Then again, maybe the tenant wants to buy the property! Before going through the effort of putting the house on the market, don’t forget to ask. Keep reading for further detail on your legal obligations and practical considerations and approaches.
This is usually the first question that arises when a landlord wants to sell. The simple answer is yes, you can sell a property with a tenant still living in it. In fact, most states’ laws give tenants the right to remain in a rental property after a sale until the lease or rental agreement expires. However, just because you can sell with a tenant doesn’t necessarily mean you should.
Before you put your property on the market, you’ll want to consider the pros and cons of selling while a tenant is still living in it. In some situations, having the tenant remain during and after the sale might work out perfectly. But without a crystal ball, the best you can do is weigh the pros and cons of selling your particular property with a tenant in place.
You’ll want to consider the following factors when evaluating whether selling with a tenant in place is a good idea.
Once you’ve examined the pros and cons, what are your options if you decide that selling without a tenant is the better option?
If the tenant is a month-to-month tenant, you’re in luck—simply end the tenancy by giving the tenant the notice required by state law. If you’re in a rent controlled area, check the law to make sure that selling the property is a valid reason (just cause) for ending the tenancy.
If your tenant has a long-term lease, ending the tenancy might not be so easy. Your best bet probably is to attempt to negotiate with the tenant. Offering money in return for the tenant’s agreement to modify the lease and move out early is a common approach. If the tenant accepts the deal, you can either have the tenant clear out in time to completely clean and perhaps stage the property while it’s on the market, or you can advertise that the property will be “vacant upon closing.”
Negotiating an early move-out with the tenant could be a bit risky, however. If the tenant decides to ignore the renegotiated terms and remains in the property beyond the closing, the new owner can be put in the situation of having to evict the tenant. The new owner could then hold you legally responsible for all costs associated with the eviction.
If the timing works, or if you cannot come to some sort of arrangement with the tenant, you might want to wait until the tenant’s lease is up before you put the place on the market. Notify the tenant in the manner specified in the lease that you are planning to sell and will not be renewing the lease.
Assuming the tenant will be staying on post-closing, and depending on your property's size and layout, you might want to market it as both a primary residence and a potential investment property. Let the buyer decide how to use it. Some buyers who want a home for themselves will not mind purchasing a primary residence with a tenant if they do not plan to move in immediately.
There are some things sellers can do to make a sale go more smoothly when a tenant is living in the property, regardless of whether the tenant will remain after the sale. If the tenant will be moving out at closing, it also helps to remember that any move is difficult, and that keeping track of showings and neatness is not going to be in the forefront of the tenant’s mind.
While financial incentives can usually ease the situation, sellers shouldn’t underestimate the benefits of being considerate toward the tenant and respecting that the property is still the tenant’s home while it’s on the market. An unhappy tenant can break a sale, especially if they prevent showings or decide to stop cleaning.
]]>One of the most common measures of a property’s investment potential is its capitalization rate, or “cap rate.” As we'll discuss below, the cap rate is a calculation of the potential annual rate of return—the loss or gain you’ll see on your investment. We'll also discuss:
There is more than one way to calculate an investment property's cap rate, but we’ll look at the most common here. The basic formula is:
Cap Rate = (Net Operating Income)/(Current Fair Market Value)
Let’s break that down:
Net operating income: Your net operating income is your gross rental income (the total amount of money you receive from rent) minus your operating expenses (such as payroll and costs of repairs). To arrive at this number, do the following:
Current fair market value: You can use either the asking price or the price you’d offer.
Example: You’re considering a two-bedroom house that’s listed for $325,000. The current tenants pay $2,000 per month. Gross rental income is 12 (months) x $2,000 (monthly rent) = $24,000.
You anticipate annual operating expenses to be $5,800: $3,800 in property taxes and $2,000 in maintenance and other expenses.
Your estimated net operating income is $24,000-$5,800 = $18,200.
You then divide your net operating income by the property’s current fair market value (we’ll use the list price of $325,000) to get the cap rate: $18,200/$325,000 = 5.6%.
If your estimates are correct, this two-bedroom property would give you a cap rate return of 5.6%.
The cap rate calculation above assumes that you’re receiving full rent each month—in other words, that the property is 100% occupied 365 days of the year (and that your tenants keep up with the rent). While 100% occupancy might happen regularly for a single-family home, it’s less likely for a multiunit building with more turnover. So, whenever possible, you’ll want to account for a less-than-100% occupancy rate when calculating your cap rate. Here’s how:
Adjust the formula for net operating income to the following:
Net Operating Income = [(Gross Rental Income) x (Occupancy Rate)] – (Operating Expenses)
Most real estate investors build a 5-10% anticipated loss of rent into their calculations. So, if you were to assume a 90% occupancy in the above the example:
Net operating income = [($24,000) x (.90)] - $5,800 = $15,800. (Note that a 10% reduction in occupancy results in $2,400 less net income.)
