Selling a rental property owned less than a year

Buying & Selling Real Estate
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Selling a rental property owned less than a year

Elizabeth O.
Investor · San Francisco, CA · Member since 2014 · 22 posts · 10 votes

Hi! I'm a new member trying to decide whether to sell a rental property and would appreciate any opinions.

The property is a SFR in San Francisco. It has 2/1 upstairs in the main house and 2/1 downstairs as an illegal in-law unit at the ground level. We purchased it last fall for $605K and the whole house was rented at $3000/month. The goal for purchasing the house was to move into it when we retire and live for free on the income from the in-law. (We thought we would be able to rent the in-law to tourists, ala airbnb, but SF has shut down that option.)

SF just approved legislation to allow in-law units to be legalized, but the actual process to follow through the building department has not been defined yet. All the tenants just moved out, so we need to decide whether to re-rent it or sell it.

Option 1: Rent out the top half and try to legalize the in-law

Since the in-law is illegal, we don't want to rent it out to 2 different tenants. Our lawyer already explained to us that tenants in an illegal unit can successfully sue you for all the illegal rent they've paid you. Your neighbors can turn you in to SF who will make you strip the illegal unit down to the studs (if the space was constructed without permits) plus paying huge fines for doing construction without a permit. The fines apply even if you bought the house that way.

The previous owner had rented the whole house to a master tenant who had in turn sublet the in-law to another family (not allowed in the lease by the way). We think we could rent out the 2/1 main house for $2500/month and leave the in-law empty while we wait for the city to finalize the process to legalize in-law units. Because the in-law was built with permits, except for the separate entrance and kitchen (added after the inspection), we think it's likely that it would be approved as a legal unit.

One problem with this plan is that we can't cover our mortgage + property tax ($2700) with the rent from the top half alone. We don't know when we could start renting the in-law, so we could lose money for a long time. Another issue is that if I legalize the in-law, the property will be permanently under rent control. I'm okay with that except that it will make it nearly impossible to get the tenants out if I need to sell it later.

Option 2: Remove the in-law kitchen and rent out the whole house

Even though the house is set up as 2 units with 2 front doors, 2 back doors, 2 kitchens, I could remove the lower kitchen and rent the whole house to one master tenant with roomates. I think we could get around $3200 for the house under this arrangement.

This plan would keep us from losing money in the short term, but we could get quite a bit more per month if we wait to rent it as 2 units. One problem is that it would be so easy for the master tenant to put a stove back in the in-law and sublet it again without our approval. (The master tenant who just moved out was subletting the in-law for $1700 despite the lease agreement.)

Option 3: Sell

The legal trickiness of renting this property plus the pro-tenant laws in SF make us think that we made a mistake in buying it. We don't have enough income to qualify for a third mortgage, but we could sell to get our downpayment money back and buy a true duplex or triplex in the East Bay for about the same price. Since we haven't owned it more than a year, we don't qualify for a 1031 exchange. The market is very hot in SF right now, so we think we would get all our money back but not make any real profit after the real estate agents took their cut. Does 1031 even matter if you're just breaking even on the sale?

Any opinions would be appreciated.

Thanks!

Elizabeth

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Steve Babiak
Real Estate Investor · Audubon, PA · Member since 2009 · 13k+ posts · 8k+ votes
12y
Originally posted by @Elizabeth O.:

... Since we haven't owned it more than a year, we don't qualify for a 1031 exchange. The market is very hot in SF right now, so we think we would get all our money back but not make any real profit after the real estate agents took their cut. Does 1031 even matter if you're just breaking even on the sale?

...

This is a case where there will be little to no capital gains realized upon sale (IMO after paying closing costs you could see a net loss), so there is no reason to consider a 1031 exchange. A 1031 exchange becomes worthwhile when there are significant capital gains that will be realized at sale, so deferring the tax bill via 1031 makes sense then. I don't believe the short initial hold period here is a real factor in whether this would be eligible for 1031 exchange - I believe since it was rented that the replacement property being held as a rental for at least a year would have been enough to establish a legit exchange; @Bill Exeter would be able to tell us with better certainty.

