Selling a rental property involves more than just hiring a local real estate agent and holding an open house. In fact, oftentimes it can be more profitable to not sell the traditional way.
Changes in the marketplace, existing tenants, repairs, and taxes can make selling more difficult than it may seem. In this article, we’ll begin by looking at the sign that it may be time to sell, then explain the steps to take to increase your potential profits, and how to minimize your tax bill.
6 Signs The Time is Right to Sell
It’s always tempting to wait to sell at the top of the market. But that may be increasingly difficult to do, given the way that the real estate market has been behaving lately.
Even though most investors buy-and-hold rental property for the long term, the time does come when it’s right to sell. However, making the decision to sell rental property isn’t always just about price.
Here are six signs that the time might be right to sell your rental property:
1. Equity level is high
According to the Federal Reserve, median sales prices of houses sold in the U.S. have increased by more than 53% over the past 10 years, and in some markets even more.
Now might be a good time to turn your equity into cash since no one knows how long home prices will remain so high.
2. Demand for housing is strong
In nearly every real estate market in the U.S., the demand for homes is exceeding supply.
According to Realtor.com, homes are selling lighting fast amid a continuing inventory crunch, spending just 43 days on the market before going under contract.
3. Local market dynamics are changing
Even though the housing market has been performing exceptionally well, nothing only goes up in a straight line forever, and real estate is no exception.
There may be an influx of new construction in the area your investment property is located in, which may make it harder to rent. Or, job and population growth in your town may be slowing down, resulting in lower overall demand for rentals in the local market.
4. Rising interest rates
If you’ve been kicking around the idea of selling your rental property, be sure to keep an eye on the change in mortgage interest rates.
That’s because rising interest rates can make buying rental property more expensive for investors, which may end up driving home prices down.
5. Property needs repairs
Investors with rental property that needs major repairs or capital expenditures – items such as a new roof or HVAC system – may find it makes more financial sense to sell rather than put additional money into the property.
Property with deferred maintenance normally sells at a discount, but after crunching the numbers you may find selling at a slightly lower price more than offsets the cost of repairs.
6. Inherited property
Although there are big benefits to having rental property, owning real estate isn’t the right choice for everyone.
You may have inherited a rental home, but don’t have the desire to be a landlord, and would rather cash out and put the money in the bank.
Steps to Take Before Selling Your Rental Property
Once you decide that the time is right to sell, follow these steps before listing your rental property for sale:
Identify your target buyer
Begin by deciding who your buyer is likely to be. It could be your current tenant, another real estate investor looking for a turnkey rental property, or a buyer looking for a home of their own. Knowing who your target buyer affects how you price your home and what you do with an existing tenant.
Decide on your pricing strategy
Rental property investors may be willing to pay more for a home already rented to a good tenant. That’s because cash flow begins the day escrow closes, and saves the new owner the time, trouble, and lost rental income of having to look for a tenant.
On the other hand, if the tenant or owner-occupant is buying your home, they probably won’t pay more than what the recent real estate comparables show your property is worth.
Order a pre-listing inspection and do repairs
One of the best ways to get top dollar for your rental property is to have the buyer’s inspection come out squeaky clean.
Before listing your home for sale, order a pre-listing inspection to discover any needed repair and fix what you can so that the buyer doesn’t have to worry about the condition of the property.
Conduct a lien search
If your investment property is financed, you have a lien on the property from the lender which is removed when the house sells and the mortgage is paid off at closing. However, you may have other encumbrances such as a mechanic’s lien that you are completely unaware of.
Ask your escrow officer to order a title search and take care of any lien issues ahead of time to ensure that your property transfers to a new owner free and clear.
Inform your tenant
Let your existing tenant know the property will be going on the market for sale. They’ll likely be concerned, so explain to them how their lease and security deposit will transfer to the new owner.
Agree to a showing schedule that isn’t too disruptive to the tenant, and that still helps you sell the property fast to qualified buyers. Consider giving the tenant an incentive for cooperating with showings, such as free weekly cleaning or an Amazon gift card.
Analyze capital gains
When you sell your rental property, you’ll need to pay tax on depreciation recapture and any remaining capital gains. At the end of this article, we’ll take a closer look at the tax consequences of selling a rental property.
But for now, be aware that depreciation recapture is taxed at a maximum rate of 25%, while the current long-term capital gains tax rate ranges from 0% – 20% depending on your income level.
