Selling a Rental Property When You Owe More Than It’s Worth

Owning a rental property is supposed to make money.

But sometimes the numbers start moving in the wrong direction.

Maybe the rent no longer covers the mortgage, taxes, insurance and HOA dues. Maybe the property needs repairs you don't want to make. Perhaps you bought when prices were higher, refinanced the property, or simply need to get out—but today's market value isn't enough to pay off the mortgage.

Then you discover another problem:

You owe more on the rental property than it's worth.

That doesn't necessarily mean you're stuck with it.

Depending on your financial situation, the property's value and your lender, a short sale may be one option for selling an underwater rental property in California.

First, Find Out How Underwater the Property Really Is

Don't start with what you paid for the property.

And don't start with what you hope it's worth.

Start with what a buyer is reasonably likely to pay for it in today's market.

Then compare that with:

• Your approximate mortgage payoff
• Any second mortgage or HELOC
• Property tax liens
• HOA liens or unpaid assessments
• Other liens against the property
• Estimated selling expenses

Suppose your rental property might sell for $450,000, but the mortgage payoff is $485,000.

You're not merely $35,000 underwater.

There are still expenses associated with selling the property.

That's why the first step is determining the property's realistic market value and getting a clearer picture of the total debt attached to it.

Can You Sell a Rental Property for Less Than the Mortgage?

Potentially—but you generally can't simply sell the property for less than the amount required to satisfy the mortgage and expect the lender to release its lien.

That's where a short sale comes in.

In a short sale, the property is sold for an amount that will not generate enough proceeds to satisfy the mortgage and approved selling expenses in full. The mortgage servicer is asked to approve the transaction and accept the proceeds under the terms of its short-sale approval.

The lender doesn't have to approve it.

The process generally involves documenting the property value, reviewing the purchase offer and providing whatever financial or other information the mortgage servicer requires.

If there are multiple loans or liens, there may be additional parties involved.

Do You Have to Be in Foreclosure to Short Sell a Rental Property?

Don't assume you have to wait until foreclosure is imminent before asking what your options are.

If the property has become financially unsustainable, it usually makes more sense to understand the numbers and possible solutions before the situation becomes an emergency.

A landlord may consider selling because of:

• Negative monthly cash flow
• Increasing insurance costs
• HOA dues or special assessments
• Major repairs
• Extended vacancies
• Problem tenants
• Declining property values
• An adjustable or otherwise unaffordable mortgage
• A need to sell another property or reduce debt
• Personal financial changes

The important question is not simply whether you're behind today.

It's whether continuing to own the property makes financial sense.

What If the Rental Still Has a Tenant?

Having a tenant does not automatically prevent the property from being sold.

But it can affect how the property should be marketed and who the likely buyer will be.

A current lease, rental amount, payment history, security deposit and the condition of the tenancy can all matter.

An investor may view an existing tenant very differently from an owner-occupant who wants to move into the property.

California landlord-tenant law can also affect notices, access, lease obligations and other parts of the sale. Those legal questions should be addressed with an appropriate attorney or other qualified professional when necessary.

From the real estate side, the important thing is to identify the tenancy early so the property can be marketed appropriately rather than discovering a problem after an offer arrives.

Should You Keep Feeding Money Into an Underwater Rental?

This can be the hardest question.

A landlord may have owned a property for years and already put substantial money into it.

That can make walking away from the investment emotionally difficult.

But money already spent doesn't tell you whether keeping the property is a good decision from this point forward.

Look at today's numbers.

How much are you losing each month?

Are major repairs approaching?

What is happening with insurance, property taxes and HOA expenses?

How much would it cost to continue owning the property for another year?

What would need to happen to the property's value or rental income for the investment to work again?

And how long are you willing and financially able to wait?

Sometimes holding makes sense.

Sometimes selling makes sense.

The important thing is to make that decision based on the property you own today—not the investment you hoped it would become.

What About Selling the Rental Property to an Investor?

You may receive calls, texts or mail from investors offering to buy the property directly.

That can be an option.

But if you already owe more than the property is worth, selling it cheaply to an investor doesn't solve the underlying mortgage problem by itself.

The lender still has to address the shortage necessary to release its lien.

Before accepting an investor's offer, understand the property's actual market value.

An as-is property may still benefit from being exposed to multiple potential buyers rather than assuming the first cash offer is the best solution.

The goal should be to find the best realistic market offer, not merely the fastest person willing to write one.

That can also matter when asking a lender to approve a short sale.

Can You Short Sell a Rental Property That Needs Repairs?

Yes, the condition of the property can be part of the valuation and marketing process.

In fact, deferred maintenance may be one reason the property's current value no longer supports the mortgage balance.

Before spending substantial money renovating an underwater rental, determine whether those repairs are likely to produce enough additional value to justify the expense.

A property needing a roof, HVAC system, plumbing work, flooring or extensive cosmetic repairs may still have buyers.

The price simply needs to reflect the property's condition and the market.

What Happens to the Remaining Mortgage Balance?

This is one of the most important questions to understand before completing a short sale.

The short-sale approval should spell out how the lender will treat the amount it does not receive from the sale.

Do not make assumptions about deficiency liability based on something you read about another person's short sale.

The loan, property, lender, transaction and applicable California law all matter.

Have the approval terms reviewed by the appropriate professional if you have questions about your continuing liability.

What About Taxes on a Short Sale of a Rental Property?

Rental properties deserve particular attention here.

A short sale can potentially involve more than one tax issue, including the tax consequences of disposing of the rental property and potentially the treatment of debt forgiven by a lender.

The IRS generally treats canceled debt as taxable income unless an exception or exclusion applies. Rental real estate may qualify for certain exclusions in some circumstances, including insolvency, bankruptcy or qualified real property business indebtedness.

Those rules can be complicated, and the tax treatment of a rental property is not necessarily the same as the treatment of someone's primary residence.

There can also be issues involving the property's adjusted basis and prior depreciation.

Talk with a qualified tax professional about your particular numbers before assuming what the tax consequences will be.

Should You Let the Rental Go Into Foreclosure Instead?

Don't make that decision without comparing your alternatives.

If you simply stop dealing with the property, the underlying financial and legal issues don't disappear.

A foreclosure can involve its own consequences, and the IRS treats foreclosure as a disposition of property that can result in gain or loss. Depending on the debt and circumstances, cancellation-of-debt income may also be involved.

If you're considering walking away, this is the time to speak with the appropriate real estate, legal and tax professionals and understand what each available option may mean.

Doing nothing is still a decision.

Start With Three Numbers

If you're trying to figure out whether you can sell an underwater rental property, start here:

1. What is the property realistically worth today?

2. Approximately how much is owed against it?

3. What is the property costing you every month you continue to own it?

Those three numbers won't answer every question.

But they'll tell us quite a bit about what question we need to answer next.

Selling an Underwater Rental Property in California

I've worked with California homeowners and property owners facing short sales and difficult selling situations for many years.

If you own a rental property that is worth less than the mortgage balance, you don't need to decide today that you're going to short sell it.

First, let's determine what the property may actually be worth and whether a traditional sale is possible.

If the numbers show that you don't have enough equity to sell conventionally, we can discuss the real estate side of a potential short sale and what information you'll need to begin evaluating that option.

The first step isn't selling the property. It's finding out where you stand.

This article is for general educational purposes and is not legal, tax or financial advice. Short sales, deficiency liability, foreclosure and cancellation of debt can have significant legal and tax consequences. Consult an attorney, CPA or other qualified professional regarding your individual circumstances.