Should I sell this property to our tenant?

[White.Beard.Doc]

I bought my very first investment property when I was a resident. I have a tenant who has been living in the property for 16 years who has a solid job but does not have much money for a down payment. The property is only an ok investment in terms of annual income due to high property taxes, but there has been appreciation and there have been great tax benefits along the way. The tenant is somewhat interested in buying the property if she can scrape together enough for a small down payment and for closing costs.

Current market value: $325,000
Current adjusted cost basis: $18,000
Initial investment was $36,000
Mortgage has been fully paid off by directing a portion of each monthly rent payment to the mortgage.

If I sell, the taxes could be quite high. There would be capital gains tax, depreciation recapture tax, and state tax owed. I am in the highest marginal bracket.

This year, I have large bonus depreciation deductions on new real estate purchases. This year, my spouse is a real estate professional, so the depreciation write offs will negate W2 income, S-corp distributions, and other real estate income.

My first question, would active losses from real estate deprecation be able to negate the gain from the sale of this property? This property has been considered a passive activity every prior year before 2021. My spouse now has real estate professional status for the first time in 2021, which changes the status of our real estate investments and real estate income/depreciation deductions this year from passive to active.

My second question is if I should consider a 1031 exchange to a more expensive and higher yielding property, thereby deferring the gain. I would likely hold the new property until death, allowing for a step up in basis. Just the same, our investments have succeeded to the point where we will be owing federal and state estate taxes, so does buying more property and holding out for the step up in basis even make sense?

The third question is surrounding how we might help our very nice tenant purchase this home. Are there 3% down loans out there that she might qualify for? The tenant and I had several local real estate folks do a comparative market analysis for potential sale, and they all came up with the same market value. Our thought was to make this a win/win by deducting 3% from the current market value from the purchase price, thereby sharing the savings from not paying the real estate commission. Or we could keep the purchase price the same, and use this 3% to pay some of the closing costs or down payment on behalf of the tenant.

[ENT Doc]

The first thing I’d get is a more solid commitment from the tenant before considering anything.

Active vs passive real estate owner won’t matter this year if selling. Everything gets realized at time of sale. How is your basis below the purchase price?

[StateOfMyHead]

From what I imagine you have more money than you will ever spend and I'm not a fan of being overly concerned with leaving money behind for heirs so I would be ok paying the taxes on the profit. The time frame to do a 1031 exchange has always turned me off and now, at least in my area, is not the time to purchase property due to lack of supply, seller's market. Also do you really want the ongoing time investment and responsibility of managing rental properties at this point in your life?

This would be a very nice thing, possibly life changing, for a good, long term tenant. I like that you would do it at fair market value. She would have to do her own investigation into possible financing options but I would work with her with regard to how the contract is written.
Please keep us posted.

[billy]

would a rent to own contract help here? (I have no experience in this btw)

[CordMcNally]

would a rent to own contract help here? (I have no experience in this btw)

"He's cut that corner pasture into acre lots
He sells 'em owner-financed strictly to them
That's got no kind of credit cause he knows they're slackers
And they'll miss that payment, then he takes it back"

James McMurtry - 'Choctaw Bingo'

[White.Beard.Doc]

The first thing I’d get is a more solid commitment from the tenant before considering anything.

Active vs passive real estate owner won’t matter this year if selling. Everything gets realized at time of sale. How is your basis below the purchase price?

The tenant very much wants to own the property. She is a bit timid though, and although I have encouraged her for many years to just buy it, she finally is thinking that this is something she might be able to do.

The cost basis is low because it gets reduced each year by the depreciation deduction. Maybe I am using the wrong terminology. Perhaps I should say "adjusted cost basis".

[White.Beard.Doc]

would a rent to own contract help here? (I have no experience in this btw)

I also don't know much of anything about this, but from what I have heard, a rent to own contract is not very good for a buyer and they take on lots of risk. If their financial situation changes, they lose the property and all of the payments they have made. We want to make this a win/win for both sides.

