Many owners of rental homes and apartment buildings are now feeling the impact of what is likely to be vast sector damage that may inhibit their ability to make mortgage payments. If this persists, smaller landlords with fewer capital reserves face a challenging future.
In many cases, small landlords utilize their investment properties — whether multifamily or single-family — for recurring retirement revenue or as critical aspects of their long-term retirement strategy. Yet despite the bleak economic conditions, properties still require improvements — appliances still need fixing and roofs still need repairing — which costs money. Money that they may not have because properties are vacant or tenants cannot pay.
This vicious cycle may raise serious questions for owners about keeping these properties. Owners may be tempted to sell assets to generate short-term cash in an effort to replace lost revenue. Their options are few but straightforward: Sell the property; hold it, or exchange it through a like-kind or 1031 exchange.
1. Selling: For many investors, selling only creates further headaches. Selling leaves owners exposed to the hefty capital gains taxes due upon sale that can eat 30% to 40% of their profits. A hasty decision to offload these investment properties may jeopardize an investor’s retirement funds and compromise the foundation they’ve built for their future.
Before making this decision, owners should ensure they understand the implications of capital gains taxes on the sale. In a simple example, if an investor has $100 of net equity in investment proceeds and an effective tax liability of 30% on those proceeds, he or she is left with $70 of investable equity. In order to make back the original $100, close to 45% appreciation is needed on the reinvestment of the remaining $70. In other words, it’s best to avoid losing 30% to 40% of profits to capital gains as it’s extremely difficult to make up this loss — particularly now with yields so low.
2. Holding: While the economic environment could worsen for the real estate sector, real estate may yet prove to be resilient over the long term. Those who are able to hold onto their investment properties can use targeted strategies to help protect value.
For landlords operating short-term rentals, it may be prudent to convert to longer-term leases to lock-in committed tenants wherever possible. In some cases, it may be beneficial for the investor to provide a discount to the tenant in order to close the deal and secure occupancy.
Additionally, property owners may consider refinancing as a way to access liquidity without having to sell the property and face the ramifications of capital gains taxes. While credit has tightened, especially on non-primary residences, investment property owners who qualify may be able to refinance their property at historically low rates, which could help cover some of their costs in the immediate term.
Even if investment property owners aren’t able to realize the income they had planned to during this time, if they can weather this storm, their long-term retirement income will be, for the most part, more protected by holding onto the property versus hastily selling.
For some investors there is a third option — exchange the property through a like-kind or 1031 exchange.
Like-kind exchanges enable owners to stay invested in real estate while allowing for a rebalancing of assets. As long as funds are reinvested in another investment property, capital gains are deferred until the investor sells the new asset, and potentially indefinitely through subsequent exchanges.
If an investor does choose to process a 1031 exchange, they’ll be able to defer capital gains. However, selling and reinvesting in another rental property doesn’t solve their problem. They still will need to maintain a property and could face challenges similar to what caused them to sell in the first place.
An alternative for investors processing a 1031 exchange may be investing in Delaware Statutory Trusts (DSTs). A DST is a type of fractional ownership structure recognized by the IRS for use in a 1031 tax deferred exchange. DSTs offer a solution that allows investors to stay in real estate without having tenants, all while deferring capital gains taxes.
Rather than owning a direct property, a DST investor owns a fractional interest in a property of institutionally-quality managed by a sponsor. This type of ownership is passive — meaning that the investor takes on a less involved role while the DST sponsor deals with the landlord duties and the typical tasks associated with direct property management. Additionally, these properties are funded through non-recourse debt, which means that if a property is unable to make its mortgage payments, creditors cannot go after the investor’s individual assets.
While DSTs have their disadvantages, they enable access to institutional-quality properties that are varied across classes, including self-storage, industrial, and large multi-family complexes, for example all of which the average investor may not be able to access on their own.
Looking ahead, my firm anticipates a U-shaped recovery for the U.S. economy over the next 12- to 18 months, but we can only make an educated guess on what the near future will bring. One thing is clear: No two property types or asset classes will perform alike in this recovery. Investors can manage their risk by being diversified, in an effort to hold onto their investments without exposing themselves to the exorbitant recovery costs associated with liquidity.
David Wieland is founder and CEO of Realized Holdings,which specializes in 1031 exchanges for real estate investors.