How Do You Sell a Rental with a Tenant Living In It?

My name is Brianna Griffis, and I’m thinking of selling my mother’s house which I’ve owned and rented out for almost 10 years as I have some financial problems with another rental property and I need the money.  My problem is that my real estate agent, a good friend of mine, says it’s almost impossible in today’s rental market to sell a house with tenant in it and suggests that I not renew the tenant’s lease when it comes up next month.  She’s a great tenant, though, and I hate to lose the income since it could take months to sell.  What should I do? 

Brianna Griffis, Olympia, WA

Hi Brianna,

Does the tenant know you’re selling?  You’re obligated to tell her one way or the other what you’re planning.  If she’s willing, you can always renew on a month-to-month basis.  That way, a buyer would only have to give 30 days notice.  This could even be done once you go to contract, so buyer could move in shortly after closing.  Alternatively, you can renew her lease but add a clause stating that if the house is sold the remainder of the lease term is negated once 30 days notice is given. 

But I suspect this isn’t the real issue.  I think your agent would simply prefer the house be vacant before trying to sell it.  There’s a reason for this, as real estate agents know that tenants can make a house harder to sell as  (1) they don’t take care of it the way an owner would, so it usually doesn’t show well; and (2) they have no incentive to make it easy to show, since a sale means they’re going to have to find another place to live (and quickly too, 30 days isn’t much time).  Still, that being said, I’ve shown plenty of properties with renters in place and it’s usually not a problem.  It often comes down to whether your tenant is a nice person or not!  If like you say she’s been a good tenant, you might offer her a relocation allowance of a thousand dollars or more if and when the house sells.  This might create the incentive you need to motivate her to make sure it shows well, and in the meantime you don’t risk losing several months worth of rent while waiting for a buyer.  In fact, houses show best when a caring and neat person or family is still living in it, so this would actually encourage a sale and might in the end get you a higher sale price than if it showed vacant. 

Why Are All The Bills My Manager Sends Me So High?

My manager in Ohio just sent me a bill for mulching the front garden and the total is $130!  I mulched it myself last year and it couldn’t have taken more than an hour and maybe $20 worth of mulch.

Jeff Sanderson, Gulfport, MS

Hi Jeff,

I can relate only too well.  But before you get upset and chew out your manager, I want you to do something.  Take a look at the account and see what kind of cash flow this property has.  (I know you’re keeping a running tab of its annual gain/loss, aren’t you?).  Try to look at the bigger picture and see how much maintenance is really costing you.  Because there’s two things to consider here, first, that maybe the guy who did the work didn’t mention the half dozen other little things he attended to simply because he didn’t feel like writing it all down, and second, that maybe your manager does pad the bills a little bit to make up for the fact that you’re not actually paying him anything to oversee the mulching.  Managers don’t really make that much money, 10% of rents is standard, plus 50% first month’s rent when they find a tenant, so I wouldn’t be surprised if a little padding does go on.   But the main thing you want to know is, are the cumulative charges excessive.  If you didn’t get any maintenance bills for the last four months, and this is the only one this month, it seems to me you’re probably doing okay.  You have to expect to pay about 1% of a house’s value in maintenance every year, so that’s the number you really want to be looking at.  If you’ve got a manager who’s keeping the place rented and not springing any nasty surprises on you, you’re ahead of the game so the last thing you want to do is micromanage him. 

Yes, padding these bills is technically illegal in many states, but that doesn’t mean it’s not going on.  Your manager probably has a clause in the management contract entitling him to charge you an hourly fee for overseeing repairs, etc., but most managers have probably long ago concluded that it makes them highly unpopular to exercise such rights.  If they can find a workman to do the job well, but tack a little extra on to pay everyone for their time and trouble well that’s probably an easier solution.  It really doesn’t matter, what matters is the final number.  If you were still managing, after all, you wouldn’t be taking into account all the hours you spent doing little things around the house or waiting in line at Home Depot to buy the mulch you then have to schlep over to your rental house.  If you did, you might find out that $130 isn’t so ridiculous after all.

How Do You Find a Good Property Manager?

First choice, look in the mirror.  I find no one cares as much about my property as I do, so no one does as good a job managing.  If that’s not an option, then you have no choice but to look for referrals or simply vet them yourself.  I didn’t know any other landlords in the area I bought in, so I vetted most of my managers myself.  The results have been somewhat spotty.  I have two great managers, and two mediocre ones.  Along the way, I have hired and fired four who didn’t make the grade.  I wish I could tell you there’s a simple way to tell which ones will be good and which ones won’t, but there isn’t.  The problem is the ones I hired who didn’t work out sounded like intelligent, responsible, take-charge people when I first talked to them.  Ultimately, I found the key difference between the good ones and the bad ones wasn’t a matter of competence v. incompetence (I can usually detect incompetence), it’s a matter of whether they think they’re working for you or you’re working for them.  The good ones let you know what’s going on, and send your check out around the same time every month.  The bad ones don’t tell you things you need to know and are often late getting your check out to you.  They act like you’re pestering them when all’s you’re really doing is trying to get them to do their job.  The good ones I have, well, I never talk to them because there’s nothing to talk about.  There’ s no surprises and things run smoothly. 