[FIREshrink]

Rather than rent to own, you could just do owner financing. She's a good tenant for 16 years, you likely know her better than any mortgage lender ever could. You can accept 3% down, avoid real estate agent fees, just get a lawyer for 1%, and come up with a 30 year payment plan at a fair interest rate. This is a way to give back to a world which has been good to you.

[Tim]

would a rent to own contract help here? (I have no experience in this btw)

I did a rent to own with an increase in the rent to force the renter to accumulate a down payment that they got credit for on closing. I made it high enough that they had to get financing or lose a ton. This works ONLY is they are a good credit risk and just don't have the down payment.

[White.Beard.Doc]

I started checking some mortgage estimates. She would likely need to make a 10k down payment and there would be almost 10k in closing fees and escrow needed to close. So even if we kept the price at $325k and paid $10k in closing fees on her behalf, she would still have to come up with $10k as a down payment to close.

I wonder if the bank would allow her any flexibility in paying that $10k, or a portion of it, in down payment funds to us as a second loan over a period of years. She was a bit reluctant to tell us exactly how much she has in cash to put down, but she did mention that her savings are better than they used to be, but still somewhat limited. As the tenant gets older, it would be so much better for her to have relatively fixed costs of ownership. She is a great tenant and we have kept her rent about 5-10% below market, but rents keep rising every year.

[StarTrekDoc]

Rather than rent to own, you could just do owner financing. She's a good tenant for 16 years, you likely know her better than any mortgage lender ever could. You can accept 3% down, avoid real estate agent fees, just get a lawyer for 1%, and come up with a 30 year payment plan at a fair interest rate. This is a way to give back to a world which has been good to you.

Depends on your priorities -- helping a long time tenant, tax efficiency, convenience.

If you want to be a lender - owner financed sale. That'll throw off lots of cashflow though.
1031 with step-up at death is most tax efficient
selling the property outright is most convenient.

Our exit plans for long time properties is to 1031 to retirement vacation locations that'll host us on trips for self and multigenerational trips. Don't care if they are highly cashflow positive at that time as we'll be pretty set and location would take priority. Then upon passing the stepups will kick in and property will be kids' problem to decide on selling to continue vacation options with no cashflow issues.

With market value 300k you have a lot of options to 1031 this

[burritos]

Is this endeavor going to add or reduce hassle to your life? Cause you don't need more money.

[Shant]

If the goal is to help this person I would just go with seller financed mortgage and ignore the taxes given your current financial situation.

[Tim]

I started checking some mortgage estimates. She would likely need to make a 10k down payment and there would be almost 10k in closing fees and escrow needed to close. So even if we kept the price at $325k and paid $10k in closing fees on her behalf, she would still have to come up with $10k as a down payment to close.

I wonder if the bank would allow her any flexibility in paying that $10k, or a portion of it, in down payment funds to us as a second loan over a period of years. She was a bit reluctant to tell us exactly how much she has in cash to put down, but she did mention that her savings are better than they used to be, but still somewhat limited. As the tenant gets older, it would be so much better for her to have relatively fixed costs of ownership. She is a great tenant and we have kept her rent about 5-10% below market, but rents keep rising every year.

Between a rock and a hard place.
Impact on her: Life changing
Impact on you: Less Roth conversion and simply using some of the other real estate tax benefits. I think you realize that you can get a tax deduction for your charity, a donation to this individual that you have a way of getting a tax benefit. Basically, a gift to a tenant that isn't to a charity. $10k won't move the needle on your Roth conversions. This is a monopoly game when you own all the properties. How do you want to end the game with this person? I don't think there are any lessons you are teaching. I see no benefit for either party of adding any future debt. Not judgemental, just the results.

[Hank]

Normally I'd recommend a contract for deed rather than an outright sale. However, if this tenant has made the rent payments regularly for the past 16 years, she probably would fulfill the terms of a contract for deed.