How Do You Know When To Sell A Rental Property?

Investing in real estate has been a winning strategy to build wealth for generations. The use of leverage when purchasing real estate allows you to supersize the returns for even greater net worth increases. Beyond your primary residence, investing in rental properties is the next logical step. So many people tell you to buy real estate, but very few talk about when to sell.

I’ve been looking at the returns on my properties and I think they’re underperforming. The big question is how do you know when to sell a rental property? Unfortunately, the answer isn't simple. This article will walk you through the different variables, from taxes to time to investment returns, to consider before choosing to sell a rental property.

3 Reasons to Invest in Rental Properties

Real estate investing is a great way to diversify your investments away from stocks and bonds. There are many flavors of real estate to choose from, including rental properties, commercial buildings, and tax liens.

I started investing in rental properties in 2006 when I sold my California home right before the real estate collapse. With the equity, I purchased multiple properties. This provided diversification among my real estate holdings rather than concentrating them in one California home.

Property Appreciation

When you buy a rental property, one goal is for the property to increase in value over time. You can force appreciation by improving the property. For example, you can rehab a distressed home or add square footage to it.

Cash flow

In a perfect world, the rent you receive would be sufficient to cover all of the costs associated with maintaining the property, such as the mortgage, the taxes, and the insurance.

Tax advantages

Many real estate investors are able to enjoy cash flow from their properties while at the same time paying nearly no taxes on the income generated by those assets thanks to the magic of depreciation.

Dive Deeper: How To Buy Real Estate In A Roth IRA

Risks Of Investing In Rental Properties

Rental property investing has many advantages, but it is not without risks. I’ve been investing in rental properties for more than a decade and still find ways to be surprised. Here are six of the most common risks you’ll face when investing in real estate

Vacancy

No matter how great your rental property is, your tenant will eventually move out. When this happens, you’ll have no rent coming in while the normal expenses are still due. Good property managers will find tenants quickly, but you still may need to do repairs and updates after the previous tenant moves out and before the new one moves in.

Investors should budget for 10% vacancy (approximately one month) each year.

Tenant Damage

Good tenants are a dream while bad tenants can be a nightmare. One bad tenant can erase years of profits through malicious acts. And their security deposit can be a drop in the bucket of the bill you’ll receive to get the property ready to rent again.

Major Repairs

Even if nothing bad happens, items around the property wear out. These repairs don’t happen every year, but you still need to budget for them. Roofs, hot water heaters, and flooring will all need to be replaced at some point.

Eviction

You may pay your bills on time, but not everyone else does. When a tenant refuses or is unable to pay their rent, you must evict them before you can find another tenant. Depending upon which state you are in, this process can be long, costly, and involve the courts.

A Downturn In The Economy

When the economy turns, landlords can be affected in many ways. Property values can stumble, tenants lose their jobs, and your property might sit vacant for months due to a lack of suitable applicants.

Distraction From Job And Family

Even if you hire a property manager, owning a rental property is not truly passive income. You'll need to be involved with major decisions about the property, but someone has to oversee the property manager, pay the bills, balance the checkbook, and prepare the taxes. Each of these steps can be outsourced at a cost. Otherwise, you'll need to take time away from work and family to handle these responsibilities.

Should You Pay Off A Rental Property Mortgage?

There are two schools of thought on this subject--pay it off as quickly as possible or utilize leverage as much as you can. Which one you choose depends on your appetite for risk.

The Case For Paying Off The Mortgage Quickly

Many believe that eliminating debt alleviates the worry of a mortgage and gives them peace of mind. Being debt-free with only basic expenses owed on the property each year provides a certain level of comfort.

Without a mortgage owed each month, the cash flow available from rents increases significantly. Landlords can use this money for personal expenses, to reduce other debt, or to invest in other assets. And the elimination of debt provides a cushion for investors in case of an economic downturn or extended vacancy.

