What is Residential Lease Option?

Residential Lease Option is becoming an alternative and popular way to purchase real estate given the present strict lending guidelines which most lenders enforce.

A Residential Lease Option contract combines a basic lease contract with an option to purchase contract, which creates a Residential Lease Option or Lease 2 Purchase.

The tenant/buyer pays to the landlord/seller a nonrefundable option deposit that is applied to the purchase price of the home. The tenant/buyer then pays to the landlord/seller rent to compensate the landlord/seller for the tenant/buyer’s use of the property.

Rent payments are usually made on a monthly basis. A portion of that monthly payment is often applied to the purchase price and/or the down payment of the home.

During the term of the lease, but before the option expires, the tenant/buyer has exclusive right to buy the home under the terms to which both parties have previously agreed.

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1. Document everything in writing

Keep a written record of everything that is agreed on in your Residential Lease Option transaction, and be careful to use the right terms in the agreement.

Refrain from using the words ‘credit,’ ’seller’ and ‘buyer’ in your agreements. Instead, use the words ‘non-refundable option,’ ‘landlord’ and ‘tenant.

Written documentation helps the tenant/buyer to prove the lease option’s validity in applying for a mortgage at the end of the agreement, William J. Archambault, Jr. of The Real Estate Institute said.

A record also protects the lease option claim on the title against other claims and liens, Archambault said.

Documenting the fair market rent up front is useful because “it’s a very difficult thing to go back and recreate what the fair market rent was a year or two years or three years ago,” Archambault said.

2. Consult an attorney

Have an attorney draft a legal Residential Lease Option document or an 1 page addendum to add to your own contracts, which will be considerably cheapter. “Use a legal document that is drafted specifically for your situation. You can create legal forms very easily if you go to Online Legal Forms.

Investors involved in lease options need to consult an attorney, Blackmon said. Property is a significant asset, and representation can be had for a fairly reasonable fee, he said.

3. Use separate agreements to create a Residential Lease Option

Write up separate agreements for the lease and the option, making certain that the lease doesn’t refer to the option, William Bronchick, a real estate attorney from Colorado said.

“It’s the option to purchase that really makes courts hesitant. It’s not the leasing,” Diana Bartolotta, a real estate investment attorney from Connecticut, said. A lease contract could state that after a certain period of on-time rental payments, an option contract will be negotiated. “If you delay that option contract, split it up more, I think that could protect the investor a little bit.”

4. Keep the Residential Lease Option term short

Set the lease option term for a maximum of one year; if the tenant wants multiple years, give a one-year term with two rights to renew, Bronchick wrote. “Draw up a brand new lease and option agreement each time.”

The longer the term, the more likely courts might view it as a mortgage instead of a lease. Most residential leases are set for a maximum of one year and are then renegotiated or renewed. By following that structure, the transaction looks less like a sale.

5. Take a security deposit

A security deposit helps to maintain the landlord/tenant relationships. “Sellers don’t take security deposits, landlords do,” Bronchick wrote. “Make it look like a landlord/tenant relationship, even if the security deposit is small.”

If the tenant hesitates at paying a security deposit and an option fee, reduce the option and put that money toward the security deposit. That way, if the tenant doesn’t exercise the option, there will still be an incentive to keep the property up. This also helps preserve the lease nature of the contract.

6. Pay like an owner

Pay the taxes, insurance and homeowners dues. “Do not let the tenant pay the taxes and insurance. This makes it look like a sale,” Bronchick wrote.

The tenant may pay water and sewer, but the investor should at least get duplicate copies of those bills because they are lienable on the property and could ultimately become the responsibility of the seller, along with penalties and interest.

7. Factor in repair costs

Don’t put the tenant in charge of all maintenance. This shifts too many burdens over to the tenant and could make a tenant’s claim to equitable title much stronger. Investors should factor maintenance costs into the rent, Bartolotta said.

Lack of funding capacity or homeownership experience mean that many tenants won’t keep the property up anyway, and it will cost the seller more in the long run if the tenant neglects the property and walks away from the option. Most tenants don’t exercise the option, so it’s a good idea to be ready for that possibility.

One strategy for a landlord could be to establish relationships with trusted repair companies so that the tenant could be responsible for arranging repairs. The repair company would ultimately report to and collect payment from the landlord to avoid abuses. This would offer a lower time burden to the landlord while ensuring that repairs are completed as needed. This also helps teach the tenant about how to maintain a home.

If the landlord does place the burden of maintenance completely upon the tenant, regular inspections can help to ensure that the property is being properly maintained.

8. Don’t give large rent credits

“The more ‘equity’ the tenant has, the more likely a judge will favor an equitable mortgage,” Bronchick wrote.

This is why preforeclosure situations can face complications with equitable title; many of the original homeowners—now tenants—have substantial equity in the home and have a stronger claim to ownership than typical tenants.

Rather than offer rent credits, which can be viewed by courts as built up equity, reduce the monthly rent. The lower rent will most likely produce a better quality tenant much faster. In addition, the closer the monthly rent is to market rates, the better case landlords have if tenants try to push the equitable interest envelope.

