Your tenant wants to buy your house — should you sell it to them, or keep making money renting it out?
“In the right scenario, yes,” it may make sense to sell to your renter, says AJ Petterson with The Advisory Realty Group, a high performance real estate team in Minneapolis that also specializes in Townhome sales. Petterson explains that selling to a tenant can be an advantageous move for your investment portfolio — if done correctly, and under specific circumstances.
So, how do you know if you should sell to your tenant, or keep your asset and the passive income it collects? Read on to learn how to make a savvy investment choice and how to potentially defer paying taxes by trading up, if you do decide to sell to your tenant.
1. Evaluate the offer strength with the help of a top agent
As is advisable in any home sale, work with a top real estate agent to evaluate the strength of your renter’s offer.
A stellar agent will help you compare what you paid for your home and how much you invested in its rehab against your renter’s offer. They’ll also help you determine your home’s worth based on other homes for sale in your area by running a comparative market analysis.
If your renter’s offer isn’t extraordinarily competitive, consider the cost-benefit of selling to them anyway.
“There’s a convenience in selling to a renter that you should factor in when considering the sale price,” Petterson explains. “You may be able to skip the repairs, the contractors, scheduling the cleaners, hiring a photographer, posting it to the market, and hosting an open house.”
You also won’t have to worry about the difficulty of trying to sell the home to another interested party while the tenant is living there, which presents unique challenges. “How much more money are you willing to pay, or lose, for the convenience of having a sale now, rather than waiting for it and expending time, energy, and money just to hopefully earn more?”
2. Weigh home sale earnings vs. long-term rental income
More goes into determining how much money you’ll walk away from your home sale with than the sale price alone.
“As a math guy, my brain always goes straight to the numbers,” Petterson says. “What title fees are you paying? How much will you pay the agent who represents you or the attorney who drafts your documents?”
To ensure you’re making the best long-term financial move, Petterson advises you to figure your estimated net proceeds based on your renter’s offer against your house’s long-term rental income, factoring in carrying costs.
“It’s important to have a long-term investment strategy,” Petterson says. “Are you better off in the long-term with the immediate gain from a home sale? Will that home sale ultimately net you more than rent’s netting you?”
Petterson says working with a financial advisor is always a good idea, but becomes especially essential when you find you need an impartial opinion — “someone who can take the emotion out of it to clear that picture up.”
3. Decide if the market conditions are favorable
Before you decide whether to sell your house to your renter, ask yourself this: are market conditions on your side?
Signs that it may be a good time to sell:
- Market conditions are currently competitive.
- Home supply is tight in your area.
- Houses in your area are selling for more than you paid for your home, plus what you invested in repairs.
Signs you may want to hold onto that rental:
- You’re in a highly desirable rental market, and inventory is tight enough that the house is a promising source of long-term income or would attract a top dollar offer from another buyer.
- Your home equity isn’t yet high enough to justify selling, meaning it’s a better financial decision to continue renting it out while you pay down the mortgage.
4. Consider how capital gains may impact your net proceeds
If you sell your house to your renter, the proceeds will likely be counted as taxable capital gains, as far as Uncle Sam’s concerned — you won’t qualify for the homeowner exclusion, because this is an investment property, not your primary residence. This means you could easily kiss 15%-20% of your profit goodbye, depending on your income tax bracket.
If that’s enough to scare you off selling, hit pause — there’s a tax advantage that can make selling to your tenant a profitable strategy for leveling up your portfolio: a 1031 exchange.
A 1031 exchange allows you to defer paying taxes on your home sale’s gains, and reinvest them into a new property, so long as you meet several criteria:
- The property you’ve sold is productive-use, meaning you hold the property for investment purposes or otherwise use it to make money, as in the case of an office. To avoid being flagged as a dealer, rather than an investor, you should plan to hold the property for at least 2 years.
- The property (or properties) you trade up for should be of equal or greater value, else you’ll pay capital gains on the difference in price.
- You work with a qualified intermediary to hold onto your home sale’s proceeds until you acquire the next property.
- You buy a like-kind property, which simply means another investment property in the same country.
- You identify a trade property (or up to three trade properties) within 45 days of the sale date of the property to be replaced, and you must close on a new property within 180 days of the closing date on the first property.
- You’ll report the exchange using IRS Form 8824.
“Say we could sell a property at a $50,000 gain and acquire a property that fits our portfolio better,” Petterson explains. “If we simply sell the home to the renter, we’re hit with those capital gains taxes right away.” However, if you closely follow 1031 tax code, you can put that $50,000 directly into the next property.
“Be sure to consult a tax professional who’s worked with clients that have done this before,” Petterson advises. Specific verbiage is required in the sale contract, and parsing the relatively complicated tax codes of a 1031 exchange can quickly become murky water. A CPA or tax attorney will help you ensure you qualify and check all boxes.
5. Explore the pros and cons of rent-to-own agreements
Rent-to-own agreements are, first and foremost, leases. Your renter is still your legal tenant until final purchase, you’re still the legal landlord, and there’s not necessarily any requirement that the renter does, eventually, buy the property.
Rent-to-own agreements can allow buyers to work toward buying their first home if they don’t yet have the money for a down payment. While every deal is drawn up differently, rent-to-own agreements have common advantages and disadvantages for investors.
Pros
- If you anticipate selling your rental property sometime in the future, a rent-to-own agreement allows you to continue earning income with a potential buyer locked in down the line. This is especially helpful in slow, buyer’s markets.
- Since your tenant has interest in your house and its longevity, they’re likely to treat it well.
- If the renter backs out of buying the house, you’ll usually still keep the initial option fee and any contributions the renter made to the down payment in escrow.
- It’s typical to charge higher monthly rents for this type of lease agreement.
- You’ll have room to negotiate tenant responsibilities for repairs, which helps you cut maintenance costs.
Cons
- There’s no guarantee that the renter will buy the property.
- You’ll agree on a purchase price upon entering the rent-to-own agreement. If you enter a rent-to-own in a buyer’s market which later swings into your favor, you’ll take that loss while the buyer wins instant equity.
- The buyer/renter may request an initial home inspection before entering into the agreement, which could require you to pay for repairs upfront that otherwise wouldn’t be of immediate concern.
6. Negotiate the price and terms in your favor
After you field your renter’s offer with the help of a top real estate agent, you can decide whether to decline your renter’s offer outright, accept the offer, or negotiate.
Before you begin the negotiation process, talk to your agent about your selling priorities. Together you’ll decide on the absolute lowest price you’re willing to accept, and counter your tenant with a price in the sweet spot.
If you’ve already locked in your next property and could use the liquid cash, then your priority may be to sell as quickly as possible — so long as you don’t take a loss. The speed and convenience of selling to your renter may then constitute reason to sell at a lower profit.
If your ultimate goal is to make the highest profit possible on your home sale, it’s in your interest to counter the renter’s offer with a deal that’s at or greater than market value. Your renter may choose not to play ball, in which case you can try sweetening the deal by offering to help with their closing costs — or simply say no harm, no foul, and continue holding the rental and generating income.
7. Hire a real estate agent or attorney to facilitate the transaction
If you decide to sell your house to your renter, work with a real estate agent or attorney to help you close. Selling to a tenant can make for a relatively streamlined selling process, but closing still requires industry and legal expertise. A top real estate agent will facilitate a smooth transaction with a good title company, a network of contractors to complete any required repairs, and a working knowledge of local closing laws.
Header Image Source: (Andres Molina / Unsplash)