Cap rate = $15,800 / $325,000 = 4.9%
When you consider reduced occupancy, the two-bedroom house now has a cap rate return of roughly 4.9%, making it a slightly less attractive investment.
The cap rate is a helpful metric when you’re assessing a property that you expect to yield regular, relatively predictable income. For example, you’d want to calculate the cap rate for a 4-unit apartment building occupied by tenants with year-long leases.
You’ll want to calculate and compare the cap rates of similar potential investment properties you’re looking at. For example, if you’re weighing the pros and cons of two duplexes located in the same downtown area, comparing their cap rates can help you determine which property will be a better addition to your portfolio.
Knowing the cap rate of a potential investment also helps you decide if the asking price is reasonable—if it’s overpriced based on your cap rate calculations, you might be able to negotiate a lower price.
Calculating the cap rate of a property isn’t particularly useful if you’re planning to flip it, offer it as a vacation rental, or rent it out on a short-term basis. When you flip a property, one of your goals is to hold onto it for as short a time as possible—making the cap rate’s 12-month frame of reference less relevant. For vacation or short-term rentals, you’re likely going to experience swings in income and occupancy, not to mention operating expenses that fluctuate due to seasonal maintenance or repairs resulting from high tenant turnover. These factors combine to affect your net operating income, which in turn results in an unreliable cap rate calculation.
Also, the cap rate is calculated on the assumption that you’re paying all cash for a property—not taking out a loan. Therefore, it doesn’t take into account any costs associated with a mortgage, such as interest or points paid. It also doesn’t take into account the other costs of acquiring the property, such as closing costs and brokers’ fees.
When you’re looking to buy an investment property, most of the time you want to see a higher cap rate. The higher the cap rate, the better the annual return on your investment. If you are looking to make at least a certain percentage of income off your investment each year, you should let that drive your decision to invest. You can divide your calculated net income figure by your target cap rate to determine the price you’d be willing to pay for a particular property.
The “cap rate” you should buy at depends on the location of the property you are looking to buy in and the return you require to make the investment worth it to you. In other words, you’ll want to gauge your aversion to risk. For example, professionals purchasing commercial properties might buy at a 4% cap rate in high-demand (and therefore less risky) areas, but hold out for a 10% (or even higher) cap rate in low-demand areas. Generally, 4% to 10% per year is a reasonable range to earn for your investment property.
Continuing with our two-bedroom house example from above, dividing the net operating income by a minimum acceptable cap rate of 5% will give you the top price you would be willing to pay:
$15,800/ 5% = $316,000. Because the current asking price is $325,000, this would not be a good investment for you—you’d be paying $9,000 more than you should to get your goal cap rate.
Whatever rate of return you are aiming for, make sure the projected income leaves you with a healthy amount of cash after the mortgage payment has been paid. If you have a tenant who doesn’t pay for a few months, and the cap rate on your prospective property is 2% or less, your investment property might quickly become a liability. Be sure to consider worst-case rent loss scenarios when calculating your potential return—that way, you’ll have a good sense of whether you can afford to carry the property when it’s unoccupied.
]]>Property management companies can be a huge asset to your business, but they don't come cheap. And there are other reasons why you might not want or need one. Here are some things to consider when hiring a property management company.
Most rental property management companies deal with the whole range of landlord activities, including:
Plus, a good management company brings its know-how and experience to your property, giving you the peace of mind that comes with knowing your investment is in good hands.
Although hiring a property management company has many advantages, using one can be expensive. And, even apart from the cost, relying on a property management company is not for everyone.
Consider hiring a property management company if:
If you decide to hire a property management company, use caution in selecting one. Here's how:
When you interview potential property managers, one of the topics you’re sure to discuss will be cost. How property management companies get paid can vary depending on the market rate in your area and the services the company provides.
Most property management companies will charge a percentage of the monthly rent—typically anywhere from 5-20%. Be sure to ask the company what services the charge includes, and whether the amount is based on the amount of rent charged or the amount of rent actually collected. Find out what the company’s policy is when a tenant fails to pay rent or breaks the lease.
You’ll also want to ask whether the company offers flat rate services. For example, do they charge separately for preparing and serving a notice to quit when a tenant violates a term of the lease?
