How to Sell Your Investment Property and Avoid Taxes

One of the most attractive elements of real estate investing is the ability to shelter your profits and take them to the next investment. This guide will teach you ways to do that while avoiding capital gains to help you become a more successful real estate investor.

First, a quick disclaimer. The information in this report is not provided as legal advice, financial advice, and/or tax advice. Before making any decisions about your property, consult with real estate and industry professionals.

Now back to what you’re here for. The four basic methods for avoiding capital gains taxes when selling investment properties are an UPREIT, Installment Sale, Doing Nothing, and a 1031 Tax-Deferred Exchange.

1. UPREIT

UPREIT is an acronym for Umbrella Partnership Real Estate Investment Trust. This strategy is generally only available to owners of large properties ($10,000,000 and up). Rather than selling the investment property in the typical way, you would sell to a Real Estate Investment Trust (REIT) in exchange for operating units in the trust. Since REITs are basically mutual funds that own thousands of properties, you’re essentially selling one property and buying shares in many. This isn’t a taxable event. Taxes are only due if sellers start selling the units purchased in the REIT. This is one of the more complicated tax deferment strategies, which is very effective, but not very common. 

2. Installment Sale

This is another term for offering financing to the property’s buyer or offering a purchase money mortgage. Basically, you (the seller) become the lender. With this method, you only pay capital gains taxes as you receive your payments from the buyer, which means you get to pay them over time rather than all at once. Also, if the buyer defaults on their payments, it allows you to foreclose on the property. While this situation may not seem ideal, you’ll almost always be getting the property back at a steep discount (the balance you have on the loan). This lets you realize profits in the property all over again. The installment sale is another uncommon method, but it might be the right move for certain sellers.

3. Doing Nothing

This strategy means you don’t sell the property at all. Under the current IRS law, if an owner passes away and leaves property to their heirs, all gains in the property are eliminated or there is a step-up in basis to the current market value. This method is mostly for family circumstances and benefits the heirs greatly.

4. 1031 Tax-Deferred Exchange

This is the method we’ll spend the rest of this report talking about. This is the most common way to shelter gains, avoid taxes, and build wealth.

1031 Tax-Deferred Exchange

The 1031 Tax-Deferred Exchange is the most common method of avoiding taxes when selling real estate. This technique involves reinvesting the proceeds from a sale into a “like-kind property.” Rather than cashing out your investments, you just invest in a similar property. With this strategy, there’s no economic gain to pay a tax, so no tax accrues.

Now, this doesn’t mean that the seller never has to pay taxes. This is more of a tax-deferral technique. The new property has the same low tax basis as the old property. When the new property is eventually sold, the original deferred gain, plus any additional gain realized since the purchase is subject to tax. But there are no limits on how many times you can do a 1031 Exchange. So, you can sell the newer property as part of another like-kind exchange and do it all over again.

Like-Kind Properties 101

What’s a like-kind property? Virtually any real estate is like-kind to any other real estate (such as vacant land for a shopping center, an office building for an apartment building, etc.). Personal residences can’t be exchanged, and foreign property can’t be exchanged for U.S. property.  Long-term real estate leases (30+ years) can qualify as real estate for purposes of exchange.

This 1031 exchange method is different from a sale and purchase. The owner hasn’t cashed out any of the investment. They’ll use the cash proceeds from the sale to buy a property that’s equal to or more expensive than what they’ve just sold. The sale and purchase of an exchange must be part of an “interdependent” transaction. Many years ago, the buyer of the old property had to purchase the new property first and then sell the new property to the taxpayer. That’s not necessary today.

What is a Qualified Intermediary and Why Use One for a 1031 Exchange?

By using qualified intermediaries, the buyer of the old property and the seller of the new property don’t need to be involved in the exchange. (However, there is a technical requirement that other parties be notified that the exchange is happening.) A qualified intermediary is an independent agent that facilitates the exchange. Most intermediaries are affiliated with banks, trust companies, or title companies (the taxpayer’s attorney or accountant can’t be the qualified intermediary).

Using a qualified intermediary is one way of “safe harboring” the exchange. Essentially, the qualified intermediary takes an assignment of rights in the sale contract for the old property and in the purchase contract for the new property. An attorney can fill out all of these documents for you. Through these documents, the intermediary is brought into the exchange and, subject to compliance with the timing rules discussed below, the transaction can qualify as an exchange rather than a taxable sale.

The qualified intermediary holds the proceeds of the sale pending reinvestment in the new property. This is because the IRS says that if the seller receives (or has direct or indirect control over) the proceeds of the sale, then there should be a tax. By having a qualified intermediary hold the money, the taxpayer never receives the cash and the transaction is viewed as an exchange.

Getting the Timing Right

With 1031 exchanges, there are a few rules each investor needs to follow. For example, within 45 days of the closing, you must “identify” the new property (using specifics like the address). You can do this by sending your qualified intermediary written notice of the targeted new property.

