Lease-Option Process

Tom Donnell

The Lease-Option program is and can be a very lucrative investing program for someone who understands the process and is looking to make it a “win-win” outcome.

Lease/Option:

A lease/option is really two transactions: a lease and an option to purchase. Under a lease, a tenant may have the option to 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. When looking at structuring a lease/option agreement, remember the following:

Money upfront
Cash flow in the middle
Money on the back end of the deal

Note: If you can achieve at least two of the three above items within a deal, it most likely is a good deal.

Desirable Tenant Profile:

In order to be profitable and cost effective in the Lease-Option arena, you must do your homework in finding good reliable tenants. The following is a list of necessities in a good quality tenant.

Good to decent credit history
Married couple or at least engaged
Few or no children
No pets or small house broken pets ( I do charge an extra deposit for all pets)
Looking for long term lease (2-3 years)
Secure job
Adequate income
Above all a person or persons motivated toward your long term goal-to purchase the house outright!

Lease Option Tips & Strategies:

Lease/Options can be fun and profitable, but there are certain pitfalls. The following are some practical, legal and tax tips I have learned and utilized from doing many deals.

Protecting Your Option:

Lease/options are great, except when the seller decides not to live up to his/her end of the bargain. Sure, you can always sue the seller to force them to sell the property, but this can and most likely cost you thousands of dollars in legal fees and take years to accomplish. You need to be in a better position if you want your investment to be protected.

Here are three good ways to protect your option:

Record the Option. If your option was signed before a notary, you can record your option in the public real estate records. This will give the world public notice of your interest. If the option was not notarized, you can sign an affidavit called a “memorandum of option” and file it in the real estate records where the property sits. Keep in mind that this does not create a lien, it only creates a “cloud” on the title.
Escrow the Deed. If the seller has died or disappeared, you will have a hard time getting him/her to sign the deed. An escrow should be created up front in which a title company or attorney holds an executed deed. When you are ready to exercise, you simple tender the money to the escrow agent and collect the deed.
Record a Mortgage. Typically a mortgage is recorded to secure payments on a promissory note. A mortgage can be recorded to secure performance of any agreement, even a purchase option. You as an optionee (buyer) will now be a lienholder, in the same position as a secured lender.

Avoiding the Equitable Mortgage:

Tenant/buyers who default on a lease/option do not always go away quietly. Sometimes, they fight the eviction and go into court kicking and screaming, “I HAVE AN EQUITABLE INTEREST IN THE PROPERTY”. What they are arguing is that the lease/option is not a landlord/tenant relationship, but rather a seller/buyer relationship. If the Judge agrees, your lease/option is “re-characterized” as an installment land contract. This may require you to foreclose the tenant, not just evict him/her.

Here are some tips for avoiding equitable mortgage:

Use Separate Agreements. Give your tenant a lease and a separate option agreement. Make certain the lease does not refer to the option. More than75% of the time, the tenant loses his paperwork.
Keep Your Term Short. Do not give tenants more than one year lease/options at a time. If the tenant insists on three years, give them a one year with 2 rights to renew. Draw up a new agreement each time they renew. If you give a cumulative rent credit, raise the purchase price each time.
Take a Security Deposit. Sellers don’t take security deposits, landlords do. Make it look like a landlord/tenant relationship, even if the security deposit is small.
Pay the Taxes and Insurance. Do not let the tenant pay the taxes and insurance. This makes it look like a sale.
Don’t Give Large Rent Credits. The more “equity” the tenant has, the more likely a judge will favor an equitable mortgage.
Watch Your Language. Refrain from using the words “credits”, “seller”, and “buyer” in your agreements. Instead, use the words “non-refundable option”, “landlord” and “tenant”.

Tax Implications of Lease/Options:

As you have read from the previous information, 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 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.