Lease option sales first became popular financing instruments in the late 1970s and the early 1980s. They were used primarily used as a way to circumvent alienation clauses in mortgages, but they have some other advantages as well. Proponents claimed the sale was not a sale because it was a lease, but courts have argued otherwise.
Today, options to purchase, lease options, and lease purchase agreements are three separate financing documents. They’re very similar, but they differ in the finer details.
The variances are state-specific and not all states have identical laws. Consult with a real estate lawyer before entering into one of these agreements with a seller so you’re sure you understand its implications.
Option
The buyer pays the seller option money for the right to purchase the property later when he enters into an option arrangement. This option money can be substantial, or it can be as little as $1.
The buyer and the seller might agree to a purchase price at that time, or the buyer can agree to pay market value at the time his option is exercised. It’s negotiable, but many buyers want to lock in the future purchase price at the beginning.
The term of the option agreement is negotiable as well, but the most common duration is generally from one year to three years.
Option money is rarely refundable. Nobody else can buy the property during the option period, but the buyer can sell the option to somebody else.
The buyer isn’t obligated to buy the property. If the buyer doesn’t exercise the option and purchase the property at the end of the option, the option simply expires.
Lease Option
A lease option works much the same way. The buyer pays the seller option money for the right to purchase the property later. In this case, however, the lease option money can be substantial.
As with an option, the buyer and seller can agree to a purchase price at the inception of the agreement or the buyer might agree to pay market value at the time the option is exercised. It’s negotiable but, again, most buyers want to lock in the future purchase price at the beginning of the lease option agreement.
The buyer agrees to lease the property from the seller for a predetermined rental amount during the term of the lease option agreement. The term is also negotiable, like an option, it’s usually from one year to three years.
The option money generally does not apply toward the down payment, but a portion of the monthly rental payment can apply to the purchase price. Option money is rarely refundable.
Nobody else can buy the property during the lease option period and in this case, the buyer generally cannot assign the lease option without the seller’s approval.
If the buyer doesn’t exercise the lease option and purchase the property at the end of the term, the option expires. The buyer is not obligated to buy the property.
Lease Purchase
It is another variation on the same theme with some minor differences. The buyer pays the seller option money for the right to purchase the property later. The buyer and seller agree on a purchase price, often at or a bit higher than current market value.
During the term of the option, the buyer agrees to lease the property from the seller for a predetermined rental amount. The term of the lease-purchase agreement is negotiable, but again, the common duration is generally from one year to three years.
The buyer applies for bank financing and pays the seller in full at the end of the term. The option money generally does not apply toward the down payment, but a portion of the monthly lease payment goes toward the purchase price. The monthly lease amount is typically higher than the fair market rental value for this reason.
Option money is nonrefundable. Nobody else can buy the property unless the buyer defaults. The buyer typically cannot assign the lease-purchase agreement without the seller’s approval.
Buyers are often responsible for maintaining the property and paying all expenses associated with its upkeep during the term, including taxes and insurance, and they’re contractually obligated to buy the property.
Doing a Lease Option/Lease Purchase
Hire a real estate lawyer to draw up the documents and explain your rights, including those of possession and default consequences, if you decide to take one of these routes to home ownership or to sell your property.
The property might be encumbered by underlying loans that contain alienation clauses, giving the lender the right to accelerate the loan when the owner enters into such an agreement. You’ll want to look into this.
Sometimes sellers give the option money to their real estate agent as full payment of commission. Agents aren’t always involved in the exercise of lease options or the fulfillment of lease-purchase agreements, and you’ll probably still need a real estate lawyer even if you’ve retained real estate agent representation. Agents are not lawyers, and they can’t give you legal advice.
Obtain all the disclosures and do your due diligence just like you would with a regular sale. This means getting a home inspection, examining the title policy, getting an appraisal, and reading any and all seller disclosures.
Consider obtaining pest inspections, a roof certification, a home warranty plan, and hiring other qualified inspectors as well.
Benefits for Both Sellers and Buyers
Lease purchase agreements are commonly offered by owners of hard-to-sell properties. Think about it—the owner would sell it to a conventional buyer who would pay the seller cash if the property was a plum and easy to sell.
Sellers generally get market value at today’s prices and relief from coming out of pocket for the mortgage payment on a vacant property during the term.
Although the lease payments can exceed market rent, the buyer is building a down payment in some cases and she’s banking that the property will appreciate beyond the agreed-upon purchase price.
Buyers generally make a small down payment with little or no qualifying and this makes a lease purchase an attractive way to ease into the benefits of homeownership.
Buyers enter into a forced savings plan when part of the lease payment is credited toward the purchase price at the end of the lease option agreement.
If the buyer defaults, the seller does not refund any portion of the lease payments or the option money and he can retain the right to sue for specific performance.
Tax Consequences
The Internal Revenue Service can and has classified these transactions as installment sales, not leases. Special rules can apply to them at tax time.
A portion of the buyer’s rental payments can sometimes be categorized as interest and would, therefore, be tax deductible to her.
As for the seller, the option payment can be treated as a down payment or the initial payment of the transaction. The total amount of the payments can ultimately contribute to a capital gain or loss, both of which have tax implications. Rental income also contributes to capital gains.
The seller can no longer claim depreciation on the property if it’s considered that he no longer owns it—he entered into an installment sale.
Several other potential tax rules apply as well so you might want to consult with an accountant prior to entering into such a deal.