It is important to understand exit strategies with any investment you make. There are many different ways to implement a real estate exit strategy when investing. This allows you to be creative and build some great safety nets for yourself. That being said, you still need to plan ahead for these items, as opposed to just taking it in stride.
The last thing you want to do is get finished with a project, realize it won’t cash flow, and not have planned out any way to exit the deal without losing money.
A great real estate ext strategy you can use immediately is to wholesale the house to another investor. Wholesaling is the art of putting a property under contract, then “assigning” that contract to another real estate investor at a higher price.
Let's say you get a property under contract for $50k, that will be worth $100k after completing $20k in renovations. You could wholesale this property to another investor for $60k, and they would still have room to make a profit after they fix it up!
This is a good strategy if you get a property under contract and realize that you are too busy to complete it, or just want to make a quick buck.
This is the most self-explanatory exit strategy of them all. However, there can be some intricacies involved in the sale of your home. You need to understand that if you list the home with a realtor, you will traditionally pay out a 6% commission that is split between the buyers’ and sellers’ agent(s). You may also be responsible for some closing costs and even some repairs depending on the results of the inspection. Be sure to factor this in before listing the home. Ensure you won’t have to bring money to the closing table because you’re losing money by selling the home.
Also, selling your home as a for sale by owner (FSBO) might mean you’re eliminating the realtor’s commission, but FSBO homes stay on the market longer and sell for less money than homes sold by agents. Don’t get sucked into the FSBO trap. Just list the home with a realtor and avoid all the headaches of trying to do it yourself.
Capital Gains Tax Upon Sale
If the property appreciated a lot in value, you could be on the hook for capital gains tax when you sell. Long-term capital gains tax ranges from 0%-20%, depending on how much money you would be receiving in capital gains. Short-term capital gains are even more expensive, but you won’t have to worry about that if you owned the home for at least one year.
Also, if you live in the home as your primary residence for 24 months (cumulatively) out of the previous 60 months leading up to the sale of the home, you will not have to pay any capital gains tax when you sell. For active duty, you can avoid capital gains tax if you lived in the property for 24 months (cumulatively) out of the last 15 years prior to the sale of the home! Talk about an incredible tax benefit! You can avoid paying capital gains tax for up to 15 years after moving out of the house, as long as you reside there for 24 months during that time period.
3. Rent to Own
Selling a property on a lease option contract, or commonly known as rent-to-own, is a cool way to exit a real estate investment. There are several ways to structure this, but essentially you are renting the home to a tenant with an option for them to purchase it. This can be a great real estate exit strategy and create win-win scenarios for everybody involved!
Typically, the tenant will pay you a fee to lock in the option. Then they'll sign a long-term lease with an option to purchase the home at an agreed-upon price.
Let’s assume the home is worth $100,000 at the time you sign this option contract. You, the lessor, could have the tenant (lessee) pay you $5,000 to lock in the lease option price at $100,000 for the next three, four, five years, etc. If they choose to execute their option to purchase the home, you are obligated to sell it to them at that price, no matter what the value of the home is at that point. This is a good deal for the lessee because they have the option to purchase the home for $100k. If the property appreciates to $110k or more, they win, if not, they can walk away.
It is a good deal for you because you keep the option fee and can charge more for rent. That is because an agreed-upon amount of each rent check is placed in an escrow account. This money goes towards the purchase of the home if they execute their option. If the tenant executes their option to purchase, they get the money in escrow. If they fail to execute the option, break the lease, or violate the terms of the contract, you can keep the escrow money. Also, with a lease option contract, the lessee is on the hook for maintaining the property, depending on how you write the contract, which increases your cash flow.
This is a win-win strategy that can help both parties a lot. Landlords like to use this strategy to increase their cash flow and mitigate expenses on a property. Tenants like the rent-to-own option because it allows them to find a home they like while building their credit or improving their finances to execute the purchase. They also get to take the home out for a test drive so to speak. They are not obligated to execute the option and purchase the property if they decide they don't like the home.
4. 1031 Exchange
The term 1031 Exchange is defined under section 1031 of the IRS Code. To summarize, this strategy allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property.
The 1031 exchange is a very popular real estate exit strategy!
The 1031 exchange is a great strategy for real estate investors to dodge a large tax bill, at least for the time being. Basically, if you want to avoid paying that pesky capital gains tax on your investment properties, you can utilize a like-kind exchange to defer those taxes until a later date. It is important to note that you aren’t erasing these taxes, simply deferring them until a later date. But it is possible to continue deferring these taxes until you pass away. Probate is a great way to mitigate the taxes you pay!
