There seems to be no shortage of articles on how to start investing in real estate or taking your business to the next level. What you don’t often see is a post on how to wind down your career. To someone just starting out this may be something they aren’t worried about. But they should be. Just as you want to have an exit strategy for a particular investment property, you should have one for your investing career as well.
Last week I was having lunch with several seasoned real estate investors. One of them broached the subject of packing it in. Though he had made a lot of money, the fire in the belly had gone out. It was time to move on to something else in life. Sounds simple, but is it?
A Myriad of Complications
This investor had a few problems to deal with. He had successfully laddered a number of properties as buy and hold investor. When the value of a property had increased sufficiently, he would refinance and use the proceeds to buy more property. It was always done with an eye on cash flow, if the rental income couldn’t service the debt and expenses he wouldn’t refinance. Cash flow wasn’t the concern, equity was. He wasn’t upside down on the mortgages but he was on the income taxes. Huh?
The double-edged sword of depreciation had reared its ugly head. Investors often tout the tax benefit of being able to take a depreciation write off to reduce income taxes. That’s all well and good – until it’s time to sell. This investor has owned a number of properties for a long time. That means the cost basis for capital gains has been greatly reduced and there is the seldom-talked about issue of recapture. You know all of those lovely depreciation deductions? Well the IRS wants them back. That is why they call it “recapture,” the IRS is going to recapture those deductions when you sell. The problem for this investor is that when liquidating many of his properties he would have to put money in to cover taxes. That’s a downside of pulling out equity along the way.
Many of you are saying, “just do a 1031 exchange to defer the taxes.” While that is a solution, this investor wants to move on from real estate. After several decades of investing he wants to do other things with his life. His biggest complaint is that he didn’t plan for this sooner. He is working with his accountant and attorney on a liquidation plan. It won’t happen overnight. He figures it will take three to five years to accomplish, if not longer.
So what’s the plan? The easy part is to simply liquidate the properties that don’t have a tax problem. For the ones that do this investor is exploring the use of a Charitable Remainder Trust. Wealthy people that have stock portfolios that have appreciated significantly frequently use this. It can also be used for real estate to minimize taxes. In simple terms, a charitable trust is set up and highly appreciated and/or depreciated assets are “gifted” to the charity via the trust. The property can then be sold tax-free and the proceeds reinvested in income producing instruments. The grantor (person who set up the trust) receives the income but the assets of the trust given to the charity upon death of the grantor.
There are certainly drawbacks to this plan. Not the least of which being loss of access to the principal. To this investor that isn’t an issue. When that is an issue other avenues need to be pursued. The main point here is that your business plan needs to include an exit strategy. You do have a business plan, right?
Begin with the end in mind. – Stephen R. Covey (The 7 Habits of Highly Effective People)