale of your building should give you enough time to make your property more cost efficient to operate and therefore more profitable and appealing to the next buyer.

For example, although you have to shell out some money upfront, investing in energy efficiency by insulating your property and installing modern appliances can really slash your operating costs. If you haven’t evaluated your insurance for at least a couple of years, shop around to be sure you’re getting the best insurance value that you can.

Don’t be penny-wise and pound-foolish. If you have doubts about the value of your property, even after having real estate agents prepare a CMA, spring for the fee of several hundred dollars to hire a good real estate appraiser who has experience with rental properties like yours in the area.

Utilize Agents with Investment Property Experience

Be sure to hire an agent who specializes in selling your type of investment property in your area. An agent lacking experience with selling investment real estate similar to yours may misprice your property or lack the special skills necessary to market and successfully sell it — or both! Be sure to ask agents you’re interviewing for activity lists detailing each property they listed and sold during the past year.

Visit Comparables and Review the Valuation Analysis

Especially if you’ve owned investment real estate for a number of years, your property may be very valuable. But if you overprice your property, it may sit unsold for many months and end up fetching less than it otherwise could in the real estate marketplace. Underprice your property and you may leave money on the table.

If you’re going to hire a real estate agent to help sell the property, interview at least three agents who specialize in selling such property in your area. Each agent should prepare a comparable market analysis (CMA) to evaluate your property’s worth.

By digging into the details of each CMA the agents provide you, you can better determine your property’s real worth. And as you continue finding out more about your local market and visiting properties, you can determine which agent did the best job with her analysis.

For properties that have sold recently, there’s no substitute for actually seeing the property. You may be surprised at how many property owners are willing to show you their properties. Remember, though, you won’t get to see any unless you ask.

Some rental buildings simply are a pain in the posterior to find comparable sales for. Perhaps no similar buildings have sold for a long time in the area or no similar properties exist.

Don’t be penny-wise and pound-foolish. If you have doubts about the value of your property, even after having real estate agents prepare a CMA, spring for the fee of several hundred dollars to hire a good real estate appraiser who has experience with rental properties like yours in the area.

Work with Tax and Legal Advisors Who Understand Rental Property

If you’re dealing with rental real estate, expect complicated and unclear tax and legal issues to get in your way. If you choose to hire advisors to help you navigate the morass, be sure you’re getting your money’s worth in good advice.

Working in residential real estate isn’t sufficient experience for advisors to whom you’re paying high fees for advice about your rental property. Tax and other laws pertaining to rental property sometimes differ tremendously from laws regulating owner-occupied housing. Hire advisors who specialize in dealing with rental property.