When you find a management company that you feel comfortable working with, be sure to get your agreement in writing. The management agreement should at the very minimum contain details about how and when you’ll pay for the services and how the agreement can be ended (usually it’s with 30 days’ written notice by either party).
To learn more about protecting yourself when hiring a management company and to get help with other risks facing landlords, read Nolo's Every Landlord's Guide to Managing Property.
Other great books for landlords include:
Nolo’s Landlord page also contains a wide-ranging library of free articles for landlords looking to learn more about screening tenants, handling security deposits, dealing with repairs and maintenance, evictions, and much more.
]]>Here’s what a landlord being sued in small claims court should expect, along with some tips on how to prepare.
To begin a small claims court lawsuit, a tenant making a security deposit claim will have to file and serve a complaint on the landlord. In the complaint, the tenant will have to describe the alleged wrongs of the landlord, as well as request a certain amount of damages (money) from the court.
Landlords can use a tenant’s security deposit to cover unpaid rent as well as the cost of repairing damage caused by the tenant that goes beyond normal wear and tear. If the landlord doesn’t charge a cleaning fee, the landlord can usually also use the security deposit to cover cleaning if the tenant leaves the rental in a dirtier condition than it was in when the tenant moved in.
Security deposit lawsuits brought by tenants typically involve a claim that the landlord wrongfully withheld some or all of the tenant’s security deposit. This might involve claims that the landlord:
Landlords have a duty under most states’ laws to provide a timely accounting of how they use the security deposit. Usually, this involves a requirement that the landlord provide receipts for any repairs or cleaning performed. When a landlord doesn’t adhere to the rules, depending on state law, the tenant might be entitled to damages.
Similarly, landlords must make only reasonable deductions from the security deposit. For example, if a landlord pays $200 to have an electrician replace a broken light fixture, the landlord can’t turn around and charge the tenant $1000.
A landlord who is sued by a tenant must carefully review the complaint to find out what the tenant is claiming. Sometimes this can be a challenge—small claims court lawsuits typically don’t involve lawyers, so it’s up to the tenant themselves to describe their grievance. That means that complaints can run the gamut from a simple “My landlord didn’t return my security deposit” all the way to a detailed, pages-long list of examples of the landlord’s supposed wrongdoing.
A tenant can sue only for money in small claims court, not for court orders. In other words, the tenant cannot ask the judge to order the landlord to do something or stop doing something.
The tenant's claim must also fall below the legal limit allowed in small claims court. For example, in California small claims courts, a tenant can sue for up to $10,000. The tenant also has to be able to prove all of the money damages in the lawsuit. This means small claims judges typically won’t award damages for more nebulous harms such as time spent dealing with a dispute or emotional distress.
Small claims court rules vary from state to state, so be sure to check the rules in the state you live in.
After the landlord receives the tenant’s complaint, the landlord will have the opportunity to respond in an answer that must be filed with the court. Be sure to review the complaint to find out how long you have to file your answer—typically, answers are due within 20-30 days.
Be sure to respond in your answer to all the points raised in the complaint. It isn’t necessary to go into great detail; just lay out the facts. For example, if a tenant is claiming that the charge for a repair is unreasonable, you could simply respond by stating the amount you paid, and note that you have the receipt to back up the amount. If you’re allowed to attach documents to the answer, attach a copy of the receipt. If you can’t attach documents, be sure to bring the evidence to court.
In most courts, when the tenant files the complaint, the court clerk will also assign a date for a trial (or a hearing) with the judge. The date, time, and place of the trial will be noted in the summons, which will be served with the complaint on the landlord.
Nearly all small claims court trials are in front of a judge—there’s no jury. The trial or hearing is both parties’ opportunity to present their cases to the judge, along with any supporting evidence (such as paper receipts, witness testimony, or video). Although there are procedural rules that the parties must follow, the rules are usually more relaxed than they are in other courts, and the judge will usually guide the parties on how to present their cases.
When the judge makes a decision varies court-to-court. Some judges will issue an order right on the spot after the parties have presented their cases. Other judges will write up an order after the trial, and the court clerk will notify the parties when the court has entered the order. Usually, the order will be entered within no more than two weeks after the hearing.
Once you’ve received the court’s decision, you have the option of accepting it, or you can appeal it. Because appeal laws and procedures vary state-to-state, you’ll need to check with the court’s clerk to find out in which court you should file your appeal.
The best piece of advice is to read everything that you receive, including the complaint, summons, and any attachments. Also, most small claims courts have detailed guides about rules and procedures—check online or ask the court clerk for any publications they have for parties to small claims lawsuits.