EARLY WARNING SIGNS 

 I can tell you a couple of things I consider warning signs, though, that may help you head off a bad manager before they get entrenched… (1) Ask them who gets the late fee if a tenant doesn’t pay by the deadline.  If they say they do, find another manager; (2) Ask them what day checks go out.  It should be by the 15th at the latest.  If they say something like “generally by the 12th” or “we get them out by the end of the month”, find another manager.  Good managers don’t hang onto your money.  (3) Ask them for referrals.  If they act like this is an unusual request, or it takes them several days to produce them, move on.  (4) Call them.  If they’re hard to get a hold of, or don’t call you back within 24 hours, move on.  If all’s you get is voicemail whenever you call, move on.  Professional property managers always have someone answer the phone.

Also, I haven’t had good luck with property managers who also do sales.  I think it’s a business that requires specialization, and anyone who does sales as well as rentals isn’t truly a professional property manager in my opinion.  If they tell you that your tenant is paying late chronically, it’s the sign of a bad manager.  A good manager will make good on a threat to file notice to vacate if a tenant keeps paying late, and usually the tenant knows this and starts paying on time.  If your property goes vacant for three months or more, you’ve got a bad manager.  I don’t care how slow a market is, no property should be vacant for that long.  If YOU were managing, it wouldn’t. 

Three Ways to Avoid Paying Taxes on your Real Estate Gains

Primary Residence Exclusion (Section 121)

The tax code allows an exclusion of $250,000 in taxable gains on your primary residence ($500,000 for married couples), which can be taken over and over again (but only once every 24 months). So when the time comes, move into your rental house and make it your primary residence.  As long as you’ve lived there for at least two of the last five years you can keep up to $500,000 of your appreciation when you sell. 

Starker Exchange (Section 1031)

A Starker or 1031 Exchange shields the sale of your investment property from capital gains taxes as long as you turn the money around and put it into another investment property (specific rules need to be followed).  Some investors use this method to consolidate all their rental property into one.  Some also combine this with the Section 121 method listed above to create a dream home for retirement.  You have to rent it out for at least a year to complete the Section 1031 requirements (talk to your tax advisor), after which you can move in yourself and eventually qualify for the primary home exemption.  You can then cash in up to $500,000 of appreciation without owing a dime in capital gains.

Bequest

The third investment strategy is to simply never sell.  Many investors distribute their rental properties amongst their adult children as part of their estate.  The children receive them at their stepped-up basis (current market value) without having to pay tax on the gains.

All About Rental Property Depreciation

The IRS allows you to write off the depreciation of your residential investment property over a 27.5 year period.  This is based on the assumption that, like all other assets, it will gradually wear out and become obsolete when in reality your property is likely gaining in value.  To see what this hidden benefit is worth, take 80% of your purchase price (the land is worth approximately 20% and cannot be depreciated) and divide it by 27.5.  The result is a deduction that you can apply towards ordinary income every year.  If you bought a small $250,000 house, for instance, you could write off $7,272.73 of your ordinary W-2 income every year.  At a 25% tax rate, that’s a savings of over $1,818 in income taxes paid annually.  In addition, you can write off all maintenance, management, interest, insurance, and property tax expenses.  Buy three houses and get an annual $21,818 depreciation write-off to take full advantage of this benefit (the limit is $25,000)*.  That’s a total of $750,000 in real estate that the government actually rewards you for buying by lowering your taxes.  First rule of wealth accumulation? never turn down free money.  [And don’t forget to take a home office deduction for managing your rental properties.  See Internal Revenue Code 280A or talk to your tax advisor.

 * If your adjusted gross income is more than $100,000 you cannot claim the entire deduction.  It phases out and disappears at the $150,000 level.  It is suspended, however, for future use or upon sale of the property.

The New Mortgage Insurance Deduction

The government passed a new break this year, called the Qualified Mortgage Insurance Deduction, that lets taxpayers with an adjusted gross income of less than $100,000 write off the full cost of mortgage insurance. Folks who earn less than $109,000 can take a write-off for part of it.  To qualify, the mortgage must have originated between 2007 and 2010. The deduction can be taken for insurance on a principal residence or a second home.

