Thinking about selling a rental property? There are a few things you should know before you do.
For one, the capital gains tax on a rental property is much steeper than it is on a primary residence.
Also, when it comes to a tenant-occupied property, the process is a little more complicated. Your tenant, after all, still has leasehold rights.
Finally, "as-is" clauses can protect you from a slew of costly lawsuits.
Now that you've gotten the "tldr" version, let's take a deeper dive ...
When you sell your property for a profit, you owe capital gains tax. The 2020 capital gains tax rates are as follows:
So, most of the time, you’ll end up paying at least 15-20% for capital gains tax. You’ll also have to pay capital gains tax on the amount that you claimed in depreciation over the course of your ownership of the property. If you claimed over $25,000 in depreciation, and you sold the house for $75,000 more than what you bought it for, then you’ll have $100,000 of total taxable capital gains.
If you just want the money, you’re going to have to pay the tax-man. However, if you’re looking to re-invest, there’s a strategy to avoid the capital gains tax.
One way to get around the tax bill is to immediately re-invest the money into like-kind property, also known as a 1031 exchange. As long as you choose a new property in 45 days and close the sale within 6 months, the IRS allows you to keep the money you made in escrow, deferring capital gains, until you put that money into a new property.
You could do 1031 exchange after 1031 exchange, never having to pay for capital gains, as long as you hold the properties for longer than 2 years to avoid triggering “dealer status,” according to the IRS.
However, if you realize that you don’t want to be a landlord or you’re trying to raise money for another venture, you’re just going to have to pay the taxman.
Another way to avoid a sizable tax bill (albeit not entirely, of course) is to incorporate. You might have less access to the gains, but the savings on your tax bill will likely make this a desirable option regardless. There are some serious tax benefits to using an LLC structure. You might want to discuss the details with a qualified CPA.
Incorporating also helps you protect your assets from any liability issues, as well as protecting your anonymity.
What if you’re selling a rental property but there’s still a tenant living on premises?
The exact laws might depend upon your state, so check the Landlord-Tenant laws wherever the property resides, but you generally have a few options:
The easiest option, by far, is to wait for the lease to expire. You might want to check the lease for an early termination clause. That way, if you can prove that you absolutely need to sell, you might be able to break the lease.
Additionally, you could try to incentivize your tenant to move by offering them cash to cover the cost of moving. This is only a good option if you know that your property is going to sell for much more than you bought it for. If you’re cutting it close, you don’t want to cut it even closer by having to pay to get a tenant to move.
And, finally, you could try to find another real estate investor interested in buying a tenant-occupied property. The downside here is that your property is much less marketable. There’s a wider swathe of possible buyers for single-family homes, but a much narrower market for rentals.
What is an as-is clause? An as-is clause is a condition clause: the buyer is purchasing the property “as-is.”
It typically states that “the buyer accepts the item for sale in its presently existing condition without modification or repair.” Without it, the buyer is relying upon the seller’s representation of the property. In some cases, that gives the buyer solid footing for a lawsuit.
Now, that doesn’t mean that the seller can engage in any knowingly misleading behavior, or attempt to hide a defect in the property, but it does provide additional coverage in case there are any disagreements. Sometimes there are issues with the property that the seller doesn’t even know about, but that won’t stop some buyers from filing a lawsuit.
To avoid the worst-case scenario, include an “as-is clause” in the sales contract when you’re selling your rental property.
When it comes to selling a rental property, there are three things you need to know:
1) The capital gains tax for rental properties is not the same as for primary residences, and it can take a serious chunk out of your potential profits. You might be able to avoid capital gains tax (or minimize it) in one of two ways. First, you could do a 1031 exchange. Next, you could incorporate to see if you can take advantage of certain tax benefits.
2) Selling a property with tenants still there is not an easy task.
3) When you do sell your property, make sure to include an “as-is clause” to avoid the potential for certain lawsuits. Interested in learning more? Read our article “The Rental Property Asset Protection Checklist.”
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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