Without proper planning, investors who have improved, maintained, and even filled their properties with good tenants risk selling those assets for less than true value or paying capital gains taxes that could have been deferred. After an investor has determined that there are valid reasons to dispose of property, the next decision is how to effectuate the sale.
Outright Sale and Lease/Options
In an outright sale, an investor transfers title to property in exchange for payment without keeping any interest in the property. The buyer either pays all cash or makes a cash down payment and finances the balance of the purchase price with funds from a mortgage lender. If the investor has carefully considered the expenses, such as a real estate commission or unexpected repairs, and tax consequences – the local realty transfer tax and federal and state capital gains taxes – of an outright sale, this is the most expedient way to dispose of property.
For some investors, a short-term lease with the option to purchase may be more in keeping with their real estate investment plans. In such an arrangement, an “optionee” pays the owner for an option (also referred to as a down payment) to buy the property at a later date and then pays monthly rent for the duration of the lease. The owner and the optionee decide how much of the monthly rent is to be credited toward the purchase price. When exercising the purchase option, the optionee pays the balance of the purchase price with a conventional loan or other funds. The owner retains full ownership of (and tax responsibility for) the property until title passes to the optionee.
The lease/option is ideal for individuals who want to buy property but do not immediately qualify for a conventional mortgage because of inadequate income or what the lender deems to be a poor credit history. The lease/option transaction can save the seller the commission that a real estate agent would earn on an outright sale.
At times, a real estate investment plan is best served by the gradual sale of a residential property and the transfer of maintenance, insurance, and tax responsibilities to a qualified buyer. In this type of transaction, the investor is both the seller and a lender who takes back a mortgage on the property being sold. Because the U.S. tax laws consider this an installment sale, the seller can defer payment of the capital gains tax while receiving monthly payments akin to rent but without the usual landlord burdens.
At the same time, the buyer gains title to the property without all the paperwork and fees associated with a conventional mortgage loan; this often allows the seller to ask for a higher purchase price. The interest rate and the length of the mortgage term determine the monthly payment amounts. For investors amenable to installment sales, this can be an astute way to attract buyers in a tough lending environment. The downside to an installment sale is that the seller will have to go through foreclosure procedures if the buyer defaults under the terms of the purchase agreement.
Due Diligence Is Always Paramount
Many investors have successfully engaged in more creative and risky exit strategies than the ones described above. Regardless of the disposal method chosen, investor-owners must never neglect their due diligence. Among other things, this means verifying that a buyer has the funds to purchase a property outright or to make monthly rental or mortgage payments to the owner.
There are other factors to consider. For example, if the owner is disposing of a multi-unit residential property and a prospective buyer lives far away, is inexperienced as a landlord, and has no plan for managing the property, the owner may decide that the risk of default on an installment sale would be too high.