Want to Avoid Tax Hits? Sell Your Investment Property at the Right Time and the Right Way

Strategies and tips to maximize profits!

Investment properties can be reliable sources of income to build personal wealth and enjoy recurring monthly income. If your circumstances change, however, you may need to sell a rental property to improve cash flow, reduce debt, or for other reasons.

Many variables affect your success when selling, and careful planning is necessary to make sure you get the best sale price. Here are several strategies and tips to help you maximize your profits, reduce your taxes, and make the selling process go as smoothly as possible.

When to Sell an Investment Property

The right time to sell a rental property will be different for each investor. It’s important to keep a close eye on your property’s performance to help you decide when to sell it. Also, be sure to consider the local market to make sure there is strong demand for rentals. This will ensure your property will be attractive to potential buyers if you decide to sell.

A few common reasons for selling include:

• The loan is nearly repaid.
• The property isn’t profitable.
• Property taxes are increasing.
• You seek portfolio diversification.
• Other rental markets are more lucrative.
• The property has been fully depreciated.

How to Avoid a Tax Hit

Before a rental property sale, consider the tax implications to help avoid unpleasant surprises. It will also help you determine whether selling makes financial sense for your situation. Because the tax code changes every year, be sure to consult with a tax professional to ensure you comply with all tax laws and regulations and to optimize your tax position.

Analyze your tax liability before selling

There are different tax rules to consider when selling a property, and you will most likely be liable for capital gains taxes and the depreciation recapture tax. How much tax you will pay depends on the amount of the capital gain, the depreciation deduction, and how long you owned the property.

Three taxes to consider when selling a rental property include:

• Short-term capital gains tax: If you sell a rental property you owned for less than a year, you will be liable for hefty capital gains taxes.
• Long-term capital gains tax: If you sell an investment rental property you owned for a year or more, you will be liable for the long-term capital gains tax, which is almost always lower than the short-term tax.
• Depreciation recapture tax: When you sell a rental property, you must pay taxes on depreciation deductions you claimed on your tax returns to reduce the taxable net income.

You may be able to defer capital gains taxes when selling a real estate investment by swapping one rental property for another. Section 1031 of the tax code, known as a 1031 exchange, lets you do this.

A few things to consider when deferring paying the capital gains tax include:

• You are still liable for paying closing costs and legal fees.
• You must reinvest all the proceeds of the sale to avoid taking a tax hit.
• The replacement property must be of equal or greater value to the property sold.

Sell at the right time to reduce property taxes

Timing the sale of a rental property may influence your tax liability. If you hold a rental property for more than a year before selling it, for example, you will pay capital gains taxes based on the long-term rate, which is usually lower than the short-term rate.

Strategies for Selling an Investment Property

Selling a rental property can be daunting for a new real estate investor. It usually means paying a capital gains tax and dealing with existing tenants. Here are nine strategies to help ensure a smooth transaction when you decide to sell.

1. Assess the health of the local real estate market

Before you sell a property, assess the local market to make sure there’s strong demand for rentals. This will help you determine whether the market is attractive to potential investors.

You will also want to determine whether you are currently in a buyer’s or seller’s market. Selling in a buyer’s market could be tough. It could mean that your property takes longer to sell and that you will get less for it than if you sold in a seller’s market.

If you are in a buyer’s market, selling may still make sense. It depends on your financial situation and investing goals. A few factors that may help you get a strong offer in a buyer’s market include:

• High occupancy rates
• A strong local economy
• Positive population growth
• High demand for rental properties
• Upcoming development or construction projects

2. Determine the right price

Listing a rental property at its fair market value to attract investors is crucial. To determine the right sale price, you can analyze the average prices of comparable homes (comps) in the community sold in the past three to six months. Another option is to seek a home value appraisal from a local real estate agent.

These methods will help you price your home to attract potential buyers. This will help to ensure that your home sells quickly and that you get the best possible price.

3. Identify your target buyer

Identifying your target buyer when selling a real estate asset will affect your selling strategy, sale price, and negotiation tactics. A buyer who wants to purchase a property for business or investment purposes, for example, will have different wants and needs from someone looking for a primary residence.

It’s important to keep in mind that most real estate investors are only interested in one thing: potential return on investment. Selling a single-family rental home to a young couple, therefore, requires a different approach than selling to an investor.

Potential buyers to consider include:

• A current tenant who is interested in buying the property
• A cash-only buyer who wants to buy a property in any condition
• Buyers looking for single-family homes to serve as their primary residences
• Real estate investors seeking turnkey rental properties for investment purposes

Depending on your target buyer, you could use a real estate agent or sell a rental property yourself. Doing it yourself will require more work than if you used an agent. You will, however, save money on the agent fee.

Your selling strategy will depend on the type of buyer you target. An investor may be willing to pay more than the asking price for a property if it’s in a community where there is strong demand for rentals. But if you sell to the current tenant, you may only get fair market value.

4. Minimize your rental property’s expenses

You want to ensure the rental property you are selling will be an attractive investment to potential buyers. You may be able to do this by reducing expenses to improve cash flow.

