Tricky tax rules, existing lease terms, and wear-and-tear from tenants can make selling a rental property a major headache. —-
DISCLAIMER: As a friendly reminder, this blog post is meant for educational purposes only and is not intended to be construed as financial, tax, or legal advice. HomeLight always encourages you to reach out to a tax professional, real estate attorney, or other advisor regarding your personal situation.
Owning a rental property is great… until it’s not. Kyle McCorkel, a seasoned real estate investor in Hummelstown, Pennsylvania, saw the writing on the wall when the property taxes for one of his rentals spiked by more than $2,000 annually. At that point he knew it was time to sell. Shortly after, a pandemic-driven housing market boom encouraged him to unload an additional two rentals while prices were hot.
“My expenses were going up faster than rent was going up, so I decided to seize the opportunity to cash out and move my equity into better performing investments,” he says.
Let’s not sugar coat it, though. Tricky tax rules, existing lease terms, and wear-and-tear from tenants can make selling a rental property a major headache. However, when the time is right, you need to act — and with the right approach and preparations, you can make a graceful exit without too much disruption.
With tenant communications and handling repairs weighing on your to-do list, here’s what experienced rental property owners, landlords, and real estate agents say it will take to pull off a smooth rental property sale.
1. Don’t get blindsided by hefty capital gains taxes.
When you go to sell a house you’ve used as your main residence, the upside you make from that sale is usually tax-free. Generally, you can make a $250,000 (if single) and $500,000 (if married) profit without owing in taxes on the sale so long as you’ve owned the house for two years, and lived in it for two of the past five years.
However, the IRS doesn’t extend the same generous capital gains tax breaks to property investors as it does to owners selling a primary residence. You’re playing the ball game with different rules.
Most likely, your rental property has increased in value over time, resulting in a capital gain i.e., the profit you earn when you sell) like any other house. However, since you’ve been renting the property rather than living in it, you won’t qualify for the “use” test of the capital gains exclusion, meaning that any profit you make, even under the $250,000/$500,000 threshold, could be taxable.
If you’ve owned the rental property for just one year or less, the profits will be considered short-term capital gains, which are taxed at the same rate as your income. That means depending on your tax bracket, you could owe anywhere from 10% to 37% per tax code as of this writing.
But if you’ve owned the property for more than one year, the long-term capital gains are taxed at a lower rate: 15% for joint filers earning between $78,750 and $488,850, or 20% for filers with taxable income of $488,851 or more.
If your taxable income is less than $80,000, you’re off the hook for paying capital gains taxes. But even if you earn more than that, there may be workarounds to avoiding them (read on to learn more).
2. Defer capital gains taxes with the 1031 exchange.
Maybe it’s time to unload a poor-performing rental property in a declining neighborhood, but you want to try your luck in an up-and-coming area. With the 1031 exchange, you may be able to sell one property and then buy another “like-kind” property with more income potential, without having to pony up the capital gains tax.
What exactly does “like-kind” mean? Well, you can’t use the 1031 exchange to buy a personal residence that you intend to live in — it has to be another investment property that you plan to rent out or flip. And the clock starts ticking as soon as you’ve sold the first property. You have 45 days to find and identify up to three properties you’re interested in purchasing, and a total of 180 days to close on the chosen property.
“In addition to the timing of the sale and subsequent purchase, there are many other rules that you must follow with a 1031 exchange, so the most important first step is to contact a qualified intermediary, whose job is to facilitate all aspects of the exchange and ensure that you follow all the required steps,” says Eric Hughes, founder and CEO of Rental Income Investors, an advisory service for new investors in New York.
3. Consider living in your rental before selling.
If you don’t want to use the 1031 exchange to parlay your profits into a like-kind property, another option is to move into your rental home before you sell. As long as you live there for at least two years, you’ll pass the IRS’ “ownership and use” tests, which require that you’ve:
- Owned the home for at least two years (the ownership test)
- Lived in the home as your main home for at two years of the past five years (the use test)
When you pass these tests, you’ll be eligible to waive capital gains taxes for up to $250,000 (if filing single) or $500,000 (filing jointly). However, if the rental property is an investment turned sour, you may be better off unloading it now to cut your losses.
4. Honor your lease period, or give tenants ample notice to vacate.
If your rental property is occupied when you decide to sell, one option would be to negotiate with the tenants and offer an incentive for them to vacate. But if they’re intent on staying put, or if you have a good tenant and want to use that as a selling point, you’ll have to respect the terms of the lease.
