Legal Question in Real Estate Law in California

Generally it is "not illegal," but is somewhat immoral. Since you didn't ask about the moral question, I won't linger on that. In terms of legality, there is a law in California which makes collecting rent and not first applying it to a mortgage loan secured by the rental property both a crime and a civil cause of action. It is called Rent Skimming, however, it is technically only applicable during the first year in which the property is owned. I would suggest that while you can do it (assuming you are not in the first year of the loan), you may want to work out some alternative arrangement with the tenant during this time which would benefit you both - i.e., reduced rent in return for more access to the property for Realtor showings, etc...

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This is a rather tough one to answer, because there are both legal and ethical issues, and "OK" probably covers both.

From an ethical standpoint, I believe you should keep your tenants informed as to what is happening. They will at some point find out anyway, in all probability.

Legally, the tenants are obligated to continue paying rent to someone as long as they live there, and that would be you so long as you own the property, have not breached the lease, and are not subject to the lender's exercising its rights under an assignment of rents clause in the deed of trust. However, the tenants might assert a breach of an (implied) covenant of quiet enjoyment, repudiate the lease, and stop paying on that basis, but they would also have to stop accepting the benefits of the lease, i.e., move out.

Also, be aware of Civil Code section 890(a)(1) defining "rent skimming" to include failure to make mortgage payments at least equal to rent received within the first year of ownership, and following sections regarding the rights of an affected tenant.

It may also be worth while to consider the position of the proposed short-sale buyer with regard to the tenants, the lease, and the rental income.