The Basics of Lease Options and Purchase Sales
There are some subtle differences
Lease option sales first became popular financing instruments in the late 1970s and early 1980s, and they were primarily used as a way to circumvent alienation clauses in mortgages. However, 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. Although similar, they differ in the finer details because 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 to ensure you understand its implications.
Option to Purchase
With the option to purchase route, the buyer pays the seller money for the exclusive right to purchase the property within a specified term (often six months to a year). The buyer and seller might agree to a purchase price at that time, or the buyer can agree to pay market value at the time their option is exercised. It's negotiable, but many buyers want to lock in the future purchase price at the beginning.
Option money is rarely refundable, and while nobody else can buy the property during the option period, the buyer can sell the option to somebody else. The buyer isn't obligated to buy the property; if they don't exercise the option and purchase the property at the end of the option, it simply expires.
A lease option works much the same way. In a lease option, the buyer (the property renter) pays the seller (the property owner) option money for the right to purchase the property later. Lease option money can be substantial. The buyer also agrees to lease the property from the seller for a predetermined rental amount during the term of the lease option agreement. The terms are also negotiable, but like an option, it's usually from 1–3 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. 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.
A lease purchase is another variation on the same theme with some minor differences. The buyer (renter) pays the seller (the property owner) option money for the right to purchase the property later, and they agree on a purchase price—often at or a bit higher than the current market value. During the term of the option, the buyer agrees to lease the property from the seller for a predetermined rental amount.
Terms of the lease purchase agreement are negotiable, but again, the typical duration is generally from 1–3 years.
The buyer applies for bank financing and pays the seller in full at the end of the term. While the option money generally does not apply toward the down payment, 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, and 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 contractually obligated to buy the property.
Steps to Take
When doing a lease option or lease purchase, hire a real estate lawyer to draw up the documents and explain your rights, including those of possession and default consequences.
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.
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, including the following:
Benefits for Both Parties
Owners of hard-to-sell properties commonly offer lease purchase agreements. They 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 banking that the property will appreciate beyond the agreed-upon purchase price. Buyers generally make a small down payment with little or no qualifying, making 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 option money, and they can retain the right to sue for specific performance.
The IRS has classified these transactions as installment sales, not leases, and 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.
As for the seller, the option payment can be treated as a down payment or 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 they're no longer considered to own it.