Lesson 11
Disposing of Property
Many of the aspects of buying
an income property are also important when selling one. One just views
things from the other side of the transaction. We won't, in this
lesson, try to deal with every issue from the other side because it should
be obvious what the other side is of all issues discussed in the previous
lessons, but we will discuss
some of the more important ones.
Why Sell It?
There are, in general, two possibilities.
First, because you have to do it and second, because you want to do it.
By "have to" we mean you
need to sell because of health or some other reason that limits your ability
to pick the market conditions in which to sell. "Want to" covers all cases other
than "have to" no matter what the reason, be it that you're tired of
the business, want to retire with the freedom to travel, or want to utilize your
equities to enjoy the lifestyle of the rich and famous. The major
difference from "have to" is that you have more flexibility as to when you do it.
When To Do It
Like many other things in life, timing the disposal of your property is important. The time to dispose of
property is when it's a seller's market, that is when the the demand is
higher than the supply. Unfortunately, real estate investors must
often dispose of property under less than ideal circumstances for reasons of
health, divorce, or general financial condition. However, even when
you "have to" dispose of property, following the correct
procedures will help you realize the highest possible return.
How To Do It
You have several options regarding getting rid of
a property. You can give it away, you can sell it, or you can trade
(exchange) it. There are also two other ways. One is to stop paying your
loan payment or your property taxes and have it
taken away, but this option doesn't require instructions. The other is to
die and leave it to your heirs, and, while no instruction is usually necessary
for the dying part, proper estate planning is recommended.
Gift It
There are several reasons why you might consider
giving it away. One would be to gift it to a family member or friend. Gifting
to relatives or other individuals or entities (other than charities) can have an
impact on overall estate planning Another
would be to donate it to a charity. There are even ways to put a property
into a charitable trust that allow you to retain control even as to future use
long after your demise. All of these possibilities have tax consequences
and require that you seek competence legal help. Timing of a gift can be important
because the stepped up basis for the recipient is related to the value at the
time that the gift is made. If gifting to a tax-exempt organization timing
has no tax consequence, but there could be other issues.
Charitable Trust
Since the
charitable trust is probably less well-known than are gifting to a family member
or donating directly to a charity, we'll discuss it further.
The happy thought of selling a rental property for cash can be easily squelched by the unhappy reality of capital gains and depreciation recapture taxes, which often take up to 35% of the cash received from a sale. On a $100,000 rental house, a landlord is often faced with a choice: "Would I rather have a $100,000 rental house that drives me crazy or
$65,000 in cash?" It's a painful choice. What every landlord would really like is to have $100,000 of hassle-free cash. After all, cash doesn't call you at 2 o'clock in the morning to say the furnace isn't working!
To avoid the taxes on a sale, many landlords have utilized the 1031 exchange program over the years. The problem is that a 1031 exchange puts you into more property, not into
cash (you are taxes on any cash taken out). More property means more ongoing real estate management issues.
So why isn't there a simple way to sell the property and receive tax-free cash?
Actually, there is. A charitable trust is an easy way to sell the property, keep the cash, and skip the tax. What is a charitable trust?
It's a very simple type of trust that basically says, "While I am alive, this trust money belongs to me.
When I die, a charity can have whatever is left over."
Utilizing this vehicle, a charitable trust is set
up, the rental property is transferred to the trust, sold tax-free, the proceeds are invested for a good return, and the trust
thereafter makes hassle-free payments back to the landlord for as long as the landlord and his or her spouse are alive.
The landlord decides what size monthly payment to withdraw, but the IRS does have some rules. In theory, they
want you to withdraw no less than 5% annually, but they also don't want you to withdraw so much that they believe there will be less than 10% left for charity as a gift (for example, on a $100,000 property, the IRS wants at least $10,000 left for charity). In practice, landlords are able to select IRS approved trust payout rates that range from 5% up to 12%, depending upon their age when they establish the trust. Therefore, the trust payments from a $100,000 trust could range from $416 to $1,000 monthly, at the landlord's discretion.
That's much better than depositing $70,000 in the bank at a 3% return to create a $175 monthly payment. Most people would agree that, given a choice between paying up to 35% in taxes today or giving 10% to their favorite charities at death, the charitable option makes more sense.
Some people even think this obvious benefit sounds too good to be true. So why does the IRS permit that choice?
From the IRS's point-of-view there are only two things that can be done with charitable trust dollars-either distribute them and pay income tax on the earnings, or die and leave it to charity.
