If you have inherited a house, you may be wondering if you should sell the home or keep it as a rental property. You might be considering whether or not to buy it yourself from the estate, or to sell to a sibling. The answer of course depends on several factors.
Should I keep inherited house as a rental?
Like any job, being a landlord has both rewards and risks. Let’s take a look at the rewards, and then some of the risks.
Rewards of owning rental property
Rental income has lower taxes
Renting a home can be a great source of passive income. Passive income is income you don’t earn by being an employee on a time clock. It’s called passive because you aren’t “working” for it in the traditional sense. The great thing about passive income is that it isn’t subject to several taxes such as Social Security tax .
This is different from earned income, which is what you receive from your employer. When you receive a paycheck from your employer, you pay a portion of your paycheck to the IRS: FICA, Medicare, Social Security Income, etc. These taxes add up to roughly eight percent that gets deducted from every paycheck! This type of income is called “earned income”.
Many landlords get started in the business, simply to change the type of taxable income they receive, from earned income to passive. Some landlords refer to passive income as “mailbox money”. They don’t have to actively “work” for it. They go to the mailbox once a month and collect the rent.
Rental income can pay existing mortgage
If you inherited a property that still has a mortgage, you may be able to keep the house and let the rental income pay the mortgage. However, if you’ve never owned a rental before, you may be a little overly optimistic about how much money you’ll make. There’s not just the mortgage, but also insurance, vacancies, property taxes and repairs you need to account for. If you inherited a house a house without a mortgage, this makes the expenses more manageable.
Prior to purchasing a rental, experienced landlords want to know if it’s a good investment. Will the house generate enough income to pay for all of the expenses, and still leave some money left over? There are a couple of rules of thumb that they will use to determine if a property is a good rental opportunity.
One percent rule
The one percent rule simply says, that the monthly rents for the home must be at least one percent of the purchase price. For example, if the purchase price of the home is $200,000, then the rents must be at least one percent of that, or $2,000 per month. Of course, you cannot charge more for rent than what the market will bear. This particular rule of thumb is hard to follow in California where the median priced home as of December 2018 is $547,000. It’s pretty unusual to be able to rent a home for $5,500 a month unless you’re in the Silicone Valley or San Francisco.
Fifty percent rule
Landlords who use the 50% rule state that vacancy, repairs, insurance, management, etc, add up to between 25% and 50% of their rental income. This percentage varies depending upon how well maintained the home has been, the neighborhood and what kind of repairs it will need. Even if a home is brand new, in 20 years it will probably need a new roof. In 5 years it will need new carpet and paint. If the home is older, these repairs will be needed sooner. Experienced landlords will account for upcoming repairs, even those that are several years out, and begin putting money away for them.
For the typical, reasonably maintained home, you can expect roughly 35% of your rental income to go toward expenses. For example, let assume your gross rental income from a property is $1,500 a month. You can expect to spend $525 of each month’s rent to go toward repairs. It may not be that much this month or next, but over the lifetime of the rental. For a home with deferred maintenance or significant repairs, that amount will be much higher.
If your inherited home passes either of these two tests, you may have a great rental opportunity!
The risks of rental properties
Tenants are both the reward and the bane of a landlord’s success. If you have good tenants, you love your rental property. If you have bad tenants, you hate your rental property. Avoiding bad tenants requires good screening of applicants and being a good landlord. That means fixing problems and complaints immediately.
In California, tenants have an implied warranty of habitability. This “requires landlords to maintain their property in a condition that is fit for the occupation of human beings”. If your rental property is considered to be uninhabitable due to leaking windows or roofs, mold, or drafty exterior doors, you may be ordered by the court to put your tenants up in a hotel until you solve the problem.
Warranty of Habitability – “requires landlords to maintain their property in a condition that is fit for the occupation of human beings”
However, even great landlords who screen well, still encounter problem tenants. Every landlord has tenant horror stories to tell. These professional tenants often view themselves as “live in code enforcement”. They tear up the property and then report landlords to code enforcement. Next, they stop paying rent citing habitability issues. If the claim is false you end up spending money and go through the process of evicting your tenants. Then they destroy the property when they finally leave.
Everyone knows most tenants do not take care of a home like it was their own. As a result, you can expect to have more repairs for your inherited rental home than a home you live in.
Some landlords like to say, “I respect your privacy. I won’t bother you if you don’t bother me”. If this is you, you can expect your tenants to only report the worst repairs. That means they probably won’t report the leak under the kitchen sink, that is rotting out the cabinet. That is, until it smells like mold.
We all know that carpet wears out, so do appliances, paint and a lot of other things. The IRS “allows” you to depreciate the value of items over time. Even though you may not have spent a dime on them! Landlords love depreciation, because it’s free money. Who wouldn’t want extra tax deductions?
I say “allows”, because the IRS actually requires you to depreciate certain items. “Why is that a problem? you ask. “I get to deduct expenses I never had”. It’s because of something called “depreciation recapture tax” when you sell. The IRS wants to collect on the years of virtual deductions you have depreciated. When you deduct depreciation, and later want to sell your rental, the IRS taxes you at a flat rate of 25% on all of those deductions! That means that if you decide to sell when you’re retired and in a low tax bracket, you’re going to pay 25% on the depreciation deductions you’ve claimed over the years. Even if you’re only in a 10% tax bracket. Ouch.
