Where Does a Washington Landlord Go From Here? Which Way is Clear?
To Landlord or not to Landlord? That is the question so many of us that own rental property in Washington State have been asking this year. In Washington State (among others), there has been an all-out assault on private property rights that prevents landlords from running their businesses how they would like. In fact, forget that, right now you can’t even evict someone out of your rental property for not paying!
It’s times like these when it’s so important to understand where things are going and to get clarity on your rental property strategy. The industry “experts” will often tell you, “Let’s put it on the market! The market is super hot, and you can sell it for a lot!” While this is true, often it does not meet the Landlords’ needs, nor does it NET the seller the best return due to tax obligation and inferior replacement options that produce a lower monthly cash flow. If it’s not the market, it’s one of the dozens of post cards and cold calls asking, “Do you want to sell? We pay all cash and close quick.” These are typically wholesalers looking for a quick buck, pretending they are real buyers.
I often talk to Landlords about the following strategies:
- Hold and dial into legislative/industry change
- Get cashed out and pay the fees and taxes
- 1031 exchange into more real estate
- Be the bank
The hold and dial into legislative and industry changes option best serves those who intend to actively own the properties for at least 10 more years or those that intend to pass it along to their heirs. If you’re in the long-term hold “camp” you’re probably gearing up for the long haul to see what new legislation and tax law landlords will be battling in 2022 and beyond. The details of those legislative and industry changes are beyond the scope of this article, but you should tune into the LLA meetings and research Biden’s tax plan. If this sounds like you, it may be best to hold your rentals and refine your rental business practices over the next couple years. If you intend to pass the real estate to your heirs, this can be an excellent tax strategy because (under the tax law as of this writing) your heirs will get what’s called a “step up in basis” which will hit the resent button on depreciation and suppress the depreciation recapture that would have otherwise been due on sale.
Getting cashed out is the most expensive route by far. This strategy will be your biggest tax bill and will typically cost you 6% real estate commission (if listed with a broker), plus other costs. I recommend full cash out when someone needs the actual cash. If you need the cash to spend, this is your best route.
1031 Tax Deferred Exchange is a section of the Federal Tax Code that allows you to exchange your real estate for like kind property and, if done properly through a 1031 administrator, defers taxes on depreciation recapture and capital gain. The major challenge with this, especially in a market like today, is finding an acceptable property or properties to exchange into. You can’t touch any of the money or else you will be taxed! You typically have 45 days to identify property and 180 days to close on it. The catch here is that you’re still an active owner, and you have to “trade up” in terms of dollar volume and debt. In my opinion, this strategy is best used to change asset categories or geographical location.
Be the bank is another option. This option normally saves you the most in taxes and keeps your money secured by real estate, creating a monthly cash flow without any of the liability and accountability of active ownership. The section of the tax code that allows this (and is not on the Biden chopping block) is Section 1250 unrecaptured gain on installment contract. This allows you to decide how much cash to take today (based on how much tax you may or may not want to pay) and what to hold on a note as a monthly cash flow investment. Just like the bank, no major leg work, no liability, and it’s up to the buyer to operate it.
There is a lot to consider with the “best the bank” strategy….. how do you do it? How do you protect yourself? What would this type of deal look like to you? These are very important questions, and I have written a book on the subject to help landlords navigate their rental property plan and strategy.
Why would you pay a big tax bill?
If you own more than a couple of rental properties but your tax advisor does not own multiple investment properties nor specialize in working with major real estate clients, you may want to talk with a CPA that does own multiple investment real estate properties or specializes in working with clients that do. Having a CPA that understands the business side of real estate investment (and not just the tax code and expenses) is imperative. Why would you want to pay a big tax bill? An investor’s mind set should be to legally minimize your tax obligation, which allows you to maximize your profit potential and increase your monthly cash flow.
Real Estate is the king of tax obligation minimization. Packaged up you have the following: operating expenses that improve your asset value, leverage that increases profits but counts as an expense, tax credits for certain projects, capital gains that can be deferred, and — granddaddy of them all — depreciation! All these aspects can be used to your advantage in different life cycles of your ownership. Having a good understanding of these subjects is important if you truly want to minimize your taxes and maximize your profits. Most people have a general concept that you can and should write off “business expenses” or “repair and maintence” items. But without an intimate understand of how deep this rabbit hole goes, or an expert CPA to guide you, a lot of tax savings is usually left on the table. Meaning you are probably paying more tax than needed.
And of course, we know that instead of giving that money to the government, those deferred funds make interest that pays you monthly. After all, it’s your money until the government says you owe it to them! Deferring the tax keeps a very nice long term monthly income in play for the selling landlord. In fact, in most cases sellers can permanently reduce their tax obligation by good planning with their CPA and/or positioning themselves in a lower tax bracket in the future when they plan to receive most of their equity.
Let me give you a real-life example of some landlords we were able to help out with this strategy. John and Marcy S. owned 3 buildings totaling 22 units. Marcy had long since retired from her day job but still had to help on the rentals. John was a mechanical engineer getting ready to retire. John was doing the management of the buildings himself and trying to keep up with all the new regulations, maintenance, and tenants. John was starting to think about the next chapter of his life beyond active ownership.
John and Marcy had owned the buildings for 21 years, so they were staring down the barrel of a large tax bill between capital gains and depreciation recapture. John was also not really excited about paying 6% of the gross selling price in real estate commissions. After talking to his CPA but before listing it with a real estate broker, John called me and asked if I wanted to “take a look at them and make him an offer”.
I made John an offer on all 3 buildings that fit his needs. He sold them in one transaction and paid zero real estate commissions. But it got a lot better for John and Marcy from there! John wanted to buy a new Corvette! He didn’t want to take a huge down and create a big tax liability, so we agreed on a down that would give him the money to buy a new Corvette, cover what little tax obligation he might have, and put a couple bucks in his pocket for a rainy day. We also agreed on a monthly payment that would cover all their bills and support a lifestyle with some travel.
The result was John and Marcy saved over $100,000 in taxes that they would have otherwise owed if they were cashed out. That tax savings created an additional $525 per month cash flow totaling an extra $168,273 in equity and cash flow ($100,000 tax deferred, $68,273 interest on those deferred taxes). This doesn’t even include the savings of not paying commission! That’s awesome but not the best part! The best part is since John planned to retire the next year, his tax bracket dropped from 33% to 10%. This means most of the tax obligation was not just deferred but permanently eliminated! Instead of paying that tax they accomplished the extra cash flow, protected their equity, and got rid of most of the tax obligation they would have had if they got cashed out. Now they had a monthly income for the rest of their lives!
Today more than ever, it is so important to understand where things are going and get clear on your rental property strategy. With that in mind I am putting together a separate free report that will be available to LLA members November 2021 (stay tuned). As a landlord for over 20 years, broker/property manager for over 16 years, and sitting member on the Board of Directors for both the Inland Northwest Landlord Association and the National Association of Residential Property Managers, I have a very unique and insightful look into the market and what is coming down the pike. I will share it all with you!
In summary, if you plan on holding for a continued, long period of time, or buying more rentals, I suggest you talk to a CPA about tax strategy. If you are considering selling or like the idea of a more passive approach, then call me at 509-414-5123 or visit us at easyapartmentsell.com We have helped many real estate investors with their exit strategies. There is never a cost or obligation to see what an offer would look like for you! After all, our mission is to help you achieve freedom through cash flow.
Extant Investment Real Estate Company