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  • Amit M.
    Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    12y

    @Elizabeth O.  Hi, and thanks for your update. Couple of questions for you:

    1- did the architect just come our, make an inspection, and list what she thinks will be required?  You guys didn't go further with meeting with the city, drawing any plans, etc?  I'm curious what she charged you for her work. 

    2- did she go by that multi page doc that DBI published about all the code requirements for  legalization?  If that is all she found, about how expensive do you think it will be?  Is the unit a 1br?  Do you think it's not worth the cost to added value, or do you not want to deal with the hassles, etc?

    I have spoke to several people at DBI, and it looks like you basically have to meet all the current codes for adding a new unit. The only thing you really get a break on, I believe, is that you can go beyond the current density of your lot, and that you don't have to do a 3.11 neighborhood notification. Otherwise, it seems all the current codes apply. I never got a straight answer how flexible they will be on certain things that will be onerous. I think you just have to go through the process and find out. 

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  • Elizabeth O.
    OP
    Investor · San Francisco, CA · Member since 2014 · 22 posts · 10 votes
    12y

    Hi @Amit M. ,

    The architect gave me a free 1 hour consultation - nice! Before she came out, she previewed the DBI screening form, then inspected the unit and gave me a verbal list of what her best guess would be required to permit the unit. She told me that she'd charge $115 / hour to draw up the existing plans and proposed plans and fill out the screening form. I think she estimated it would take her less than 8 hours to complete all that. The unit is 1 bedroom plus office.

    She said she could call DBI and try to find out how stringent they are going to be in enforcing code before we turn in the screening form. It's possible they would let us get away with height violations on the existing stairway to the backyard which is outside the unit, but she didn't think they would be flexible on things like one hour firewall.

    We did not ask her to proceed or ask the contractor to estimate the cost of the changes (blowing in insulation in walls and ceilings between units, moving bedroom doorways for height limitations during egress, upgrading the laundry ventilation to stove ventilation, increasing the size of the front door by at least 2 inches, drywalling the entrance hall which has exposed brick and beams). 

    The house has already been empty for 2 months while we were fixing it up after the previous tenants. We only bought it last year, so our mortgage is pretty expensive. Since we don't know how long the legalization process will take, we would need to go ahead and rent out the top half to help cover the expenses. If we then find out that the in-law can't be permitted without some expensive construction, we can't back out of the process and still cover the mortgage, since we aren't willing to rent out the lower unit illegally. The only way we see to lower our risk is to move in ourselves and rent out our own house until the process becomes more clear. If we were already living in the house, I'd proceed, because I would prefer to have a 2 unit to retire in. Instead we're handing it over to our realtor to see what he can get for it rather than deal with moving right now (I have 3 kids, so it's a pain to move).

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  • Amit M.
    Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    12y

    @Elizabeth O.  Yes, I think your perception is accurate: it's not a straightforward project, and with the city, anything not straightforward = more time. Sometimes lots more time. 

    So are you basically saying that if legalization is not feasible, you don't want to keep it as is, or connect inlaw space to main house?  How much are you willing to spend on legalization?  $50-75k or more if needed? Remember, you will probably be adding at least $2-300k in value for the 2nd unit. So if you can deal with the hassle, time and money investment, it may make sense. 

    You can spend a bit more $ with sujo, get plans, and do a prelim meeting with DBI, then assess. But you're definitely going to need to spend money in the project. I don't think insulation and fire proofing is such a big deal. Fireproofing is often a 2nd layer of Sheetrock, and perhaps you can blow in the insulation (and not remove Sheetrock?). The key is, how much can you afford/want to spend on legalization?

    Thanks for the info on sujo. Did you get the feeling she has enough experience dealing with DBI, planning dept, etc?  How did you hear of her?

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