The Often Overlooked Property Feature: The Tenant

Rental 2

Authored By: Ryan A. Featherstone, Esq.

We frequently handle closings that involve a lease or tenancy, and more often than not, we are not informed that the property is occupied by a tenant.  This can lead to numerous issues during the closing process.  With the exception of some foreclosure scenarios, any property that is sold with a tenant occupying the property is sold subject to the tenancy.  This could be whatever term remains under a lease, or it could be a month-to-month tenancy.  However, regardless of the situation, the simple fact that the property is changing ownership does not alone provide the buyer with any right to remove a tenant.

Paragraphs 6 and 18D of the FAR-BAR contracts address rented properties, and whenever a tenant is occupying a property and will remain for any period of time after closing, the box in paragraph 6 should be checked.  This should also be disclosed to prospective buyers by the seller in advance of any offers, and the MLS listing should reflect the property is currently occupied by a tenant. 

These paragraphs should be reviewed carefully.  Collectively, they obligate the seller to provide the following to a buyer: (1) copies of any lease(s) and (2) estoppel letters from the tenant(s), or a seller affidavit.  The buyer has expiring cancellation rights that commence from the delivery of each of these items, so for a seller, it is imperative to provide this information as timely as possible.  Estoppel letters from the tenant(s) are documents that specify the nature and duration of occupancy, rental rates, and advanced rent and security deposit amounts.  This is so the buyer can cross-reference the lease and other information provided by the seller with the information provided by the tenant(s), to ensure accuracy and have the opportunity to question any discrepancies.  Items like prorated rent and transferring of security deposits and prepaid rents must be correctly handled at closing, so dealing with discrepancies is crucial to an accurate closing.

But as with most things in real estate, what the contract states is merely the beginning.  The following is a discussion of some of the more common (and overlooked) issues when dealing with rented properties. 

If the ongoing tenancy is month-to-month, like in cases where a lease term has expired, and the buyer wants the tenant to continue to rent the property after closing, then the tenant needs to sign a new lease with the buyer.  If the buyer wants the tenant to vacate the premises, then the buyer/new owner should provide the tenant with a notice to vacate.  For month-to-month rentals, Florida law requires a fifteen (15) day notice be given to the tenant prior to the next rent payment being due.  If this notice is not given until the buyer closes the transaction, then there is no way to know if the tenant plans on “holding over” after the notice period expires, requiring an eviction be filed.  This is a risk to the buyer, and ideally the notice would be done before the closing takes place.

However, if the lease has not yet expired, then there must be an assignment of lease prepared and executed at or before closing.  This is essential for the buyer so that the buyer receives all the rights the seller had under the lease, most importantly, the right to receive the rent and evict the tenant in the case of non-payment of rent. 

Next, if the seller is using a rental agent for the collection of rents, and the buyer plans to continue renting the property after closing, does the buyer plan to use that same rental agent?  If not, then the rental management agreement needs careful review to determine what the termination provisions state, as many times lengthy notice must be provided to terminate the rental management agreement.  Additionally, even after termination, the rental agent may still be entitled to a commission if they were responsible for placing the tenant.  Conversely, if the buyer plans to continue using the rental agent after closing, a new agreement with the rental agent should be executed, or at a minimum, the pre-existing one with the seller should be assigned to the buyer.

Is the rental agent holding any security deposits or prepaid rents?  If so, then it needs to be confirmed that these will be transferred over by the agent to the account of the buyer after closing, and not disbursed to the seller.  This is especially important if the buyer does not plan to use the rental agent after closing.  Another question is whether the rental agent has disbursed any rents to the seller for the month of closing.  For example, if the closing occurs on the 15th of the month, presumably the rent has been paid by the tenant.  If the rental agent has disbursed the rent to the seller (less the rental agent’s commission), then appropriate prorating of the rent on the closing statement is necessary to ensure the buyer receives from the seller the rental credit from the date of closing through the end of the month. 

Next, if the buyer is obtaining a mortgage for the purchase of the property, what impact might the tenancy have on eligibility?  For example, most primary residence mortgages require that the buyer occupy the property as their residence shortly after closing.  Typically, there is an “Occupancy Affidavit” signed at closing by the buyer attesting, under oath, to the fact that the buyer will actually occupy the property no later than sixty (60) days after the closing.  Obviously, if the tenancy expires more than sixty (60) days after closing, the buyer would be lying when signing this affidavit.   Additionally, the rental usage could impact a buyer’s eligibility even for a second home loan.  When dealing with a rented property, these issues need to be addressed as soon as possible with the loan officer for the mortgage.

Another concern is related to insurance.  What impact might the rental have on homeowner’s insurance availability and rates?  If the tenancy expires after closing, the insurance companies will likely require the buyer to purchase a DP-3 policy (insurance for rental properties) versus an HO-3 policy (insurance for primary residences).  The coverage is different, as is the cost, with DP-3 policies typically being more expensive.  Once the buyer moves in, the policy can be converted to an HO-3 policy, but this is a hassle for the buyer and something that can cause delays to closing. 

An additional major concern, which currently is a hot topic with the advent of Airbnb and VRBO type services, is the legality of short-term rental usage of a property.  Many buyers are wooed into purchasing a property with the promise of substantial income from vacation/short-term rentals.  In most cases, the seller can provide legitimate evidence of the income-producing history.  However, zoning restrictions do not typically allow for short-term rentals in most local areas.  When this is explained, we often hear the response “but everyone in that area is doing it.”  This is where we should all hear our parents saying, “if all your friends were jumping off a bridge, would you jump too?”  Just because others are doing it, doesn’t make it right, or in this case, legal.  In fact, properties that are off the “barrier islands” cannot be rented for periods less than thirty (30) days.  The seller may have been renting the property for shorter periods, but not legally, and there can be no guarantee such use will continue, as governmental offices are cracking down on these violations.  Of course, this is a separate issue from whether the short-term rentals violate any applicable homeowners association or condo association rules against short-term rentals.

Lastly, note that a rented property will not be exempt from IRS reporting at closing.  Therefore, the seller will be receiving a 1099-S (Sale of Real Estate) at the closing table and should anticipate this prior to closing.  The seller should consult with the seller’s accountant relative to any capital gain taxes that might be due on the sale of a property that is subject to a tenancy.

Naturally, there are additional concerns with rental properties not covered here.  Whenever dealing with a property that is currently being rented and will remain so after closing, for whatever period of time, we recommend that you consult with a licensed Florida real estate attorney to discuss all of the potential pitfalls to you and your client that might be overlooked.

This blog is intended for informational purposes only and it is not intended to be, nor should it be construed as, legal advice or legal opinion.  The reader should not consider this information to be an invitation to an attorney/client relationship, should not rely on information presented here for any purpose, and should always seek the legal advice of counsel in the appropriate jurisdiction.