In my pursuit of Financial Independence, I focused on paying off my rental property mortgages early. I wanted the extra cash flow to provide income to replace my wages. By the time I left my corporate job, I had paid off two rental property mortgages totaling $200,000 and was working on a third rental property mortgage of $85,000.

Why Leverage Is So Attractive

When buying real estate, leverage is your friend. For most people, you can buy your primary residence with as little as 3% down. Rental properties require a larger down payment of around 25% depending upon the lender. Interest rates for rental properties are usually 2% to 3% higher than a primary residence mortgage.

By preserving your cash and making use of the bank's money, investors can buy more properties than they could if they had to pay 100% in cash. When each property is cash-flow positive, your income can grow quickly.

The downside is that all of this leverage can bankrupt an investor if they have extended vacancies and don't have cash available to pay the mortgages when no rents are coming in. During the financial crisis of 2007 to 2010, many investors lost everything when they couldn't make their payments.

When To Sell A Rental Property

Real estate doesn't have a daily indicator of market health like the stock market does. Instead, real estate investors need to piece together clues and make decisions for themselves. Some of the factors you'll need to analyze are:

Cash flow of the rental
Hassle and personal time involved
Vacancy trends for your property and the local market
Economic trends
Upcoming repairs
Other investing opportunities

In my situation, I initially focused on paying off my mortgages to increase my cash flow. What I didn't focus on were the returns on my equity for each property. While preparing my tax returns this year, I started doing the math and realized my ROE (return on equity) was not very good when factoring in all of the risks I was taking.

Listen: Real Estate Investing Strategies With Paula Pant

Should You Keep Your Rental Property Or Sell?

To determine your return on equity, you'll need to know your Annual Net Income and your Cash From Sale.

The Step-by-Step Math

Here's how to calculate return on equity to determine whether or not to sell rental properties.

Determine the value of your home. Websites like Zillow can provide an estimate, but requesting a broker's price opinion (BPO) from a real estate agent will provide a more concrete estimate.
Factor in selling costs. No matter what you list your home for, you will never receive 100% of that amount. Real estate agents will take 6% of your home's value, and repairs, painting, and other maintenance may be required to make the home attractive. The buyer will try to offer something less than the list price. And there are city and county transaction costs to consider.
Subtract your mortgage. If you have a mortgage, you'll need to pay it off when you sell your rental property. Make sure to factor in any prepayment penalties that may apply.
Cash from sale. What you have left is an estimate of the amount of cash you'll receive after selling your rental property.
Subtract taxes owed. Most likely, you won't get to keep all of the money you receive. If there are capital gains, Uncle Sam will want his share. Keep good records of improvements and depreciation claimed to arrive at the final calculation.
This is your Cash From Sale (or Net Equity). The amount that you would net from the sale of your rental property.
Take our your tax returns or income statement. Find the annual net income (excluding depreciation) from the property?
Divide your Annual Net Income by the Cash From Sale. This result is called the Return on Equity, or ROE. After adjusting your cash from sale for taxes, divide that number by the cash that you would receive from selling your rental property (value of the property minus all selling costs). For me, that number was around 3.5%, which is not adequate given the risks compared to other investing alternatives.

For example, let's say on average you expect to receive $10,000 per year in net income from the property and your cash from sale is $200,000. That would make your ROE 5%; (10,000/200,000 = .05).

Everyone's hurdle rate for ROE is different. And a lot depends upon what other alternatives there are. Just make sure that you factor in the risks of those investment alternatives as well.

In my situation, I can find 5-year CDs that are paying just under 3%. Why would I take on the risks of a rental property for an increased return of less than a 1% (3.5% rental property return minus 2.75% 5-year CD)? Whether you are investing in rental properties, the stock market, or your own business, make sure that the returns you're receiving are commensurate with the risks you are taking.

Related: What Is House Hacking?

What Happens When I Sell My Rental Property?

When you sell your rental property, that sets in motion a number of processes. First, the new owner will either want to be a landlord or will have to wait until the tenant's lease expires. In some situations, the new owner can offer incentives for the tenant to move out so that way they can move in.

