The job of a real estate agent is to contact local landlords and inquire about whether they want to sell. Among the common responses from landlords include…” I will never sell.” This response may seem unreasonable to the rookie investor; however, if you take a survey of some of the most successful investors in real estate, you will learn that the majority of them rarely, if ever, sell their real estate. Why? The answer is simple: Transactional Friction.
What is Transactional Friction?
Simply put, transactional friction is the sum of costs, both indirect and direct, that an investor sustains when performing a transaction. When investors include these costs in the financial assessments on the proposed sale of an asset, they often find that their return diminishes upon a sale. Here are a few examples.
When an investor sells their real estate and cashes out, they are responsible for paying capital gains taxes – they must pay taxes on the rise in the value of their asset. For example, if you purchase an asset and in five years the value of said asset doubles, you have to pay capital gains on 50% of your properties sale value. As a result, in many cases, the sale does not make economic sense because the profit that an investor makes in their years of ownership is often equal or less to what they will be required to pay in capital gains tax. As a result, they are better off holding the asset and avoiding paying capital gains.
One of the many benefits of investing in real estate is that annual depreciation reduces the amount that a property owner pays taxes on. It takes into account the wear and tear of a tangible asset. However, when an investor sells their real estate, they will have to take into consideration costs incurred due to depreciation recapture. This is a tax provision that permits the IRS “to collect taxes on any profitable sale of an asset that the taxpayer had used to previously offset his or her taxable income.” This income is reported and taxed on ordinary income rather than the capital gains tax rate, resulting in higher taxes to be paid upon the sale of a property. Due to this, many investors lose the benefit of depreciation when they sell their real estate.
Costs Associated with Debt
When you take on debt for a property, often in the regular payments you are responsible for paying both the principle and interest on the loan. The longer you hold the property and the note, the more principle you pay down – However, the structure of the loan often has the borrower paying more of the interest down in the beginning than the principle. So, when an investor sells their property before the loan is paid off, their profit on the sale will be reduced by the existing debt. If they sell earlier on, then the majority of the existing debt paid was to the interest payment; therefore, it is best to withhold a sale until the principle is paid down and you have more equity in the real estate.
In some cases, there may also be a balloon payment or prepayment penalty that a borrower may be responsible for upon the sale of the real estate. The primary way to avoid the balloon payment is to refinance and the way to avoid the prepayment penalty is to wait until the loan is paid off. If an investor sells their real estate, they may be responsible for both.
Risks of New Properties
Now that we have covered the more technical costs associated with a sale, let’s look at some of the practical ones by assessing the losses associated with reinvesting in new markets.
First off, when you buy real estate, every new deal has unique risks and set of unknowns. These often result in unanticipated costs that reduce an investors initial investment. In addition, it may take time to stabilize the deal so that it meets the goal of the investor’s strategy. So, when an investor sells an existing property that they have already stabilized and understand, and then reinvest, they are entering into the unknown of a new asset. Successful investors want to reap the benefits of their hard work and therefore do not want to sell once they get a deep understanding of the operations of a property, and would rather stabilize the deal and gain the financial rewards.
Secondly, selling a property in a good location means that you are letting go of your potential for future appreciation. When you buy an asset, it will appreciate over time – that is, it will increase in value. The longer that you hold a property the more gain you will experience. By selling you are letting go of the future appreciation you are gaining from your initial investment.
While some may agree that selling is too costly, they may be approached with the idea of participating in a 1031 exchange to avoid some of these costs while repositioning their portfolio. A 1031 exchange allows an investor to sell a property and reinvest with the proceeds into a like-kind” property, and they can defer all capital gains taxes. Although this is a strategy for some, it does incur its own costs. When you sell the property, you will still be responsible for the costs previously mentioned, as well as agent fees and closing costs which can run upward of seven percent (more or less depending on the transaction) of the value of your property.
A Final Word
A hold strategy can help you build your portfolio, grow your wealth, and avoid the unwanted costs associated with selling. However, to ensure the ongoing performance of an asset, remember, location is key. If you continue to acquire properties in established and growing markets, you will have a stronger foundation to hold the strength of the future performance of your portfolio.
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