Evaluating whether to sell or hold rentals that have appreciated rapidly

[RumBurgundy]

Do any of the users here have a rule of thumb for the point where you would sell a rental property because the rental income lags the potential investment returns from the proceeds of selling said property?

I guess in theory the potential for rental income should rise to an appropriate level as well as a building appreciates. But in my case with a multi-family where I have recently listed 2 apartments on the property in recent months, gauging from the interest and quality of tenants that responded, I've pretty much maxed out the rents on this property. Additionally, the building has appreciated significantly so there is a lot of equity that I think could be better invested.

Approx numbers projected for 2020 below:
Rents: $44k
Insurance: $4k
Mortgage interest: $9k
Repairs: ?
Taxes: $4k
Utilities: $3k (water/sanitation)
Depreciation: $6k
$223k mortgage balance
$600k anticipated sale (agent has estimated a bit higher)

Looking at about $24k net BEFORE repairs and taxes.
I have not worked through the tax forms to nail down how much I would be taxed in capital gains/depreciation recapture if I sell the property but for the sake of this mental exercise I'm assuming I'd be in the ballpark of 275k-300k in proceeds after taxes RE commission, and repairs for sellers.

Were I to simply invest the estimated proceeds of $300k in VTSAX, at 8% return I'd be matching the *best* case (no repair expense or vacancy) of rental income if I kept the house, only with virtually no work required on my part and a lot less stress/inconvenience.

So, I ask the landlords here, would you sell? Would you have sold yesterday? Or would you evaluate this differently?

[Scortius]

I'm not an expert, but I think the simple answer is absolutely. You should compare it to the opportunity cost of not using that value to invest in other assets. On the other hand, if you've seen massive appreciation, you may want to add potential future appreciation into your possible return when evaluating what you may earn by keeping it.

[RumBurgundy]

On the other hand, if you've seen massive appreciation, you may want to add potential future appreciation into your possible return when evaluating what you may earn by keeping it.

While my crystal ball is quite cloudy, I have to say that I see much more potential for the property to lose value as a result of natural disaster (hurricane alley), and systemic issues with the city administration. Flood/home insurance could rebuild the home but I suspect overall value of the property itself would take a long time to recover to current value (which is approx double the replacement cost). If ever.

Faced with the choice of putting 6 figures in the stock market during all - time highs vs betting against the possibility that urban real estate nationwide isn't peaking again (plus the disaster risks), I think I'd rather bet on the choice that gives me more freedom of mobility.

[RumBurgundy]

Faced with the choice of putting 6 figures in the stock market during all - time highs vs betting against the possibility that urban real estate nationwide isn't peaking again (plus the disaster risks), I think I'd rather bet on the choice that gives me more freedom of mobility.

I realize that will sound like I have made up my mind. I'm open to looking at this a different way if anyone cares to share what I might be overlooking/underestimating.

[clarkfan1979]

I think you need a 3rd option, which is a cash-out refinance.

Dead equity in real estate is a real thing. However, it is a good problem to have.

If you like the property, do a cash-out refinance and keep it.





 

[Another Reader]

What are the tax consequences, i.e. what is your capital gain and how much depreciation must you recapture?

[RumBurgundy]

I think you need a 3rd option, which is a cash-out refinance.

Dead equity in real estate is a real thing. However, it is a good problem to have.

If you like the property, do a cash-out refinance and keep it.

This is an interesting proposal. I like the property in some respects but it (or rather, the historical society that has much more say than they should) has become increasingly demanding over the years. If I do a cash-out refi I still have the looming potential for a headache from the city. Additionally, I'm burned out with the landlording thing (I have 7 total units at the moment) so if I have cash to invest, it's going straight into an index fund at this point. I'm apprehensive of what happens if I put the house's equity in the market and both the stock market and real estate market end up popping.

[RumBurgundy]

What are the tax consequences, i.e. what is your capital gain and how much depreciation must you recapture?

If the house sells for $600k, which was my previous estimate, I'm estimating the following:
Federal & State capital gains tax: $38k
Depreciation recapture: $14k
Net proceeds after taxes/depreciation, RE commission & mortgage paid off:  $296k

I actually met with my long time RE agent today to do a walk through for recommended repairs/improvements and the info I got from her suggested my potential selling price may be closer to $550k, which changes the tax/depreciation estimates to the following:
Federal & State capital gains tax: $31k
Depreciation recapture: $14k
Net proceeds after taxes/depreciation, RE commission & mortgage paid off:  $257k

There's an extra wrinkle here too: the above numbers assume that 40% of the capital gains are tax exempt because this house has been my primary residence for the better part of a decade and I rented out the other 60%. I have recently stopped treating this as my residence (due to divorce) and I do not foresee myself living in this house in the future. The rental income numbers in the OP assume the house is fully rented so there is no additional profitability due to my moving out. If I choose not to sell within the next year or two, I lose that tax exemption and the entire house will be considered a rental.

