Tax Implications of Lease/Options
The lease/option strategy is a great way to leverage your real estate investments because it requires very little cash. The lease/option is more of a financing alternative than a financing strategy because you don't own the property. The basic lease/option strategy involves two legal documents, a lease agreement and an option. A lease gives you the right to possess the property, or, as an investor, to have someone else occupy it. If you can obtain a lease on a property at below market rent, you can profit by subleasing it at market rent.
An option is the right to buy a property. It is a unilateral (“one-way”) agreement wherein the seller obligates himself to sell you the property, but you are not obligated to buy. By obtaining the right to buy, you control the property. You can market the property and sell it for a profit. The longer you can control the property in an appreciating market, the more value you create for yourself. By combining a lease and an option, you create a lease/option.
The two primary objectives of the real estate investor are cash flow and appreciation. You don't need to own a property to make cash flow or benefit from appreciation. A lease entitles you to possession, which allows you to make cash flow. An option gives you the right to buy at a set price, which allows you to benefit from future appreciation.
Lease – The Right to Possession
Under a lease agreement, the lessor (landlord) gives the lessee (tenant) the right to possess and enjoy the property, which is one of the most important benefits of real estate ownership. The lessee is usually not responsible for property taxes and major repairs. Once you have the right to obtain possession of property, you can profit by subletting or assigning your right to possession.
A sublease is a lease by a tenant to another person (subtenant) of a part of the premises held by the tenant under a lease. The sublease can be for part of the premises or part of the time period. For example, if the tenant has a three-year lease agreement with the landlord, he can sublease the rental unit for two years, or sublease part of the unit for three years.
An assignment is a transfer to another of the whole of any property or any estate or right therein. As with a sublease, the master tenant is not relieved from liability for obligations under the lease. However, the assignee of a lease is in contract with the landlord, and thus the landlord can collect from the assignee or the master tenant for nonpayment of rent. Assignment and subletting are always permissible without an express provision in the lease forbidding the tenant from doing so. As a tenant/investor, it is imperative that there are no anti-assignment or anti-subletting clauses in your lease with the owner of the property.
More on Options – The “Right” to Buy
A real estate sales contract is a bilateral or two-way agreement. The seller agrees to sell, and the purchaser agrees to buy. Compare this agreement with an option; an option is a unilateral in which the seller is obligated to sell, but the purchaser is not obligated to buy. On the other hand, if the purchaser on a bilateral contract refuses to buy, he can be held liable for damages.
A bilateral contract with contingency is similar to an option. Many contracts contain contingencies, which, if not met, result in the termination of the contract. Essentially, a bilateral contract with a contingency in favor of the purchaser turns a bilateral contract into an option in that it gives the purchaser an out if he decides not to purchase the property. Though the two are not legally the same, an option and a bilateral purchase contract with a contingency yield the same practical result. The receiver of the option (optionee) typically pays the giver of the option (optionor) some non-refundable option consideration, that is, money or other value for the right to buy. If the option is exercised, the relationship between the optionor and optionee becomes a binding, bilateral agreement between seller and buyer. In most cases, the option consideration is credited towards the purchase price of the property. If the option is not exercised, the optionee forfeits his option money. An option can be used to gain control of a property without actually owning it:
A speculator who is aware of a proposed development can obtain options on farmland and then sell his options to developers.
To take advantage of appreciation in a hot real estate market, an investor can use a long-term option to purchase property.
To induce timely rental payments, a landlord can offer the tenant an option to purchase. There are literally hundreds of ways that an option can be structured and every detail is open for negotiation between the optionor (seller) and optionee (buyer).
An Option Can Be Sold or Exercised
An option, like a real estate purchase agreement, is a personal right that is assignable. If you were able to obtain an option to purchase at favorable terms, you could sell your option. The assignee of the option would then stand in your shoes, having the same right to exercise the option to purchase the property. As with a lease, an option is freely assignable absent an express provision in the option agreement to the contrary.
Alternative to Selling Your Option
Rather than sell your option to purchase, you may wish to exercise the option yourself, then sell the property to a third party buyer in a double closing, as described in chapter five.
A lease/option is really two transactions: a lease and an option to purchase. Under a lease, a tenant may have the option the buy the property. The option itself can be structured in various ways. For example, the option may be that of a right of first refusal in the event the landlord intends to sell the property. The option may also be an exclusive option for the tenant to buy at a certain price. When combined with a lease, a purchase option may also include rent credits, that is, an agreement that part of the monthly rent payments will be applied to reduce the purchase price of the property. There are literally hundreds of ways that an option or lease/option can be structured and every detail is open for negotiation between the landlord and tenant.