Owning a rental home is the Holy Grail of passive income and revenue streams. It can provide a great path to achieving financial freedom — or so you thought.
There are a lot of “gurus” out there who promise and talk about how to buy homes and create a positive cash flow in your life so that you can quit your job, sip mojitos on a beach, and live the life you always dreamed.
They tell everyone that they just need to get started. Our world seems to celebrate and applaud people who dip their toes in the water and go for it. While all of those self-professed gurus share with you amazing success stories, they fail to mention the people who did get started, but flamed out.
But just getting started is the kind of advice that causes a lot of problems when it comes to real estate. There are a ton of posts about how to buy a rental home, but almost none about how to sell one.
There is little advice in the world of creating an effective exit strategy — a plan for how you will sell your rental home given specific circumstances so that you can minimize loss or capture the largest profits.
The wrong exit strategy could leave you with a large bill from Uncle Sam. Or, holding too long in a negative cash flow situation could tear apart your personal finances. Very few rental investors have a strategy for exiting their rental home if things go wrong,
There are various reasons that you may find yourself needing to sell your rental home. Today, we’re going to identify some of the reasons you may need to sell your rental home and a few different strategies for selling.
Do take note, some of the stuff that we will be talking about is related to taxes, finances, and law. I’m not a licensed professional in any of these fields, so if you need help creating a customized exit strategy, I would talk to those professionals.
Understand Why You Need to Sell
There are a dozen or more reasons you may need to sell.
You want to capture the unrealized gains from the appreciation of your house over the last few years. For example, homes bought in 2012 likely have increased by 30% in price.
You’re tired of the landlord thing. Managing your own properties can be stressful because of all the problems associated with renting to tenants.
You don’t want to hire a property management company because it will eat the profits but you don’t want to manage it either.
You need to move away quickly and won’t be able to manage it.
You’re retiring and you want to access your capital now rather than continue to get a check every month.
Or the worst situation, you’re in a bad deal — a rental home that produce negative cash flow — because you bought wrong, vacancy issues, or terrible tenants.
The first step to determining your exit strategy is understand your needs for selling. Just ask yourself, “Why do I need to sell this rental unit?”
Selling a rental home can be challenging depending on your circumstances. It could take weeks or months to sell. There are all of these tax and business implications. Plus, the headache from needing to sell your unit while it’s being occupied by your tenant.
Sell Your Rental Home Quickly
There’s no way around it. A bad deal is a bad deal. When working with investors, the one problem I experience is they’re too afraid to cut their losses.
They will hold a house on the market for an additional four months to try to get the highest selling price because they believe they can minimize their loss. But this just usually ends up hurting them. They will start to make emotional decisions that are often more harmful.
When you’re in a bad deal, the best thing you can do is simply offload it quickly and take your losses. Work with a real estate agent to create what I call an offload-loss strategy. This is a strategy for selling your rental home when certain conditions are met that cause a bad deal.
For example, you’ll talk to your real estate agent and tell them what counts as a bad deal. You tell your agent, “If I buy a home, get tenants, but after six months I’m producing a negative cash flow of $200, then let’s start to sell it.”
If this situation happens, your agent will automatically implement your exit strategy so that they can minimize your loss and you’re not making any emotional decisions.
How to Sell With a Tenant
If you’re not fortunate enough to be able to wait and sell the home without a tenant, you will have a huge challenge in front of you. This can kill you emotionally if you’re running a negative cash flow since it’s almost like you’re paying them to live in your house.
That’s why it’s important to have an exit strategy from the beginning. If you’re rental home has some tenants and you need to sell, you have a few options.
Wait Until Lease Expiration
You could wait until the lease expires, but don’t offer your tenants the ability to renew. Send your tenants a note sixty days before expiration that you will be selling the property. This isn’t usually the best strategy if you’re running a negative cash flow.
Alternatively, if you have a bad tenant — someone who has violated your lease terms like failing to pay rent, a no-pet clause, or causing property damage — you can terminate the lease by sending them a notice of eviction.
Sell With An Active Lease
It is possible to sell with an active lease. I love this strategy because everyone usually wins. You get to sell your house fast, the tenants get to stay, and an investor found a new property.