The IRS is perfectly happy with either of these options. So a charitable trust is a nice blend of benefits for a landlord and his or her chosen charities that actually have the approval of the IRS.
Sell It
You can, of course sell the property,
just as you can sell your personal residence. And, just as when
selling your personal residence you want to maximize the sale price.
However, selling income property is usually more complicated and can have significantly
more tax consequences.
Selling an income property
involves many of the same issues as buying one, except from the other side of
the fence, and having completed the previous lessons, you certainly realize
that that buying can be a bit complicated.
One of the most import tax consequences is
that taxable gain will be based on sales price (less selling costs) less
your basis at the time of sale. In other words you will pay tax on all
the depreciation that you deducted during the years of ownership in addition to
paying tax on the actual increased value.
There are ways to somewhat cushion the tax blow, for example, by structuring the sale as an installment sale, but
further details are a subject for a future e-course.
Timing is obviously important for
selling a property because you'd like to sell at the top of the market or at
least not at the bottom. If in an increasing market, you might want to
delay the sale if practical and add more dollars to your price, using that time
to maximize rents and minimize expenses where ever possible.
Exchange It
Unless you want to get out of the landlord
business, it will usually be advantageous to exchange your
income property under Section 1031 of the Internal Revenue Code. The
exchange also provides a means of trading your existing real estate portfolio
for one that is less management intensive when you want to slow down, but not
entirely retire from the rental business. While
this is sometimes referred to as a "tax-free' exchange, it is
in reality a "tax-deferred" exchange. The main advantage of a
tax-deferred exchange is that it allows you trade up to larger property or
higher quality property after
your previous property has increased in equity in order to improve your leverage
position, utilizing untaxed dollars to do so. As indicated by the word
deferred, you will eventually have to pay the piper if you wish to cash out and
retire from the landlord business. However, there are ways to cushion the
blow.
When exchanging property, timing is of
only secondary importance regarding tax consequences. One issue that can
be important in timing your exchange is that it can be more difficult to find
the desired property if supply is limited because it is a seller's market.
This can be of significant importance if you are doing a delayed exchange and can't find the
replacement after having disposed of your old property.
Addition discussion about 1031 Exchanges
is included in the next lesson of this course and even more details about
Exchanges and other possible tax strategies are subjects for another e-courses.
Marketing
Pricing
To determine what your property is worth when
it's time to sell, you follow the same procedures as when you bought it as
discussed in Lesson ? of this course or as covered in much more detail in our Valuing
Income Property e-course.
Preparation
Take care of all physical and legal problems
regarding the property that might be considered an issue by a buyer.
Having them become an issue in the middle of a deal can result in cancellation of
an escrow or re-negotiation of the price or other terms. Physical issues
include inoperative sprinkler systems, out-of-code electrical or plumbing
systems, cracked
windows,
. Legal issues include tenant disputes, building code violations,
delinquent taxes, and missing licenses or permits. On reason to take care
of these issues before even putting your property on the market is that some
might suggest to a savvy buyer or agent that you are having financial
difficulties and could result in lower offered prices.
Also consider various relatively inexpensive
cosmetic upgrades that might make a difference. Exterior painting,
cosmetic landscape improvements, re-coating of asphalt. and repairing
superficial defects that make the property look ragged can have a significant
impact on potential buyer's initial reactions even to the point of writing the
offer.
Documentation
Be prepared to provide the same documentation
when you sell as you should have required when you bought, as discussed in a
previous lesson.
Many of same issues are important in selling the property as were important in buying
it. Selecting an agent, maintaining control over the deal, setting the
price, being careful about
contingencies, etc. However, everything is from other side of the
fence. If things are not to your advantage as the seller
(maybe the buyer completed this e-course),
try to change them in your counter offer. For example, try to get
contingencies worded so that each one is approved if written disapproval is not
given within the time period and make time periods as short as possible.
To avoid the likelihood of a buyer suing you for
misrepresenting the square footage because the listing had the wrong number or
because the seller was quoting gross and the buyer thought it was net, it is a
good idea to include a statement that any published or otherwise mentioned sizes
are not warranted and that if sizes are a material matter to the
buyer, he should make his own measurements.
Legal Issues
If there are any issues regarding zoning or building
codes, it is best to disclose it up front so that it doesn't become an issue two
months into the escrow where it could either kill the deal or require
re-negotiation of the price. If there are things that you can't fix ahead
of time, it is best that they be considered in negotiations up front rather than
after everyone is expecting escrow to close.
