December 12, 2022

How do I calculate my return on equity? What return on equity should I aim for? How do I exit tax efficiently on my property? 

In this week's LearnLikeaCPA Podcast we take a deep dive into return on equity, what it means, and how to exit properties tax efficiently.

Return on Equity

Investors like you constantly ask the same question. The Learn Like a CPA team has heard it from over 200 real estate investors. What is the Return on Equity calculation? Return on Equity is the amount of equity that you have in a property (whether forced or contributed through capital) vs. what amount that equity is generating in cash flow. Many investors are seeing tons of appreciation in the California, Texas, NY, and Florida markets. This means that they are getting forced appreciation on the properties they hold. Wait, aren't appreciating properties good? An appreciating property is a good thing, but not taking advantage of the increase in equity could mean missing out big! Let's dig in.

If we hold a property at 50,000 dollars and it generates cash flow of 5,000 dollars we have a 10% return on equity. Now, if that property appreciates to 100,000 dollars and we continue to get the same 5,000 cash flow we are only getting a 5% return on equity. See how we're losing out? This is often overlooked. The cash flow of 5,000 dollars is still there but, often the possibility of a bigger return is forgotten. Now, is getting the equity into another asset able to give a higher return on equity? Possibly, it depends what the investment is, but this calculation can shed light on what returns we are getting for our money. Remember 10-15 or even 20% Return On Investment is not unheard of. Sometimes it is better to exit cash flow producing properties to get into a higher ROI percentage.

All this being said, there are a couple of factors that should be considered. The first is what was discussed in the last podcast, the Wherewithal to Pay problem. To refresh, this is when a refinanced property is sold. This sale can produce a capital gain and the tax incurred could be more money than is generated after all the fees of the sale are paid. Secondly, mortgage rates should not be overlooked. Scenarios like going from a 3% interest rate to 6% interest must be factored in to determine what our actual outcome will be. Lastly closing cost and fees from the sale of the property cannot be ignored and must be accounted for when exiting investment properties. If we are able to factor these in and still see opportunities to increase ROI, it may be time to exit the current property.

Exiting Tax Efficiently

This idea of maximizing Return on Equity is all well and good, but can fall apart quickly when we exit a property and are left with a substantial tax bill. This is where Exiting Tax Efficiently becomes very important. The podcast gives three excellent ways to do this. 

1) 1031 Like Kind Exchange

A 1031 like kind exchange is a way to trade up in assets while deferring the capital gains tax bill. This is a great method to exit efficiently. It allows us to capitalize on appreciated assets without being punished for disposing of them. However, this method does not come without its drawbacks. The most obvious is timing. A 1031 exchange requires identifying the replacement property within 45 days and closing on that property within 180 days. We can’t miss that window! This problem is linked directly to what kind of market we’re in. In 2020-2021 it was very hard to do a 1031 exchange because properties were exiting the market so quickly. Sometimes in just a day. When turnover is so high, properly identifying a property and closing on it in such a short time frame can be near impossible. A good rule of thumb is to be extra careful in a sellers market. It might not be the best time to try a 1031 exchange. In these types of markets it is important to consider other strategies.

2) Poor Man’s 1031 Exchange

Similar to the 1031 exchange is the poor man’s 1031 exchange. This, as the name implies, is the same concept but with more wiggle room. The idea is selling one property outright and purchasing another in the same year. When this is done, accelerated depreciation can be used on the new property to offset the gain of the old. It archives the same benefit without going through the struggle of a normal 1031 exchange. It avoids the timing issue, the paperwork, and holds on money from the property sale. These things together makes it not only easier to do, but can also open the door to more opportunities. Another benefit of this method is getting a step up in cost basis for the new property. This means when we buy the new property it is considered at cost as opposed to what we paid for the previous property. This would not be possible with a traditional 1031 exchange.

3) Investing in Syndications 

Investing in syndications is very similar to the poor man’s 1031 but could be more appealing for someone who wants to be more hands off. Maybe they don’t want to divert more of their time or go through the hassle of purchasing and maintaining another property. This option involves selling the property and investing that money into syndications. These syndications are also capable of bonus depreciation and cost segregation on their assets which will pass back losses. These losses can offset the gain from the sale of property. This method is the most passive way to increase return on investment and exit tax efficiently with the least effort. 

4) Sell in Lower Taxable Income Years

The last method is the most straightforward. Selling assets in lower taxable income years is the simplest way to exit efficiently. It also can also be combined with other methods. When we sell in years with a lower tax bracket, the tax incurred on the gain is reduced. This allows us to maintain more of the benefit of the appreciated asset. Sometimes the simplest solution is the best and this small detail could lead to saving big on existing properties.

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