As for the trial, what matters in small claims court is not so much what you say, but the evidence you bring with you to the courtroom. When you do land in court, you will need to convince the judge of your position: For example, that the damage was not there when the irate tenant moved in, that you have spent reasonably for needed repairs, and that you followed your state's procedures for itemizing deductions and refunding the balance of the deposit.
Before going to court, ask the clerk how many copies you should have of each piece of evidence you plan to bring. Some courts also require you to label them as “exhibits.” For example, a receipt for repair work might be your Exhibit A, a photograph of the rental when the tenant moved in might be your Exhibit B, and a video of the destruction when the tenant left might be your Exhibit C.
Bring your receipts, pictures, and any helpful witnesses. If your witnesses are not able to appear in person, a signed declaration (sworn statement) explaining what they saw or did (such as cleaning or repairs) will probably be sufficient. For example, if you hired a cleaning person to vacuum up excessive pet hair left behind in the rental, you could ask them to write and sign a letter detailing the work they performed and stating that the letter truthfully describes the work.
It’s important that the judge believes you’re being reasonable and presenting the facts without embellishment or exaggeration. Be calm, factual, and as succinct as possible when making your presentation. Find out if the court has a time limit on how long you have to present your case, then practice your presentation in front of a friend (or even the mirror) so you’ll be more comfortable presenting it to the judge.
Try not to be nervous. Small claims court judges have seen it all, and as long as you tell your side of the story truthfully, you’ll be fine. Dress professionally, be courteous to the judge and all court staff, and get a good rest the night before.
Finally, if you’re at all concerned about the evidence you have or how to present your case, consider contacting an attorney. Although you probably won’t be able to bring an attorney with you to court, most attorneys—especially ones with smaller practices—are willing to provide advice on an hourly basis. Spending just one or two hours with a local attorney talking over your case can greatly increase your chance of a successful outcome.
]]>The conventional wisdom is that condominiums might not pencil out well as rentals, primarily because of the condominium association dues, management fees, and agency costs. However, many small landlords make condos work as rentals (nearly four million rental units are condos, according to recent Census data). To successfully rent out a condo, you must do your homework before buying, and understand the very unique traits of condos and the way they operate.
The story behind renting condos is more complex and nuanced than for other types of property. Renting a condo tends to mean less building maintenance for a landlord, but you'll be dealing with a more people-intensive and bureaucratic enterprise. You'll have to contend with a board of directors of the condo association and possibly even a property manager. Plus, you'll own the common areas in tandem with all the other owners.
But if you can live within these parameters, condos can be relatively worry-free rentals and marketable when you sell. Their monthly dues can eat away at cash flow, but in a well-run association, you should be getting a variety of services in return. These often include exterior maintenance, insurance, utilities, trash collection, and even some management of complaints, policies, and budget. A major factor in your success, however, will be finding the right condo and a strong association.
This article outlines key steps to successfully choosing and renting out a condo—assuming you’ve identified a good location, checked that the property pencils out in terms of positive cash flow, and done your homework in researching the prospective property and disclosures. The focus here is on renting out a condo to tenants under a month-to-month rental agreement or a fixed-term lease (not a short-term vacation or Airbnb rental).
It’s crucial you check into the letter and spirit of the rules and regulations of a condo association (including the covenants, conditions, and restrictions, or "CC&Rs") before buying a condo you plan to rent out. It’s especially important that you find out the condominium association's stance towards renters.
Any listing agent should be able to tell you whether renting is allowed. The answer might simply be "no." The more nuanced situation is when renting is allowed or conditional. Then you also have to look at the written and unwritten rules regarding renters, for example any extra fees, notice to the board about tenants, or limits on the term or type of lease. Also be sure to check any condo rules that may restrict your intended pool of tenants—for example, by prohibiting pets or limiting the types or size of pets a tenant may have.
If renting is allowed, first find out what percentage of condo units within that community are currently owner-occupied. Some state and federal loan programs require a set limit. For example, the Federal Housing Administration (FHA) requires over 35% of units in the association be owner occupied. The condo association might also mandate owner-occupant percentages in its rules. Renting might be allowed conditionally or more openly, depending on how many of the other owners are already renting.
An ideal ratio from your perspective is around 60%-70% owner-occupants and 30%-40% rentals. This way, renting is accepted and widely practiced, but not overwhelming and a potential cause of community friction. Owners who rent their units will also have some clout in the voting and administration of the association. If you see a predominance of rentals, this could also be a red flag that could impact the marketability of the unit when you sell, due to a lack of financing.