Counter Offers
When you are selling your property it will be
the buyer who will be writing the original contract terms and they will likely be written to his
advantage. It is almost certain that no offer written by the buyer and/or his agent will be ready for the
seller's signature. You should be particularly concerned about certain
items and should try to change them to you own advantage or at least make them
neutral.
Contingencies
General
There are a number of general principles that you
should follow when trying to modify contingencies in your counter offer.
- It is to the seller's advantage to that all contingencies are automatically approved if not disapproved in
writing.
- As we recommended for you are the buyer, it is usually in your best
interest as the seller to require the buyer bear the cost of inspections and
then take that fact into account in deciding the minimum price your will
accept. The reason for this is two-fold. First, it is usually
better that the vendors to be hired as the agents of the buyer rather than of
the seller for obvious reasons. Second, you want the buyer to be
responsible for timely completion of inspections and not be at fault if a
contingency is not met in a timely manner.
- Rather than wanting maximum time for contingency periods as you do as
buyer, you want to be sure that the requested periods are not unreasonably
long to avoid them being used to buy time for a non-performing buyer.
If the buyer requests a time that is too short, that's his problem and you
can always give him additional time if desired..
- To the degree possible, schedule inspections in order of importance
relative to decision making in order to have the cancelled as soon as
possible if there are problems.
INSPECTION
PERIOD. Contingency expirations for the various disclosures
and inspections are listed below. Buyer shall deliver to James
Stevenson, as agent of Seller, written notification of dissatisfaction
regarding any disclosure or inspection within the time specified. If written notice of dissatisfaction for an item is not received within
the specified time, that item shall be deemed approved. |
1 |
Size Measurements |
7 calendar days after acceptance |
2 |
Lease Documents |
10 calendar days after receipt |
3 |
Financial Records |
10 calendar days after acceptance |
4 |
Estoppel Certificates |
7 calendar days after receipt
of completed forms |
5 |
Seller Property Disclosure
Statement |
5 calendar days after receipt
of completed form |
6 |
Preliminary Title Report |
5 calendar days after receipt |
7 |
Physical Inspections & Tests |
30 calendar days after
acceptance |
8 |
Boundary Survey |
20 calendar days after
acceptance |
9 |
Phase 1 Environmental Report |
30 calendar days after
acceptance |
10 |
All other matters (except
financing) |
20 calendar days after
acceptance |
Note that contingencies requiring action first
by the seller have periods starting from receipt of the items from the seller,
whereas, other items that are completely up to the buyer have periods starting
from date of acceptance. Note also that calendar days are specifically
defined to avoid confusion about weekends or holidays.
Financing
Be sure that all specified terms including maximum interest rate,
discount points, and other costs as well as the minimum number of years of the
loan are realistic in terms of the current market, with room for probable
changes.
Licenses & Permits
If there are any problems
regarding inability to obtain legally required licenses and permits, get them
resolved before putting the property on the market.
Financial Records
The value of the property and the amount that a
buyer will be willing to pay for it are entirely dependent upon the income and
expenses so you should expect to provide sufficient financial documentation to
enable the buyer to make his decision.
Be sure that the buyer is not requiring financial
information in formats that you do not have. In your counter offer
specifically state the specific documentation that will be provided. For
example, state that the financial statements to be provided are those already in
existence or those provided by your management company. If the buyer insists are income tax records, limit it to your
Schedule E for that property only (or those included on your Schedule E).
Lease Documentation
Leases documents are exceedingly
important for two reasons. First, they verify the income information that
is being provided in the financial records. Second, they disclose how long
tenants have been there (indicating the stability of their business), the
expiration date of tenancy and possible extension options (indicating when you
can raise rents), future rent increases already built in (indicating future
automatic income increases), and all
sorts of other important information that has an impact on the current and future
value of the property.
Provide good readable copies
of all leases and other documents, including
amendments, checklists, and house rules so that the buyer can provide copies to
lenders rather than you having to make additional copies.
Physical Inspections
As stated elsewhere, you should have taken care
of any deferred maintenance before putting the property on the market, so that
physical inspections don't find serious defects.
Survey
A
boundary survey is seldom needed and if desired, should be buyer's
responsibility and at his expense.
Environmental
Is the property in a super-fund site? If
so, disclose it up-front and don't allow the fact to be a contingency..
Do you have a previous Phase One Report? If
so, provide a copy and require the buyer to accept it without contingency.
For a residential property built before 1978, provide copies of executed lead-based paint disclosure forms for each tenant.