In most states, the lease agreement will be transferred with the sale and the new owner can only make changes after the current lease has expired. “If your tenant has six months left on their lease, then buyers will have to accept the lease agreement as part of their purchase,” says Robert Taylor, a residential real estate investor with over 15 years of experience with renting and flipping homes in Cameron Park, California.
If your tenants are month to month, you can choose to give them notice to vacate. Check to see what the rules are in your state. In Taylor’s state of California, landlords must give 30-day notice to tenants who have lived in a property less than a year, and 60-day notice if they’ve lived in the property longer than a year.
“Also keep in mind that different states have different rules during the COVID pandemic regarding giving tenants notice,” Taylor warns. “Additionally, evictions without cause are currently prohibited due to federal moratoriums.”
5. Use a good tenant as a selling point.
Hughes points out that for some investors, an occupied property is preferable to an empty one. “If you’re selling with a tenant, remember that you’re marketing the property to investors only, so you should include information in the listing that investors will care about,” he says. These might include:
- How long has the tenant been in place?
- What’s the monthly rent?
- Is the rent paid consistently on time?
- Does the tenant cover any utilities?
- What security deposits, licenses, or other permits are in place with the lease?
- When does the lease expire?
- Does the tenant take good care of the property?
To keep your tenants happy and cooperative during the selling process, you might consider offering some type of incentive — perhaps gift cards or discounts on rent — in exchange for keeping the property looking its best and being amenable to showings.
6. Evaluate the property for needed repairs (they’re tax deductible!).
It might be tempting to get a rental property off your hands as quickly as possible by listing it right away, warts and all. And you might get lucky enough to find an investor who wants a house that needs some work in exchange for a better deal. But it might be worth your while to fix that leaky faucet, jammed window, or creaky door before you sell.
“Generally speaking, a clean, updated, home sells for a higher price than a rental property in need of repairs,” says Taylor. “However, the cost of lost rents, repairs, and other expenses can often exceed any profit you may have made fixing up your property to sell it.”
When deciding whether or not to spend the time and money on a repair before listing, ask yourself these questions:
- What’s the condition of the real estate market? Is it a low-inventory seller’s market, where buyers are more likely to forgive undone repairs, or are you competing against many other properties at your price point?
- Will you need to work around tenants to make the repairs?
- Do the repairs require the property to be empty, thus sacrificing rental income?
As long as you’re not doing a 1031 exchange, any repairs you make on a rental property — defined by the IRS as “expenses to keep your property in good working condition but that don’t add to the value of the property”— will be tax-deductible. The key is to know the difference between “repairs,” which are immediately deductible, and “improvements,” which the IRS treats differently because they’re seen as adding value.
“For example, if you replace the roof of your rental, the IRS considers that an improvement that must be depreciated over several years,” says Taylor.
“But if you make a repair by replacing some flashing or roof shingles, that could be considered a tax-deductible repair.”
When in doubt, consult a skilled tax professional for clarity.
7. Don’t count on rental income to drive up the price.
While a good, well-paying tenant could make your single-family property more marketable to investors, don’t expect it to inflate the value.
“When single-family rental homes are appraised, they are appraised just like any other single-family home,” explains Taylor. “But if your rental property falls under the classification of multi-family housing, meaning it has five or more units, your appraisal will be based on the rental income.”
That means raising a tenant’s rent won’t have an effect on the appraised value, but it could make your property more attractive to investors looking for reliable rental income.
8. Hire an investor-savvy real estate agent to market your property.
It might be tempting to try to sell your rental property on your own, but the marginal amount you’d save on commission costs (about 5.8%, per the national average) could pale in comparison to the higher price that a real estate agent would fetch.
Researchers at leading real estate data source Collateral Analytics, now owned by Black Knight, looked at numerous geographic real estate markets, including Phoenix, San Diego, and Boston from 2016-2017 to study the price differential between FSBOs vs. traditional agent-represented sales.
Their report concluded that the gap in “selling prices for FSBOs when compared to MLS sales is remarkably close to average commission rates.” On average, the study found, FSBOs sell for 5.5% less, and in some cases nearly 6% less, than agent-assisted sales, indicating that expertise real estate agents bring to a sale often more than makes up for their cost.
To get an even bigger advantage, consider looking for an agent who specializes in working with investment properties and can offer insider’s access to:
- Rent trends in your area
- Tax implications of selling a rental
- A network of investors seeking properties like yours
- Return on investment
- After-repair value (AVR), an important metric for investors
It is possible to sell your single-family rental property and still maintain your sanity. If you’re not sure where to start, connect with an experienced real estate agent to get you on the right path. Along the way, you just might find your next rental investment waiting in the wings.
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