Most people are generally familiar with the terms “lease option” or “lease to own”, but often are a little fuzzy on the details. Let’s clear up the confusion.
A “lease option” or a “lease to own” is really two contracts: a lease and a purchase option. A lease is a contract for the use and possession of land which creates a landlord/ tenant (or lessor/lessee) relationship.
A purchase option is a contract or agreement that the “seller” agrees to give the
“buyer” the exclusive right to purchase the lease premises. The purchase price for the option is generally set at a fixed price at the beginning of the lease. At any time during the lease period, the tenant can exercise his/her option to purchase the property.
A purchase option is not the same thing as a regular purchase contract, which is legally binding on both parties. A purchase option is only binding on the seller, as the buyer has the “option” of purchasing the property. Think that could be why they call it a purchase option? Could be!
A lease option is not considered a sale, but rather a landlord/tenant relationship.
Even the IRS doesn’t consider it a sale until the purchase option has been exercised. With a lease option, as owner of the property you benefit from market appreciation if the tenant doesn’t exercise the option to purchase the property.
If the tenant does exercise their option to purchase the property, the tenant pays the property owner a non-refundable deposit that is applied to the purchase price of the home. Then, as the tenant pays the rent each month, the landlord (property owner) applies a certain agreed-upon amount to the purchase price of the home. This is typically a percentage of the monthly rental amount, and frequently ranges from 10 to 30 percent of the rent. For example, if the monthly rent is $1,000, and the lease option stipulates that 30% of the rental payment is applied to the purchase price, then $300 each month would be credited toward the purchase price of the home.
As with any real estate contract, if you are considering a lease option with one of
your tenants, you must clearly spell out all the terms and conditions of both the lease and the purchase option. Make sure you spell out the following:
• Identity of the parties – full names of all parties must be on the contract
• Identify the property – the full legal description must be on the contract
• Purchase Price – this is particularly important in a lease option, so there is no question later on down the road
• Signatures – a real estate contract must be signed in order to be legally enforceable
• Legal Purpose – the contract is void if it calls for illegal action
• Competent Parties – all parties to the contract must be legally competent. Minors, mentally impaired or drugged persons cannot enter into a legally binding contract
• Meeting of the Minds – each side must be clear as to the essential details, rights and obligations of the contract.
Pros and Cons of a Lease Option
On the positive side, since a lease option isn’t considered a sale, you retain full title to the property and full tax benefits. This means you have legal control of the property and can claim depreciation on your tax return.
The downsides of a lease option are you receive less money down that with a regular purchase contract, you have less of an incoming payment and you have continuing landlord responsibility.
As an investor and landlord, you need to evaluate each deal on a case-by-case basis to see if lease options work best for you.