A few ways to reduce expenses when selling a rental property include:

• Staying on top of property maintenance
• Identifying maintenance jobs you can do yourself
• Improving energy efficiency to lower utility bills
• Determining if managing the property yourself is more cost-effective than hiring a rental property manager

5. Maximize rental income

Maximizing monthly rental income can make the sale price of a rental property more appealing. Making a capital improvement, for example, may allow you to increase the rent. If you are currently undercharging compared to other properties in the community, you can also increase the rent to match the market.

If you are thinking about increasing the rent, check the lease to make sure the current rate isn’t locked in. Also, check the local state landlord-tenant laws to make sure you are compliant with all governing authorities.

6. Arrange a prelisting inspection, and make repairs

Before you sell a rental property, make sure it’s in great condition to help you maximize the sale price. One way you can do this is to have it inspected before listing it. A prelisting inspection may uncover important maintenance issues that you will need to resolve before showing the property to potential buyers.

Although there is a fee for a home inspection, it may be a good investment because it can save time and potential complications during the sales process. Addressing all known repair issues allows you to present the property in better condition. It will also help buyers feel more confident in making offers.

7. Gather documents before listing your rental property

Before making an offer on a rental property, an investor will want to evaluate the property’s current financial information to make sure the deal will be profitable. Gathering the necessary documents before listing the property may help to prevent delays.

When selling a rental property, the documents you will need typically include:

• Disclosures
• Your tax returns
• Recent utility bills
• Current year’s tax bill
• Current rental agreements
• Income and expenditure projections

8. Communicate with your tenants

If you are selling an occupied rental property, letting your tenants know what’s going on will help maintain good relations. Be sure to answer any questions they may have and assure them that their current lease agreements will not change.

If you want your tenants to move out before you sell your rental property, check the lease agreement first. Depending on the clauses in the agreement, tenants may have a right to stay.

9. Market your property

Having a solid marketing strategy is vital for selling a rental property fast. It will also help you get the best price. Before you list your rental property for sale, be sure to stage it to make it look inviting to potential buyers.

Make your property look its best by deep-cleaning everything, removing clutter, trimming bushes and shrubs, etc. You can then hire a professional photographer to take pictures so that your listing will stand out on real estate websites.

How to Sell a Rental Property with Existing Tenants

When selling a property with tenants, there are some special considerations. There may be some situations, for example, where you need the property to be vacant. You may also want to sell to a current tenant. Whenever tenants are involved, it’s important to make sure they are informed, their concerns are addressed, and all laws and regulations are followed. 

Here are four strategies to consider. 

Wait for the lease to expire

If you are selling a property with tenants and you need the property to be vacant, check the terms of the lease agreement. If your tenants have a month-to-month agreement, you can give them a written notice to vacate by a specific date, per local laws and regulations.

With a fixed-lease agreement, an early termination clause may give you some flexibility when selling. If there isn’t an early termination clause, the tenant can remain in the property until the lease expires.

Pay your tenant to leave

If you need your rental property to be vacant and you can’t wait for the lease term to expire, you may be able to negotiate an amicable exit strategy with your tenant. This may involve offering a tenant a financial incentive to leave. In other words, you pay the tenant to move.

A few options to entice your tenant to vacate the property include:

• Paying for moving costs
• Paying the security deposit on a new place
• Paying the tenant one or more month’s rent

Consider the pros and cons of paying tenants to leave. It may make financial sense in some cases to let the lease expire, depending on how much time is remaining. If you need to sell quickly, however, offering a financial incentive may help you accomplish your goals.

Structure a rent-to-own agreement

Selling a property to a current tenant may allow you to avoid the hassle and expense of staging the property, listing it, and having to deal with other stressful factors. The tenant also benefits by not having to move. Selling to a current tenant is quick and efficient, and it may also help you save money on a real estate agent fee.

A financing strategy that can be used to sell to an existing tenant is to arrange a rent-to-own agreement, which allows the tenant to continue making regular rent payments. Part of those payments count towards the down payment of the property. The tenant can later formally purchase the property after meeting the down payment requirement.

If you decide to sell to your tenant on a rent-to-own basis, a real estate attorney must draw up an “option to purchase” agreement.

Sell a rental property with an active lease

Some investors look for rental properties that already have tenants because it allows them to enjoy cash flow immediately after closing. This type of deal means the new owner doesn’t have to look for tenants. Instead, they let the current tenant stay for the remainder of the lease period. After that, the landlord can decide whether to extend the lease.

The Bottom Line

Selling a property to avoid a tax hit requires a strategy that allows you to maximize the purchase price while simultaneously avoiding hefty capital gains taxes. Consult with a tax professional before selling to help you determine the best strategy for your needs.

If you sell an investment property, you will pay tax on the capital gain and recapture depreciation. The 1031 exchange is a strategy you can use to defer paying capital gains taxes if you invest in a “like-kind” property.

Knowing the best time to sell a rental property is an important part of maximizing profit and minimizing taxes. You can learn more about refinancing, selling, and deferring capital gains taxes in BiggerPockets’ SMARTER Guide to Real Estate Investing.