Taxes may be due when a rental property is sold. Because this situation happens so rarely in a persons life, most people would benefit from working with an accountant even if they normally prepare their own taxes. A qualified tax preparer may also be able to help find ways to reduce any taxes owed from the sale.

Then you'll need to invest your money into something else. A low return is not good, but letting your money sit idle earning nothing could be even worse.

How Much Tax Do You Pay When You Sell A Rental Property?

The amount of taxes that you'll have to pay when selling a rental property varies. The taxes owed are based upon the capital gains from the sale. Your capital gains are the difference between the sale price and your cost basis. Currently, long-term capital gains are taxed at 15% at the federal level.

How Can I Avoid Paying Capital Gains Tax When Selling A Rental Property?

There are five primary ways to avoid or reduce paying capital gains tax when selling a rental property:

Maximizing your cost basis. Your cost basis is the amount of money you've paid for the property plus permanent improvements. Keeping good records is a key component of this strategy.
Harvesting capital losses. Capital gains tax laws allow you to offset gains from the sale of one asset with the losses on another asset you've sold. This strategy is more commonly used with stocks, mutual funds, and bonds, but works with real estate as well. Listen to this ChooseFI podcast episode to learn more about harvesting capital gains.
1031 Exchange. When you reinvest the proceeds of the sale into another real estate property, you can defer the capital gains taxes until you sell the next property.
Converting a rental into a primary residence. Homeowners can avoid up to $500,000 in capital gains on their property if they've lived in it for two of the previous five years.
Death. If you die before the rental property is sold, your heirs will enjoy a step-up in cost basis. The cost basis for this sale will be the value of the property upon the time of your death.

Don't forget about your tax loss carry-forwards! If you're like me and rental property investing is your side hustle, you may not be able to deduct your losses each year. Unused tax losses are carried forward to offset future income or to reduce the tax burden when you sell the property.

Calculating A Rental Property's Cost Basis

Your property's cost basis begins as the amount that you initially paid for the property. The cost basis increases when you make permanent investments in the property (ex., upgrading the kitchen or adding a bathroom).

Your cost basis is reduced each year that you claim depreciation on the property and any improvements you've made. When you sell your rental property, you may need to pay income taxes on the depreciation amounts in what is called "depreciation recapture." For any depreciation that you've previously claimed, you'll pay taxes as if it was ordinary income, up to a maximum of 25%.

Can I Move Into My Rental Property To Avoid Capital Gains Tax?

Yes. When you live in a home for two of the previous five years, you can claim capital gains exemptions on the proceeds. Single taxpayers can claim up to $250,000 in exemptions, while married, filing jointly taxpayers can claim up to $500,000.

This can be an attractive way to avoid capital gains tax. Just make sure that the property is a place that you'd want to live in for two years.

What Is a 1031 Exchange And How Does It Avoid Taxes?

A 1031 Exchange takes advantage of the tax code to avoid paying capital gains taxes when selling a rental property. The strategy here is to reinvest the proceeds from the sale into one or more rental properties or similar assets that are greater than the proceeds you've received from the sale.

You have 45 days from the sale of the property to identify another property to purchase and have a total of 180 days from the sale date to complete your purchase.

Whatever proceeds are not invested will be taxed proportionately. For example, if you are unable to invest 20% of the proceeds, you will be taxed 20% of the taxes owed on the sale.

Listen: House Hacking With Coach Carson

Is It Time To Sell Your Rental Property?

The decision of whether or not to sell is an individual choice. I posed this question to the Choose FI community on Facebook and the members had a lot of opinions on the matter. Some were against the idea, while others believed that rental property investing wasn't worth the hassle and risk.

Before you choose to sell a rental property, do the math on the tax consequences and compare your returns against the alternatives. If the returns are similar, you may be better off keeping your rental properties and benefiting from the portfolio diversification.

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How Do You Know When To Sell A Rental Property?

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How Do You Know When To Sell A Rental Property?