How to Show and Sell a Rental Property
If your property is already rented to a good tenant, you may make more money by selling to another real estate investor.
You’ll need to put together documents for a potential buyer to review, be able to show the investor-buyer the property’s financial performance and market your rental property for sale to a fellow investor.
An investor buying your house will do normal due diligence such as reviewing disclosures and inspecting the property. But, they will also want seller documents that are specific to a rental property:
- Copy of the current lease and rent roll.
- Security deposit information to ensure the correct amount is credited at closing.
- Recent utility bills if paid for by the landlord.
- Maintenance history of the property for the current and prior three years.
- Reports of any insurance claims made going back five years.
- Current and previous year’s property tax bill.
- HOA documents and financial statements, including the homeowners association’s P&L and balance sheet.
- Seller tax returns to compare income reported to the IRS to the rental property financial statements.
The easiest and best way to have all of the financial information and documents available for a rental property is by using a 100% free rental property financial management system like Stessa. Simply enter your property address, connect your accounts quickly and securely, then run the reports you need with just a single click:
- Track unlimited single-family, small multifamily, and short-term rental properties.
- Generate performance reports at the property and portfolio level from your owner’s dashboard.
- Automate income and expense tracking, using your desktop, tablet, or smartphone apps for iOS and Android.
- Run unlimited income statements, capital expense, and net cash flow reports and export tax-ready financials.
- Organize and store all real estate documents online with the industry’s best security that protects your data.
Learn more about how Stessa makes tracking real estate investments simple at Stessa.com
Market to Investors
Owners of rental property may be able to sell faster and earn more profits by marketing directly to other real estate investors. In less than four years, investors have completed more than $3 billion in single-family transactions through Roofstock by marketing listings to a global audience of buyers.
There are no showings or disruptions to the tenant, and sellers earn $8,600 more by selling with Roofstock versus a traditional sales process:
- Submit a listing by entering property information and answering a few questions and uploading some great property photos.
- Roofstock will perform up-front due diligence to prepare your listing for sale, such as gathering documents, ordering a preliminary title report, and securing a property inspection.
- Launch your listing to hundreds of thousands of investors on the Roofstock Marketplace.
- Receive offers and close completely online, generally within a 30 day period after the purchase and sale agreement is signed.
Tax Consequences of Selling Rental Property
Now, let’s look at the potential tax consequences of selling a rental property. In this example, we’ll assume the property was originally purchased for $100,000 and is sold for $150,000. Over the 5-year holding period, $14,500 in depreciation expense was claimed by the owner.
When the rental property is sold, depreciation is recaptured and taxed, and the remaining profits are taxed as a long-term capital gain:
Depreciation Recapture Tax
Real estate investors use the depreciation expense to reduce taxable net income during the time they own a rental property. When the property is sold, the total depreciation expense claimed is taxed as regular income up to a rate of 25%.
Assuming an investor is in the top tax bracket, the depreciation recapture tax would be:
- $14,500 recaptured depreciation x 25% depreciation recapture tax rate = $3,625
Capital Gains Tax
The remaining profit of $50,000 ($100,000 original purchase price – $150,000 sales price) is subject to capital gains tax. At the highest income bracket, the capital gains tax rate for 2021 is 20%:
- $50,000 capital gain x 20% capital gain tax rate = $10,000
In this simplified example, the tax consequences of selling the rental property are $13,625.
How to Defer Paying Tax
Investors selling investment property can defer paying tax on depreciation recapture and capital gains by utilizing a 1031 tax-deferred exchange to buy a replacement property within 180 days of selling the relinquished property.
The basic rules for an IRS Section 1031 exchange are:
- Real estate must be used for business or investment purposes.
- Replacement property must be of equal or greater value to the property sold or relinquished.
- Within 45 days of closing on the sale of the relinquished property, a replacement property must be identified.
- Within 180 days of closing on the sale of the relinquished property, the investor must close on the purchase of the replacement property.
Final Thoughts on Selling a Rental Property
There are a number of reasons for selling a rental property. Investors who bought several years ago and have a substantial amount of equity may decide to cash out, especially when the demand for housing today is so strong that buyers are making offers almost too good to refuse.
Other times, owners sell because significant repairs are needed and they’d rather sell than fix, or people inherit property and don’t want to deal with being a landlord.
If your property is occupied by a good tenant, it may be possible to increase your profits by selling your home as a turnkey rental property to another real estate investor looking for recurring cash flow.