Example: Sue bought an inherited home from her parents estate years ago and kept it as a rental. Sue was forced by IRS rules to depreciate the purchase costs and over time. Now Sue wants to sell the property that is fully depreciated. However, Sue’s CPA tells her that Uncle Sam wants to tax Sue on the depreciation deductions she has taken. To add insult to injury, it’s not based on Sue’s tax bracket, but Uncle Sam wants to tax everything she depreciated at 25%.
Required to capitalize instead of deducting expenses
Did you know that you cannot deduct every rental property expense? Deductions for expenses that add to the value of your rental property, must be spread out over several years, called capitalization. If you obtain a new rental and install a new roof that costs you $12,000, you may be required to spread the cost of the roof out over several tax years. However, if you wait a few years and repair the roof, versus replace, you may be able to fully deduct the costs. Repairs can typically be deducted the same year they are incurred. However, improvements must be spread out.
For more information read our post on depreciation recapture and repairs, for ideas of how to be able to deduct expenses immediately rather than over time.
Should I sell my inherited house?
You may choose to sell your inherited house. It might be because you live out of town, it has too many repairs. Or maybe, you just don’t want the hassle with tenants. If their are multiple heirs to the estate, some will likely want their money as fast as possible. Others may be interested in buying the family home from the estate.
Do you have an heir who wants to purchase the home? This can be a great benefit to a family member, allowing them to potentially purchase the family home at a discount, while allowing the other heirs to receive their inheritance.
Are the other family members willing to sell the home to one of the other heirs? This can be a big help to a family member who needs a home. When a family member wants to buy the family home, they only need to pay the other heirs for their portion of the inheritance, not their own. This allows the family member to buy the home at a discount.
Are any of the heirs willing to carry a loan instead of being paid their inheritance? This can help the purchaser even more if family members are willing to wait to receive their inheritance.
Selling house with mortgage to family member
If you inherited a home with a bank mortgage, the mortgage will need to continue to be paid . If the property is in a trust, this will be easier. While in a trust, there’s no change in ownership which might cause the bank to accelerate the loan. Most loans have a clause that allows the lender to demand full payment of the loan if ownership of the property changes. With a trust, the ownership doesn’t need to change. This allows family members to continue to live in the home, as long as the payments, property taxes and insurance are all paid on time. However, if you have an inherited home without a mortgage, there is no bank to demand payment.
If the family member wants to change the ownership name on title, then you risk the lender accelerating the mortgage payoff. When this happens, the new owner will need to get a new loan to pay off the current lender. Ultimately, the family member should attempt to obtain a loan to pay off the existing mortgage.
Can I sell an inherited house at a loss?
If the home you inherited is worth less than is owed, then you may want to consider a short sale. In a short sale, the lender agrees to let the owner sell a property for less than is owed. This prevents the owner from having to make up the difference. Because it is being sold at a loss to the lender, the lender must approve the short sale purchase price.
If you need to sell the home using a short sale, the lender will require you to sell the home through a licensed Realtor®. When choosing your Realtor® you want to make sure you choose the best agent and one who is very experienced in short sales. Don’t use an agent who has only done three or four short sales. Short sales require your agent to keep in constant communication with the bank to prevent the home from being sold in foreclosure. During the Recession, there were lots of homes being sold as short sales, but lost to foreclosure, simply due to inexperienced agents.
Selling inherited house as-is
What if your inherited home has deferred maintenance, needs lots of expensive repairs or is a hoarder house? Should you fix the home and sell it, or just sell it as-is? When selling a house as-is sale, the buyer buys the property in its current condition, saving you from having to spend any money on repairs or cleaning.
As-is doesn’t mean you don’t have to tell the buyer about known defects in the property. Legally, you must tell any potential buyer about any defects you are aware of. However, since the property was inherited, it’s unlikely you are aware of any defects. Because of this, trustees of family trusts aren’t required to complete extensive disclosures in California.
Sell through agent or to an investor
You have a couple choices to sell your home. You can choose the traditional route and sell through a Realtor®, or you can sell to an investor who buys homes as-is. It’s important to evaluate the amount of repairs prior to selling and the amount of time it will take to repair and sell, as well as the costs.
Traditional selling process with Realtor®
Is the home is in good condition? Getting a fresh coat of paint and carpet may be all you need in order to get the most dollars for your inheritance. For just a few thousand dollars, you may be able to spruce up the home giving it a fresh, clean and appealing look for buyers. In this case, selling through a Realtor® is probably your best option, unless the family members are in a hurry for their inheritance.
If the home requires a lot of repairs, then you will probably not be able to sell the home for top dollar unless you’re in a seller’s market. If you’re not, you have to decide if you want to hassle with fixing the property up and selling it or selling it as-is.
Even if you are looking to sell your inherited house as-is, you can still sell the home through a real estate agent. However, in addition to the discounted price you will be also be paying real estate commission. It may also take longer to sell your home due to it’s condition, even with a discounted price.
Hassle free sale with investor
If time is important and family members want their inheritance quickly, or simply to not have to go through everything that was left in the house, selling to an investor may be a better choice. Investors buy homes, as-is, with minimal inspections. There are several benefits to selling to an investor over the traditional real estate sale process. First, most investors are used to buying homes where the previous occupant’s things are left. This frees up the family members from spending what sometimes is several days from having to sort through everything, clean the house out, and haul things to thrift stores or to the dump. In addition, unlike traditional buyers, professional investors will not judge or belittle your family member’s home.
Not all investors are the same Be sure to read our article on Are House Buying Companies a Scam?.