The Rent House

“It sure seemed like a good idea at the time.” Buying an REO (Real Estate Owned) from the RTC (Resolution Trust Corporation)1 in 1989 was a bargain. The cash flow was great and depreciation sheltered most of it. Thirty years later that same property is fully depreciated and the only tax benefit comes when the landlord spends his hard-earned capital on remodeling or a new A/C unit. The cap rate2 is lower because the property has appreciated and rents have not kept pace. It is not uncommon in many growth areas across the country to find apartment buildings competing in neighborhoods where rental property owners once were the only choice. Property taxes chew up a significant amount of the rental income on a single rent house.

The RTC may have provided an excellent entry strategy, but many landlords now seek an exit strategy. Preferably, a customized, common-sense solution that is tax-efficient while creating reliable retirement-style income.

Four Reasons Landlords Sell Rental Property

  • Selling while taxes are low:On March 14, 2019, the Tax Foundation, a Washington DC non-profit policy advisory firm wrote: “In February, billionaires Warren Buffett and Bill Gates suggested increasing taxes on the wealthy to pay for policies that would help people without market skills keep pace in an increasingly specialized economy. Each has proposed increasing tax rates for capital gains as one potential way to generate revenue for this purpose.”3 As a reminder, the 1986 Tax Reform Act 1) eliminated the capital gains tax differential; 2) created passive loss limitation rules; and 3) lengthened the tax write-off period for real property. What ensued a sell-off of commercial real estate. In many cases, before owners could react. The sell-off depressed property values which led to loan restructures which, some argue, led to the creation of the Resolution Trust Corporation. This is a simplified explanation of the savings and loan crisis which really began in the late seventies. The point is that tax law changes matter and those who can, sell prior to a decline in real estate prices and position their replacement property, fair better than those who cannot or do not take action.
  • Selling before the properties age: Single family rental properties are aging across the country. The rule of thumb is maintenance costs are approximately 1% of the home’s value. However, as the home ages the maintenance costs rise approximately 1% per decade. So, if a landlord owns a 30 year old property, it is also costing more (approximately 3%) to maintain. If it is also “depreciated out,” the tax advantages don’t offset the rising maintenance costs. Each of these factors affect the Taxable Equivalent Yield – T.E.Y. – (i.e., Tax-adjusted Cap Rate) of rental property.
  • Selling before the landlords age:A survey of married couples who own rental property has shown that the longer they own the property the more disparity appears. One spouse may want to travel or spend more time with the grandkids while the other feels the need to “double down” on the rental business. The joy of owning rental properties loses its luster over time and married couples are increasingly aware of this. Once tax advantages are reduced (depreciated out) and maintenance costs have risen (aging property), the couple tends to focus on their remaining goal of monthly income (mailbox money).

Can a Landlord Retire?

Couples consider retirement at differing ages and times, also. Spouses with a 9 to 5 work schedule tend to leave the rental business to the spouse with the most flexible schedule. Over time, one spouse envisions retirement as leaving a job and “retiring” into the rental business while the other wants to retire out of the rental business.

Older couples, who once performed all the maintenance on their rental properties, find it physically impossible to keep up the pace of their younger years. The costs of hiring and out-sourcing maintenance reduces their monthly income at the very time in their lives that they need it most.

Lastly, couples tend to disagree on “what the children want.” One investor told this author that he was going to leave all of his rentals to his son. His wife, active in their business, responded that their son didn’t want or need the rent houses. Interestingly, the son, a cardiothoracic surgeon living in another state had not yet been consulted. Leaving an inheritance of rental units can be good for some heirs, but a giant headache for others.

These are the most mentioned reasons why landlords are seeking an answer to “how to retire.” They are not, however, every reason. Each landlord is in a different place. Some simply need to “downsize” (from 5 renthouses to 2), while others want to sell everything and upscale into a Delaware Statutory Trust (DST). The attractiveness of “mailbox money” is leading many to join the growing number of real estate investors, who are moving from active to passive real estate.

Landlords are talking more about this today, mainly because property values are so high while rent payments (impacted by the growing number of apartment complexes) have remained stagnant.

1031 Exchange Investment Option

Exit strategies are important for business owners, CEOs, investors and landlords. How to use tax laws and investment strategies to create income, save taxes and transfer wealth to the next generation is what we do professionally. DSTs are one tool.

Delaware Statutory Trusts (DSTs) are growing in popularity as replacement property.4 Used since the 16th century, these trusts were adopted by the state of Delaware in 1947 and reached national prominence with the Trust Act of 1988 followed by the IRS Revenue Ruling of 2004.

Addressing Landlords’ Concerns

Concern: The rise in property values and rent payments have slowed to a crawl.

Possible Solution: A DST provides diversification of property type and geographical diversification. Choices include multi-family residential, office, retail, industrial, hospitality, assisted living, golf courses, self-storage, and even oil and gas producing wells. DSTs are designed to provide a projected rising income to combat inflation.

Concern: Taxes – capital gains, ACA5 tax and depreciation recapture.

Possible Solution: A DST is eligible for 1031 exchanges which completely eliminates all taxes in the year which the rental property is sold. Sometimes two properties are exchanged with cash leftover. This is called “boot” and it creates an unwanted taxable event. A DST is a popular solution to the “boot”6 problem. Additionally, a DST is a favorite estate planning tool because re-registration is inexpensive and easy for passing real estate to heirs, who, in turn, receive a step-up in cost basis. This step-up can eliminate lifetime taxes on that property.

Concern: Tenants, Taxes and Toilets.

Possible Solution: A DST eliminates these “Terrible T’s” because it is designed specifically to provide cash flow. Some investors refer to this as “mailbox money.” Properties inside of a DST are prohibited from requesting additional capital. No “cash calls” for maintenance, insurance or taxes. New properties create a new depreciation schedule. So, the tax advantages of depreciation are “passed through” to the beneficiary owner reducing the taxable amount of each monthly rental income check. Seven restrictions7 of the DST protect the beneficiary owner from cash calls, recourse loans, many landlord liabilities, provides a level of asset protection, creates a delegation of management, eliminates franchise tax and provides the availability of indemnification.

Free Landlord Consultation

When you have rental property for sale, give us a call or schedule a free consultation. Our experiences with landlords could be beneficial to you and yours.

5Affordable Care Act of 2010
6Glossary – Boot