What is your Exit Strategy?

Know what you’re doing before you buy a property. And, for that matter, know what you’re doing before you sell a property or exchange one. If you can always start with the end in mind, you’ll be better prepared to avoid unintended tax results.

Possible Exit Strategies

Following is a sample of some possible exit strategies for real estate properties. Your own plan might not be listed, but whatever your plan, make sure you’ve reviewed the financial and tax consequences. Plus, make sure you know what your Plan B is, in case your first plan doesn’t work out.

Quick Sale

These sales, also know as flips, can be a great source of cash to buy property you want to hang on to. But remember that these deals will generally be considered trade or business income, so you will be considered a real estate dealer. That means the income you make will be ordinary income.

Rent to Own

The benefits of this plan are that you get higher than normal returns. You will also need to make sure that the contract will have specific language so that it is clearly defined as a rental, and not a sale. That way, you’ll be able to defer tax on the option payments that you will receive. Probably the biggest challenge that you may experience with this plan is finding tax advisors who understand the benefits of creative real estate investments.

Cash Cow

Your entire plan may be to create a stream of income from your property either now in the form of positive cash flow, or later, when the property appreciates and you can refinance to access the equity. This is called a holding strategy. There is still the question of that the exit strategy will be on the property. If nothing else, at some point you will need to determine who will inherit the property upon your death. Sometime, somehow, there is a point where you will no longer own this property. What is your exit strategy? Sometimes we get so focused on getting results right now, that we forget what the ultimate goal will be with a property.

Pay Off the Property

For some people, the ultimate security is to pay off their investment properties. The cash flow improves because there is no longer any payment on the property. It is true that the very wealthiest in the nation frequently use cash to purchase their homes. By the way, note that we said “homes” because it’s not unusual for some to have an apartment in Paris, a penthouse in Manhattan, and an estate in Phoenix. We probably left out a few choice destinations, but the point is that the wealthy often own more than one home and they generally pay cash for them. Face it, if you have $4 billion that gives you even a small five percent return … what would you do with all the money anyway? It just becomes too much of a hassle to worry about getting a mortgage.

For everyone else, leverage becomes a way to build wealth. It is true that you will increase your cash flow when you pay off your property, but you will also slow down the velocity of your money. Paying off your loan also means building up more equity that is now a target for frivolous lawsuits.

That all aside, though, paying off the property is still not an exit strategy for the property. At some point, you won’t own it. What do you want to do with it?

Gift

Perhaps your ultimate goal is to give the property to family members or to a charity. Start planning now to give gifts in the best leveraged way. The current gift tax limitation for any donor is $11,000 per recipient per year. That means that you can give $11,000 of cash or property to someone in any one year, and there will be no gift tax due. If you’re married and have two children, as a couple you could give a total of $44,000 away per year under this plan (calculated as $11,000 to each child from you, and $11,000 to each child from your spouse). If you give appreciated property, your basis in the property will be used to determine the gift amount.

For example, if you have a property with a basis of $40,000 and debt of $30,000 that is now worth $200,000, your gift value for gift tax purposes would be $10,000 ($40,000 - $30,000). But what if your property basis is more than $11,000? One strategy is to put the property into a family limited partnership (that’s the same as a regular limited partnership, it’s just owned by family instead of unrelated parties), and then annually gift a percentage of that partnership to your child. It is also possible to give more than $11,000 per year using this method. Be warned, though. The family limited partnership has recently come under fire from the IRS for the minority discounts. A minority discount reduces the value of the gift because the minority partnership interest is deemed to have less value than a similar interest percentage that has voting power. You are safe giving $11,000 in value under this method, but you may have a problem using discounted values to give larger annual gifts.

Another method is to sell the property to your intended gift recipient. Take back a note on the sale. Each year, you will forgive a portion of the note. For example, let’s say that you sell a property for $200,000 for a note for the full value. To keep our example simple, we’ll assume that there is no debt on the property. The IRS tells us we must use an interest rate or they will “impute” one for us. So we set an interest rate of five percent per year. In the first year, you can forgive $11,000 of the note ($10,000 for interest and $1,000 for principal). If your child is married and you have given the property to both, you will be able to forgive $22,000 ($10,000 for interest and $12,000 for principal).

Another strategy that are recommended for anyone who has property they want to sell in a few years is to use the property to pay for a child’s college tuition. If your child is over 14 years old, gift the property to them and let them sell it! The child would most likely pay tax at a lower rate on the sale.