Because there’s always the possibility a deal can fall through, you can designate more than one property (up to three). You can even identify fractional interests in property that will be held in a legitimate co-tenancy (and not a partnership).

When it comes to closing, you’ll need to close on one or more of those newly identified properties within 180 days of closing on the old property. This runs concurrently with the 45-day period we mentioned above. The 180-day period is cut short if the tax return filing deadline comes up before the end of that period (but you can get the full 180 days by filing for an extension).

If you sell a property and give the proceeds to a qualified intermediary in the last 179 days of the year and have a bona fide intent of doing a like-kind exchange, the gain is deferred to the next year as long as the 180th day falls in that succeeding year.

Buying More Time on the Sale of the Old Property

If you need to buy more time when selling the old property, it’s important to know that contract sales don’t work here since they’re treated as a sale for tax purposes. Instead, sellers can lease and allow the buyer to take occupancy ASAP but defer the closing. There’s also the reverse exchange option.

Reverse exchanges refer to when the new property is purchased before the old property is sold. For these to be allowed, sellers have to use a special “parking intermediary” to purchase and hold the new property until the old one sells. The old property sale can be structured as a normal “forward” exchange. The proceeds then roll over into the new property that’s being “parked”  with the parking intermediary. The intermediary can hold the new property for up to 180 days.

Exchanging for Newly Constructed Properties

You can trade into a newly constructed property, but you can’t own the land the property is being built on. The land has to be owned by the seller, the developer, or a parking intermediary. If you already own the land, you’ll need to sell it to a parking intermediary or the developer.

The seller or intermediary will contract to construct the improvements, and at the end of the 180-day period, they can convey the property (completed or partially completed) to you to close out the exchange. This is usually a race against the clock to try to spend as many construction dollars as is necessary to complete the trade. Construction costs can’t be prepaid.

Buy and Refi

Now you know that owners need to trade up or break even on price when purchasing a new property to avoid taxes. While owners can put more debt on the new property (if it costs more than the old property), they can’t refinance in the middle of the trade and take cash off the table.

Instead, owners can refinance the new property once they own it to get more cash. Just know that this process is independent of the exchange. Refinancing after the trade is generally preferable from a tax perspective.  A loan isn’t income, so owners won’t be taxed on it (just make sure it’s paid back!).

A Seller’s Timeline

When doing a 1031 Exchange, it’s crucial to make sure that the sale and purchases are structured correctly. This way, you save all of the money you’ve earned with your investment property. We’ve all heard the saying “Buy low, sell high.” But selling high usually requires a professional marketing strategy and buying low is easiest for buyers who are willing to act quickly. If done right, a 1031 Exchange allows you to do both of these things. The chart below is an example of the sale-thru-exchange timeline for clients who are aiming to do a 1031 Exchange. If your selling broker is doing his job correctly, the selling asset is marketed to a wide range of qualified investors from across the country.

The Triple-Net Strategy

As we mentioned earlier, when you sell an investment property, you have the option of exchanging it with any type of real estate investment. One option is to reinvest in another property which may offer the potential of high returns and require a lot of management.

Many of our clients choose to invest in a Triple-Net Property (NNN). These investments are usually single-tenant properties in which the tenant is responsible for all management, maintenance, and operations of the property (sounds nice, right?). The six types of NNN assets are retail/restaurant, convenience store/gas station, banks, medical, industrial, and office.

The tenants who use these properties are usually large national companies. For owners, NNN assets offer more cash flow, less complexity, increased free time, and most importantly, a way to defer paying capital gains taxes. Learn more about the basics of triple-net leases in the podcast below.

Buying a NNN property is in many ways like making any other property investment purchase. And New York multifamily owners who have been successful in their industry are great candidates to own NNN properties. This is because they’ve been doing similar work for a long time.

This is what one owner accomplished when they sold their management-intensive New York apartment building, paid no taxes, and increased cash flow by $859,000 per year with four secure investments: a fast-food restaurant, a natural grocery store, a bank, and a home improvement store.

Four Key Factors for Evaluating NNN Investments

There are four main categories real estate professionals look at when underwriting NNN properties: real estate fundamentals, the tenant’s creditworthiness, unit economics, and investment structure.

1. Real Estate Fundamentals

The first thing to look at when it comes to real estate fundamentals is the micro and macro market metrics of the new property. These include:

• Barriers to entry
• Strategic location for core business
• Property type
• Market demand for specific use and tenant
• Access to and from major thoroughfares
• Signaled intersection – ingress & egress
• Traffic counts/daytime population
• Outparcel to a shopping center
• Surrounding tenants
• Population trends
• Employment trends
• Average household income
• Market drivers
• Retail landscape: National/regional/local tenants, malls
• Retail positioning
• Road construction

Remember to evaluate these factors for the overall area and for the specific property you’re looking at. For example, maybe you heard the economy is bad in one town (a macro factor) so you don’t want to buy a drugstore property there. But, if you look at the specific location of this drugstore, it might be on a college campus next to three dorms. So from a macro standpoint, it didn’t look like a good investment, but when you look at the micro factors, it actually might be a great buy.