[tct]

I was evaluating this same scenario last year. I made the decision to sell, based on wanting to be more diversified. I was really heavy on real estate compared to equities. While the capital gains taxes were difficult to digest, I still feel like I made a good decision.

[RumBurgundy]

I was evaluating this same scenario last year. I made the decision to sell, based on wanting to be more diversified. I was really heavy on real estate compared to equities. While the capital gains taxes were difficult to digest, I still feel like I made a good decision.

It's not what I'd consider a slam dunk so I appreciate you sharing your experience.

[SeattleCPA]

I was evaluating this same scenario last year. I made the decision to sell, based on wanting to be more diversified. I was really heavy on real estate compared to equities. While the capital gains taxes were difficult to digest, I still feel like I made a good decision.

It's not what I'd consider a slam dunk so I appreciate you sharing your experience.

Probably if you're thinking about this issue, you want to stay alert to the mark-to-market accounting proposal from Elizabeth Warren and discussed in this thread: https://forum.mrmoneymustache.com/entrepreneurship/warren-wealth-tax-may-impact-your-small-business-or-business-planning/

I am not saying one makes decisions based on a mere policy proposal from one of a party's candidates... but if you were truly conflicted and stuck in the middle, it would make sense to think about impact of mark to market.

What the mark to market accounting means, in a nutshell, is you pay income taxes at ordinary tax rates on asset appreciation if your net worth puts you in the top one percent. That taxation replaces the usual capital gains at time of sale.

I don't think we know for sure now what the top one percent threshold is... but it's pretty high. Maybe $4M according to her economists? But fast forward to end of your accumulation phase and add up all your assets (house, retirement accounts, rentals, etc.), and by definition, a couple of million people would be impacted.

Given all this, some real estate investors might choose to recognize gains now and as capital gains or unrecaptured Section 1250 gain (basically the 'depreciation undo')... rather than as ordinary income later on.

BTW, this idea that tax rates will probably rise in the future also effects Section 1031 exchanges... Does it really make sense to kick can down the road if, down the road, rates are higher?

[RumBurgundy]

I was evaluating this same scenario last year. I made the decision to sell, based on wanting to be more diversified. I was really heavy on real estate compared to equities. While the capital gains taxes were difficult to digest, I still feel like I made a good decision.

It's not what I'd consider a slam dunk so I appreciate you sharing your experience.

Probably if you're thinking about this issue, you want to stay alert to the mark-to-market accounting proposal from Elizabeth Warren and discussed in this thread: https://forum.mrmoneymustache.com/entrepreneurship/warren-wealth-tax-may-impact-your-small-business-or-business-planning/

I am not saying one makes decisions based on a mere policy proposal from one of a party's candidates... but if you were truly conflicted and stuck in the middle, it would make sense to think about impact of mark to market.

What the mark to market accounting means, in a nutshell, is you pay income taxes at ordinary tax rates on asset appreciation if your net worth puts you in the top one percent. That taxation replaces the usual capital gains at time of sale.

I don't think we know for sure now what the top one percent threshold is... but it's pretty high. Maybe $4M according to her economists? But fast forward to end of your accumulation phase and add up all your assets (house, retirement accounts, rentals, etc.), and by definition, a couple of million people would be impacted.

Given all this, some real estate investors might choose to recognize gains now and as capital gains or unrecaptured Section 1250 gain (basically the 'depreciation undo')... rather than as ordinary income later on.

BTW, this idea that tax rates will probably rise in the future also effects Section 1031 exchanges... Does it really make sense to kick can down the road if, down the road, rates are higher?

Thanks for weighing in. This is an angle I hadn't considered. I won't be doing a 1031 exchange if I sell now. If I were to sell later...then maybe.

Speaking of selling later, is there any validity to the suggestion that I could get the house appraised prior to converting to 100% rental, thus "locking in" the tax-free capital gains I've seen from the appreciation of the personal share of the house?

[jpdx]

Probably if you're thinking about this issue, you want to stay alert to the mark-to-market accounting proposal from Elizabeth Warren and discussed in this thread: https://forum.mrmoneymustache.com/entrepreneurship/warren-wealth-tax-may-impact-your-small-business-or-business-planning/

If and when Warren becomes our next President, is there any realistic scenario that this becomes law? Not likely. I think presidential candidates often offer never-pass policy proposals just as a tool to communicate their values. It's absolutely fair to evaluate their policy merits, but I wouldn't make any serious financial decisions based on this campaign proposal.