Introduced by the Tax Relief and Health Care Act of 2006, the break initially applied only to the 2007 tax year, but it was extended through 2010 by the Mortgage Forgiveness Debt Relief Act of 2007.  On average, the annual tax break from the deduction will be worth around $350 per taxpayer, according to the Mortgage Insurance Companies of America, which represents mortgage insurers.

A lot of folks are confused by mortgage insurance, known as PMI (Private Mortgage Insurance) or MIP (Mortgage Insurance Premium), so I’d like to take a moment to discuss how it’s going to affect you and your loan.  PMI is insurance that protects the lender in the event you default and is only required on loans where you put less than 20% down.  It does not protect you!  It does not pay your mortgage if you are incapacitated!  It only pays your lender for their losses if your house goes into foreclosure.  A lot of mortgage brokers and loan officers now tout loans that don’t require PMI, but that’s deceptive as you will almost certainly be paying a higher interest rate to compensate the lender for the increased risk.  In other words, you may end up paying 6.5% instead of 6.125% and think you?re coming out ahead when in fact you just agreed to pay PMI for the life of the loan!  Regular PMI is an add-on that can be removed from a loan when your equity reaches around 25%, but a higher interest rate on a non-PMI loan never goes away.  Regular PMI is supposed to be automatically removed when your equity reaches a certain threshold, but you may have to remind your lender to do this.  At any time you think your equity has reached 20 to 25% of the home?s current market value, contact your lender and request PMI deletion.  This requires a new appraisal ($250 to $350); your lender will likely want to select the appraiser but you will have to foot the bill.  (You will also have to have made the previous 12 months of mortgage payments on time for them to consider the request).  Still, it will save you a great deal of money over time.  Have your real estate agent do a comparative market analysis (CMA) to see if your property has appreciated enough to warrant dropping the PMI.

Tenant Complaining About Hot Water

I had a tenant threaten to move after discovering it took almost three minutes to get hot water out of the bathroom tap.  While her suggestion was that I install a dedicated hot water heater for her unit, I discovered a far simpler and cheaper solution.  Home Depot stocks a hot water recirculating pump that installs under the sink that’s the furthest from the hot water heater.  It will maintain a hot water supply that will be instantly accessible when you turn the tap (including all the taps inbetween), and even comes with a timer so it doesn’t run at night when you don’t need it.  It will cut down your wait time to seconds and costs around $200.  Happy tenants save you money!

Equity Paydown

Sometimes my clients are so focused on a property’s break even potential, they forget about principal.  For that $100K house or condo, if you get a 30 year fixed rate loan you’ll be paying down about $100 in principal every month.  That money is yours, and it just keeps adding up.  It’s like a secret savings account, as it’s adding to the equity you’re acquiring through appreciation.  Better yet, after nine years your mortgage payment will be paying down about $177 in principal every month (principal increases and interest decreases over the life of a fixed-rate loan).  That’s why real estate numbers get better with time.  Rents go up but that mortgage payment never changes!  What were rents like in your neighborhood nine years ago?  What are they now?  Think of all the landlords you’ve turned into millionaires…

Which Should You Go With? Condo, House or Multi-Family?

SINGLE-FAMILY

Houses are easier to sell than condos or multi-families as there are so many more potential buyers. Look for a 3+2, the most popular-sized house for rentals.

CONDOS

This may be the place to start your investing career as they can still be found for under $100,000.  Look for a 2+1 or better yet a 2+2, as these are the most popular rentals.

MULTI-FAMILY

These usually have the best cash flow.  Bear in mind that anything with 5 units or more is considered commercial property and a lender will usually require 20% down.

What Will It Cost?

To figure out if a property has break-even potential, multiply the purchase price by .00878.  This number is an approximation of what your payment will be based on a 30 year fixed-rate loan at 6.375% (after paying 5% down) and includes Principal, Interest, Taxes,  and homeowners? Insurance (or PITI) plus private mortgage insurance (PMI) (necessary if you’re putting less than 20% down).  This works out to approximately $878 a month for a $100,000 property (though that will drop to around $798 a month after the PMI goes away).  You can reduce this monthly outlay by hundreds of dollars by way of an adjustable rate mortgage, option ARM or interest-only loan, but I’m a buy-and-hold strategist and I recommend the fixed-rate approach (especially with interest rates still low).  It may cost more now, but in the long run will make you richer.  So if you find a small house for $250K that you like, you know your payment will be $250,000 x .00878, or $2,195 a month, and you know you’ll have to rent it for $2200 or more per month to break even.  What if you can only get $2000?  Remember that depreciation is saving you $150 a month in taxes, you’re enjoying appreciation (at 4.25%) of $885 a month, and you’re paying down principal at a rate of $250 a month.  Over time, as PMI drops away, rents rise, and your payment remains the same, the picture improves dramatically.  Of course, you can always put more money down and get immediate positive cash flow.