Also, think about overall macro trends for the future. For example, in the industrial space, data centers are cropping up as more computing moves to the cloud. So that property type could be part of a future macro trend as everything continues to become more digitized.

When looking at real estate fundamentals, professionals also evaluate alternative use, meaning if you had to reposition this building into an alternative use, what could that be? And what would the rent be? What would the cost be to convert it into that use?

2. The Tenant’s Creditworthiness

This is where you determine who guarantees the lease and what the tenant’s strength is. When you analyze this, you have a broad spectrum from private individuals who’ll be guaranteeing leases all the way to public corporations. A lot of public companies have public credit ratings you can research. When you’re evaluating the creditworthiness of a tenant, look at things that can be tracked. What’s their track record? How many units do they own? How many do they operate? What’s the balance sheet of the credit? How did they perform versus their competitors? What type of debt does the business have?

Pro tip: Know that a lot of the details relative to your risk on the tenant’s credit will be spelled out in the actual lease. For example, let’s say you’re buying a location of a popular fast-food restaurant. The lease will say if you have the company’s corporate credit guaranteeing payments, or if there’s a single-person franchisee who is guaranteeing that.

With NNN investments, your guarantee is not solely based on the performance of that one location. The security that a net lease gives you is that the responsibility for the payment is distributed among the whole company. That gives you another layer of protection. If the store or business in that location did poorly that particular year, you as the owner are not in a risky position.

3. Unit Economics

Unit economics refers to the economic performance of the specific property. If you’re buying a business that has 100 locations, your unit economics would be a way to compare the profitability of those locations against each other.

For example, let’s say you’re buying a business with multiple locations, and the average gross income across those locations is $1 million. If the particular location you’re looking at grosses $1.7 million, you know that it’s performing significantly above the average, therefore, it’s more profitable and you have more protection from any performance downside. On the other hand, if this particular location is making a gross income of $850,000, you know it’s on the lower end of the scale and you should be purchasing this data asset at a higher return compared to the one that’s doing $1.7 million.

This is what you should consider when thinking about unit economics for each type of NNN asset:
Ex: Retail/restaurants

Think about the sales per square foot, rent as a percentage of sales, unit-level sales vs. national   average for the brand, and unit-level sales vs. competitors in the area.
Ex: Convenience Store/Gas Station

Consider the volume of gas gallons pumped, inside vs. outside sales, competition in the immediate   area, subleases/additional income generators (like a car wash), environmental status, and   accelerated depreciation.
Ex: Banks

For banks, owners need to examine deposits at the location, local competition, and average   household income trends.
Ex: Medical

If you want to buy a medical building, assess its network affiliation, capacity (like beds,   inpatient/outpatient services), medical specialization, and geographic importance.

4. Investment Structure

After you’ve looked at the other three categories above, you’ll move on to investment structure, which is basically determining what you’re going to make from this property. The first thing to think about is return metrics. Determine the capitalization rate by dividing the net operating income (NOI) by the purchase price. Also, look at your cash-on-cash return. You can find this number by dividing cash flow (after debt service) by your down payment.

The next thing you’ll evaluate is the lease terms. Is it a true triple-net lease or a double-net lease? In the industry, most companies say they’re triple-net, but are actually double-net. A true triple-net lease dictates that the owner of the real estate doesn’t have to pay for anything during the lease term (so no maintenance, no taxes, no insurance). Double-net means there may be certain categories that the owner is responsible for (like improvements to the roof). We recommend consulting with a professional who specializes in this asset class and knows what to look for in these types of leases.

Then look at how many years are left on the lease. Typically, you’ll see cap rates go up if there are fewer than 10 years left on the lease because the new buyer needs to be compensated for the uncertainty which may occur at the end of the lease. The last part of the lease terms that you need to check out is rent escalations. When does the rent increase and by what amounts?

Finally, it’s time to think about financing. Ask yourself how much financing you can get on the property. How much cash is required to purchase the property? What’s your interest rate and amortization schedule for the financing period? When it comes to net leases, it’s typical for banks to have a 25-year amortization period rather than 30 years. Depending on how high your leverage is, you also may have to personally guarantee a portion of the loan.

Conclusion

One of the greatest benefits of owning real estate is the ability to defer capital gains taxes and continue to “rollover” your profits on new investments.

If you’re unfamiliar with triple-net leases or 1031 exchanges, talk to a professional who specializes in these transactions.  The New York Multifamily Team at Marcus & Millichap completes hundreds of millions of multifamily sales and purchases of triple-net transactions each year. To learn more about how, contact our team below.

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