Options are an excellent way to obtain zero rate financing because they control an asset without any payment or interest other than the amount paid for the Option. It's sometimes possible to get an Option without any payment at all. Aren't listings, contingent contracts and non-recourse loans a form of Option, since the buyer can walk away without liability?
How Can An “Option” Help Investors?
An Option is a marvelous tool that reduces risk while passing on to the holder most of the benefits that can be obtained from leveraged real estate. An Option can be used to pass on tax-free cash to a high-bracket seller, or to enable another seller to be able to cash out a personal primary residence tax free.
EXAMPLE: If I put up Mutual Fund shares as Option Consideration with the right to replace them with equivalent cash based upon current prices, haven't I transferred the market risk to you on both house and stocks? I can make my contract subject to some contingency so I don't have to close. If the stock goes up, I'll sell it, giving you cash while keeping the profit. If it goes down, you're stuck with the loss. I'll close only if the property goes up. I get my deposit back if I don't.
Benefits of Options
Options are ideal for building up tax free cash inside a Roth IRA which otherwise would be subject to tax if it invested in conventional debt leveraged assets. An Option can be used to extend the 45 day period allowed to identify a replacement property when doing a delayed tax free exchange. Options can also enable those who can't find loans with which to buy property with a low down payment to nonetheless buy properties on the installment plan. Let's take a closer look:
Anyone who sells a property within one year of its purchase pays ordinary income tax on the profit. Suppose a seller had an opportunity to sell a property for a quick windfall profit after owning it only 9 months. He wouldn't want to turn down the offer, but would want to reap the benefit of the current 5% – 15% long term capital gains taxes rather than pay taxes in his ordinary income tax bracket.
Suppose, instead of selling the property itself, the seller sold an Option on it, then allowed the Optionee to close the Option only after a full year had passed. In this instance, he'd be able to receive the money tax free until the Option was exercised, and would only pay low capital gains tax on the sale. Alternatively, he could enter into a delayed Exchange and re-invest all sale proceeds tax free. That could be a real plus for market traders and real estate investors alike.
The same market timing strategy would apply to anyone who wanted to sell a primary personal residence that they had only lived in and owned for a period less than 2 years out of the most recent five years. In such case, a buyer could buy an Option, give them the Option money tax free; then complete the purchase and move in after the two year period had elapsed.
In special situations, such as where a home owner is selling a residence that he has bought under a lease/Option, he might have lived in the property for 2 years, but not actually owned it for two years. In this case, the owner might sell an Option to a buyer for a significant sum, and let him move in on a lease until the two years had expired. Both the Option consideration and the final payment would be tax free to the seller.
I know, I know – WOW RIGHT?
This is just Part I of my three-part blog series on how options are a perfect way for investors to be creative in their real estate investing financing and contracts. Here is Part 2 of this series.