Buy a Real Estate

At public events I cajole the audience into coming up with valid reasons to sell a property. Few of the reasons proffered are truly valid. The most common reason given is to take the profit out of an existing investment, and then to use this profit to invest in another property. There are two arguments against this.

First, when you sell, as we have seen, you will pay capital gains tax and depreciation recapture tax. Second, while you may release the equity in a property by selling, you could release that same equity by refinancing the property and still retaining it.

For example, imagine you bought a property for $500,000 with a mortgage for $500,000 (you bought it vacant, but with a tenant in place it went up in value and the bank was willing to fund the entire purchase price). Assume it is now worth $2 million. You do not need to sell it to release the $1.5 million of equity. You could achieve the same result by simply refinancing with your existing bank or a new bank. You simply get a new appraisal and submit a new proposal for finance. Now admittedly, if the bank will only go up to a 70 percent loan to value (LTV), then they will only lend you $1.4 million, which is only $900,000 more than your present loan.

However, if you sold the property, you would lose perhaps 6 percent in selling commission ($120,000) and at least 15 percent of the capital gain to tax ($225,000), more to depreciation recapture tax, and even more to selling costs, leaving you with perhaps barely a million in net, after-tax profit. Which would you rather have, a million dollars in cash, or equity of $1.5 million (from which you could easily borrow another $900,000), secured against an asset worth $2 million, and rental income for life? The property only has to go up by 5 percent for you to make yet another $100,000 (which would be tax-free so long as you continue not to sell).