The primary benefit of investing in a condominium is that you don't have to do external maintenance and upkeep. A well-run association handles and manages the exterior of the complex and common areas. An additional benefit is that owners can pool resources and all chip in for larger repairs. You will get to split the costs for the roof or parking lot with a hundred other fellow owners, for example. Ideally, some or all of this money can come from reserves designated for larger capital projects. However, an association without monetary reserves is more likely to impose special assessments for larger repairs and projects, meaning you have to kick in more money more often for major repairs. Along with monthly dues, special assessments are a major culprit in preventing condos from producing positive cash flow for landlords.
Condominium boards and associations are like miniature democracies. Consider that a 100-unit complex might house several hundred people, roughly the size of a small village. All of the housing and living issues are handled by an elected group of directors. The politics can run from logical and lukewarm to angry and contested. Check the minutes of condo association meetings and bulletin boards, and ask residents about the tenor of the association's politics. You could find everything from cooperation to active lawsuits among members.
For detailed advice on best practices for choosing and managing a condo, including unique property maintenance issues, see Every Landlord’s Guide to Managing Property, by Michael Boyer (Nolo).
]]>The additional tax applies only to people with relatively high incomes. If you’re single, you must pay the tax only if your adjusted gross income (AGI) is over $200,000. Married taxpayers filing jointly must have an AGI over $250,000 to be subject to the tax. Your adjusted gross income is the number on the bottom of your IRS Form 1040. It consists of your income from almost all sources, including wages, interest income, dividend income, income from certain retirement accounts, capital gains, alimony received, rental income, royalty income, and unemployment compensation, reduced by certain “above the line” deductions such as IRA contributions and one-half of self-employment taxes.
The new Medicare tax is imposed only on a taxpayer’s net investment income. Investment income consists of interest, dividends, royalties, annuities, and rents not derived from an active trade or business, any other gain from a passive trade or business, and taxable gains from the sale or other disposition of investment property.
You need not include tax-exempt interest (for example, interest from tax-exempt bonds), tax-free withdrawals from Roth IRAs, income earned by tax qualified retirement plans such as 401(k) plans, income earned from renting a home less than 15 days during the year or the amount of profit excluded from tax when you sell your principal residence ($250,000 for individuals and $500,000 for married joint filers).
To determine your net investment income, you deduct your allowable expenses for the activity from your gross income for the activity.
Your net rental income is subject to the tax unless you qualify for the real estate professional exemption discussed below. Your net rental income consists of your gross (total) rents minus all deductible expenses you incur in operating your rental property. Your deductible expenses for these purposes will generally be the same as shown on your Schedule E.
For example, if you earn $200,000 in gross rents in one year and have $100,000 in expenses, you’ll end up with $100,000 in net rental income that must be included in your adjusted gross income for that year. If you have a net loss from your rental activities, you can use it to reduce your AGI subject to the passive loss rules. This makes the rental property deductions available to landlords more valuable than ever.
Landlords who qualify for the real estate professional exemption are specifically exempted from the new Medicare tax. (IRC §1141(c).) This includes full-time landlords, and many part-time landlords who engage in other real estate businesses such as real estate brokerage or development. This makes the real estate professional exemption more valuable than it has ever been.
In addition, real estate dealers will not be subject to this tax on rental income they earn from property they hold for sale as a dealer. However, they will have to pay 3.8% Medicare tax on their net self-employment income above the same thresholds. For details, see "The New Medicare Payroll Tax."
The Medicare tax is a 3.8% tax, but it is imposed only on a portion of a taxpayer’s income. The tax is paid on the lesser of (1) the taxpayer’s net investment income, or (2) the amount the taxpayer’s AGI exceeds the applicable AGI threshold ($200,000 or $250,000).
Example: Phil and Penny are a married couple who file a joint return. Together they earn $200,000 in wages. They also earn $200,000 in net rental income and $150,000 in other investment income. Their AGI is $550,000, including $350,000 in net investment income. They must pay the 3.8% Medicare tax on the lesser of (1) their $350,000 of net investment income, or (2) the amount their AGI exceeds the $250,000 threshold for married taxpayers—$300,000. Since $300,000 is less than $350,000, they’ll have to pay the 3.8% tax on $300,000. Their Medicare contribution tax for the year will be $11,400 (3.8% × $300,000 = $11,400).
At most, you’ll have to pay the tax on the portion of your AGI that exceeds the $200,000 or $250,000 thresholds.
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