Also, provide the
buyer with the legally required lead paint pamphlet and
disclosure form and any required related documentation.. This is in addition to providing him copies of the
tenant-signed forms.
If you've had Radon testing and/or abatement
done, provide the appropriate documentation.
Estoppel Certificates
Although it is for the buyer's benefit that
estoppel certificates be required, they can also benefit the seller because they
eliminate potential disputes by buyer or tenants as to rents, deposits, and other
lease terms. You don't want a tenant arguing the terms of his lease or
some other matter after close of escrow.
To avoid duplication of effort, you can change
the buyer's request for estoppel certificates to apply only if the lender
doesn't require them. Be sure that estoppel certificates are to be
prepared and provided by the buyer or his agents. You don't want the
liability of being responsible for the legal adequacy of the certificates.
Other
Do not accept any contingencies that are
impossible. For example, do not accept a contingency that all air
conditioners be in operating condition when you know that some are not, unless
you are prepared to repair them, in which case you should have done so before even
putting the property on the market.
Escrow Length & Restrictions
During Period
Be sure that the requested
closing date is realistic based upon the time required to complete all contingencies
including financing. Although you, as seller, want to close as soon as
possible, it is extra hassle to grant extensions because the original
date was unrealistic. You should not worry about restrictions regarding
what you can do during the escrow period unless the buyer does. In the case he does, try to
limit the restriction if possible, remembering that you don't want to limit your
control more than necessary when there is never a guarantee that the deal will close.
Tenant Notification
Since you will want cooperation of tenants
regarding buyer inspections and estoppel certificates, it is recommended that you
notify tenants of the pending sale as soon as there is a fully executed purchase
contract. You should explain that the buyer or his agent will be making
inspections and thank them in advance for their cooperation. Keeping tenants in the loop and remaining on good terms with
them may reduce the chance of them voicing complaints about the property to
the buyer or his agent. Not only does this reduce the chance of defects
becoming more important, but it also is best that the tenants appear to be
happy.
Contingency Cooperation & Assistance
Although you might resent the need to assist in
getting access for inspections, it is again to your advantage to cooperate and even
assist in getting the contingencies out of the way as soon as possible and with
the least amount of trouble. Again, your presence when the buyer or his
agents are interfacing with tenants may reduce the chance of them voicing
complaints about the property to the buyer. You might even want to be the
one to get signatures on estopple certificates so that you can deal with any
misunderstandings or disputes yourself rather than have the buyer or his agent
involved.
Transfers & Terminations
Licenses, Permits & Taxes
Be sure that you inform the relevant governmental
agencies that you have sold the property so that you don't end up being liable
for the new owner's failure to pay fees or taxes.
Insurance
You will want to cancel insurance coverage after
closing escrow. Pro-ration of insurance premiums are usually to the
effective date of sale of the insured property rather than to the date when notice is given, so
there is no reason to jump the gun and risk cancellation prior to the date of
ownership transfer. Doing so could result in an uninsured loss resulting
from either a physical loss or a liability claim because closing was delayed and
the insurance agent didn't get the word that coverage needed to be continued
beyond the previously scheduled closing date.
Utilities & Miscellaneous Services
While you don't want to discontinue utilities or other services
prior to closing escrow, you do want to be sure to do so immediately
thereafter. You should coordinate this with the buyer to
avoid disruption of services to tenants and this issue might even be covered in
your purchase contract. While not always convenient or even possible, it
is best to provide written notices to utilities and service vendors. One
suggestion is that advance written notices be provided to non-utility service
vendors about the pending sale, estimating the date of closing and stating that oral or written final notice will be provided upon actual closing. Such
preliminary notice is not recommended for utilities because (1) large utility
companies may not take notice anyway and (2) if some clerk instead understands the
notice to request certain turn-off on a date and closing is delayed, disruption
of utilities could result in upset tenants and buyer. It is a good idea to
follow up with phone calls after the discontinuance date to verify that it
actually happened.
After Closing
Check the closing statement carefully. In
particular check pro-rations of rents, property taxes, and interest and be sure
that you are correctly debited for deposits and that the loan payoff amount is
correct.
Send written notice to all tenants that escrow
has closed and provide the name of the new owner and his address and phone
number. You might also state that they should contact the owner regarding
the exact payee for future rent checks unless you have agreed to pass that
information to them for the buyer.
File the closing statement where you will be able
to find it when it's time to prepare income tax returns for the year of sale.
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