As great as this sounds, the major downside is how tedious and complicated the 1031 process is. There are several rules that must be adhered to or you will definitely end up getting slapped with that capital gains tax bill!
The 7 Rules of a 1031-exchange
Rule 1: This must be a like-kind exchange. The term “like-kind exchange” is broad, but it means the property you sold and the new property must be of “the same nature or character, even if they differ in grade or quality.” You can’t exchange a car for real estate, but you can exchange any kind of real estate provided that it isn’t personal property.
Rule 2: The investor has up to 45 days from the closing of the first property to identify up to three potential like-kind properties to purchase. This can be difficult and may force your hand to purchase a less than ideal property if you aren’t careful.
Rule 3: The investor has 180 days from the closing of the first property to close on the identified new property. You have 180 days or until the tax return which has the sale of the first property must be filed (with extensions), whichever is sooner.
Rule 4: The new property must be of equal or greater value. Suppose your current property is worth $500,000. You must purchase at least $500,000 worth of real estate in order to defer 100% of the tax bill.
Rule 5: Only applicable for investment or business properties. This exchange does not apply to personally owned property.
Rule 6: Must not pay “boot”. If you fail to purchase a $500,000 property with the exchange and instead only buy $400,000, you will have to pay capital gains tax on the $100,000 that was not rolled into the new purchase. This amount is commonly known as the “boot.”
Rule 7: The tax return and name on the deed of the new property must be the same as the tax return and name on the deed from the previous property. The only exception to this rule is if the previous property was owned by a single-member LLC. They could title the new property in their name since single-member LLCs are technically considered pass-through income. (source)
Be sure you meet with a qualified intermediary who has experience with 1031 exchanges in order to help you navigate these complicated waters. If you can execute the 1031 exchange correctly, there are some great benefits to doing so. But it isn’t the end of the world if you pay some capital gains tax. You still made a lot of money with this investment—otherwise, you wouldn’t be paying capital gains tax haha.
Refinancing is a great way to pull equity out of the property. There are, however, many factors to consider before refinancing. “Should I refinance my home?” is one of those questions that is almost always met with an, “It depends,” answer.
There are many different refinance strategies you can take. That makes this a very powerful real estate exit strategy. Here are the pros and cons of each!
The cash-out refinance is a favored strategy for real estate investors.
A “cash-out refinance” is when you take out a larger mortgage amount against the property. At closing, you receive a check for the difference between your new mortgage and the amount you owed on the property before refinancing.
Let’s say that you have a remaining mortgage balance of $100,000 on a property that is worth $200,000. The bank could allow you to take out a new mortgage of up to 70% loan-to-value (LTV).
A cash-out refinance will leave you with a new loan for $140,000 (70% of the $200,000 property value) and a check for $40,000. This check is equal to the difference between the old mortgage and refinanced mortgage amounts.
Pay Off Debt
This is essentially a cash-out refinance, but you pay off high-interest debt with the money. This could also be done by wrapping the debt into your mortgage. That is a conversation you need to have with your lender in order to determine the best course of action.
How can you lower your mortgage payment?
You can lower your mortgage payment by refinancing to a lower interest rate and/or increasing the duration of the loan.
Both of these options can be used to lower your monthly payment, which means you'd receive extra cash flow. I'm not a huge fan of increasing the duration of a loan though.
Shortening the Loan Duration
Instead of refinancing to pull cash out or lower your monthly payment, you could refinance to shorten the loan term.
You will have a higher payment in the meantime, but if your cash flow can sustain that, it is a great way to save money over the length of the loan.
Lock-In a Fixed Rate
Another reason for refinancing is to lock in a fixed interest rate for the loan duration.
This is especially effective if you have an adjustable-rate mortgage (ARM) and interest rates are low.
When should you refinance your home?
There are a lot of strategies you can use to refinance your mortgage, and some are better than others.
Ultimately, your situation will dictate the answer, but refinancing can be a great exit strategy!
Successful Implementation of a Real Estate Exit Strategy
You need to plan out your real estate exit strategy as soon as possible before purchasing a property. The more creatively you can plan exit strategies for your real estate investments, the more lucrative they will be.
Having the ability to discover a solid real estate exit strategy will mitigate a lot of risk with your real estate investments. Warren Buffett’s number one investing rule is to “Never lose money”. These exit strategies are sure to help you accomplish that!