They way it works is you would sell the home with an existing lease. That means whoever buys the home will have to handle the tenants. As a result, you’ll pretty much only be able to sell to investors. But in order for an investor to buy it, the home will have to provide a decent return.
Most of the time this means selling at 85% of market value for any homes that are producing a negative cash flow. If you have profit, you can calculate a maximum selling price by taking yearly profit and dividing by 3%.
For example, a home that produces a yearly profit of $3,000 will sell for a maximum amount of $100,000. This is the same strategy Warren Buffett uses to pick stocks.
The idea is that an investor could take his money, place it into a bond and get a 3% return rate. As a result, the value of your home will never exceed the amount required to produce the same profit from bonds.
Pay Your Tenant to Vacate
If selling with an active tenant isn’t realistic, you can try to negotiate a settlement. I call the tactic cash-for-keys. So, what should you offer your tenant to get them to vacate the property?
There are no hard or fast rules. Your goal is to pay the minimum acceptable amount that your tenant will accept. For some, this could be a lot of money. For others, they’re willing to move out of the kindness of their heart. It really depends on your tenant.
Here are some ways to arrive at a figure that your tenant might agree to.
Make up the difference: Look at comparable rental properties and determine their rent. If you’re charging less, offer to pay the difference between what your tenant is paying now and will have to pay in the new rental home, multiplied the months left on the lease. For example, if you charge $800, there is a home for $850 and you have six months left, then offer $300.
Cover Moving Costs: You might want to offer some money to help the tenant move for the inconvenience of moving earlier than expected.
Pay their Security Deposit: You might want to offer half of what your tenant would need to move into a new place, which is usually first month’s rent and a security deposit.
Whatever You Can Afford: How much can you afford?
You can use a combination of these. Just know that your tenant is under no obligation to agree to your terms. In the event they say no, you’ll have to wait until the end of lease to sell.
Sell to the Tenant
If you have a long-term tenant, this could be a great option. You can offer to sell the home to the tenant. They can secure their own financing or you could provide seller-financing. Seller-financing is when you lend the tenant some money. Often to do this, you’ll need to own the home free and clear.
That’s how to sell a property with a tenant. One other strategy I want to go over could be used for almost any situation, except if you want the cash out of the home.
The 1031 Tax Exchange
If you’re lucky enough to have a positive cash flow or an appreciation in your home, you can look to sell and avoid potential taxes through a 1031 tax exchange. Before you decide if a 1031 tax exchange is right for you, talk with your accountant.
So, what is 1031 tax exchange and how can you complete one?
A 1031 tax exchange is used when an investor is looking to sell their property and roll it over into another property. If you meet certain requirements, which we’ll talk about in a second, you can delay tax obligations.
Here’s how it works. When you sell your property, you have 45 days to identify a new property that is worth more than your old property. Then, you have another 135 days to buy a new property.
In total, you have 180 days to buy a new property from the day you sell your property. So, if you’re thinking about selling your rental unit, start your search early. This way you can create, plan, and implement contingency plans if any deals fall through.
While 180 days may seem like a long time, it can come fast. Don’t start looking for new properties after you sell your current. Do it before.
This strategy can be used if you’re running a negative cash flow on a rental home, but don’t want to get out of the rental market.
Let’s say you invested $80,000 in a home, you’re producing a negative cash flow of $200 per month and your rental home is now worth $100,000.
After running the numbers on another potential rental home, you realized you can buy the home for 85% of its market value, or $100,000. You sell your current rental unit, buy the new one, and now, because you bought right, you have a positive cash flow.
It’s like selling a stock that is going down, then turning around and buying a stock that is going up.
Just getting started isn’t the solution. We all need to slow down and consider our plans before we jump in. Otherwise, we’re likely to fail. Buying the wrong rental home can kill your finances and cause a lot of stress in your life.
It’s why you need to have a solid exit plan. How will you offload the home quickly and at what points? How will you sell if you have tenants? What will you do with the money when you sell?
Your strategy will be unique, but hopefully you have some ideas on where to start. My advice is to not get started into real estate investing unless you have taken a significant amount of time to create contingency plans.