If you absolutely must offer a rent credit, keep it small.

9. Give the tenant a fair chance

Give the tenant a fair chance of being able to exercise the option at a reasonable price. If you ultimately don’t want to sell the property, don’t do a lease option. Investors who set up lease options on properties they don’t really want to sell are using an unethical strategy.

Ethical investors will analyze the lease option and go through with it only if the numbers make sense in the event that the tenant exercises the option.

“If the people are not now qualified to buy a home and get a mortgage, don’t do a lease option with them unless there’s some explicit concrete reason to believe that in the future, they will be qualified,” John T. Reed, a publisher of real estate investment books and former real estate investor, said.

10. Give full disclosure

Make sure the tenant has read and fully understands the ramifications of the deal. This may mean reviewing the contract with an attorney who has lease option experience and can provide sophisticated advice. Investors who frequently participate in lease options may create a lease option pamphlet and require that tenants sign off on it.

“The best way for an investor to protect himself if he’s setting himself up for a lease option is full disclosure. You want the client to be aware of exactly how you’re making your money,” Bartolotta said. “Make sure that the person…knows what you’re doing, why you’re doing it and why it benefits them.”

One of the biggest court problems for lease option landlords is that tenants claim they didn’t understand the contract or that the landlord took advantage of them. Proactive investors can help avoid this problem through full disclosure and taking measures to ensure the tenant understands the agreement.

The Lease 2 Purchase Handbook and FREE CD

What Is a Rent-To-Own or Lease-To-Own Purchase

A lease-to-own house purchase (also “rent-to-own purchase” or “lease purchase”) is a lease combined with an option to purchase the property within a specified period, usually 3 years or less, at an agreed-upon price. The borrower pays an option fee, 1% to 5% of the price, which is credited to the purchase price. The borrower pays rent, and an additional rent premium that is also credited to the purchase price. If the purchase option is not exercised, the buyer loses both the option fee and the rent premium.

As with any kind of financial contract, lease-purchase deals can be structured in such a way that all the benefits flow to one of the parties and none to the other. Buyers especially need to be careful. But lease-purchase plans have a solid economic rationale, which means that they can be structured so that both parties benefit.

Contract Features of a Lease-Purchase

A lease-purchase has 5 major provisions. The sale price of the house and the rent are market-determined, yet subject to negotiation just as in a straight purchase or rental transaction. Buyers often know less about the market than sellers, which places buyers at a disadvantage unless they do some homework, which is advisable.

Buyers generally prefer a long option period because it provides more time to build equity and repair credit. A long period can boomerang on them, however, if they are never able to exercise the option, since they lose the rent premium they have been paying all the while, in addition to the option fee. Sellers generally prefer a short option period, but if it is too short, the house won’t be sold.

The option fee and rent premium are viewed differently by buyers and sellers. To the buyer, they are part of the equity in the house they will soon own. Fully anticipating that they will exercise the option, the only cost is the interest they would otherwise have earned. To sellers, however, these payments are the best guarantee that their houses will sell; if they don’t sell, the payments are retained as income. That the benefit to the seller generally exceeds the cost to the buyer makes the lease-to-own deal a possible win-win.

Using a Lease-Purchase to Buy

The lease-purchase offers homeownership opportunities to consumers with little cash and/or poor credit, who are prepared to bet on themselves. The bet is that before the option period expires, they will qualify for the mortgage they need to exercise the purchase option. During the option period, they have the opportunity to rebuild their credit and accumulate equity while living in the house.

The development of the sub-prime market, in which consumers with poor credit or no cash can obtain loans, does not seem to have lessened interest in lease-purchase. It is very likely that those who succeed in exercising their option under a lease-purchase do better than if they had financed a conventional purchase in the sub-prime market. The savings in finance costs will more than offset a higher price on the house. But those who can’t exercise their option will lose their bets.

Consumers who need to rebuild their credit rating during the option period should understand that paying their rent on time won’t do it. Rent payment information is not used in compiling credit scores. While Fair Isaac, the company that developed credit scoring, has recently unveiled an “expansion” score based on “non-traditional credit data,” it does not yet include rent payment information from individual home owners. Lease-purchase buyers who need a higher credit score must focus on their credit cards and loans.

Even though it is costly, the right not to exercise the option is of value to buyers. If there is something seriously wrong with the house, neighborhood, or neighbors, the money left behind on a lease-purchase is much smaller than the cost of an outright purchase followed by a sale.

Here are some practical tips I have learned from doing lease options over the years. Lease options are great, except when the sellers decides not to live up to their end of the bargain.

Sure, you can always sue the seller to force them to sell you the property, but this can 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:

1. 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.

2. Escrow the deed. If your seller has died or disappeared, you will have a big problem getting him to sign a 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 simply tender the money to the escrow agent and collect the deed.

3. 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 optionee (buyer) will now be a lien holder, in the same position as a secured lender. If the seller refuses to sell the property, you foreclose. Now the SELLER has to go to court to protect himself, rather than the other way around.

Avoiding the “equitable mortgage”

Tenant/buyers who default 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. Here are some tips for avoiding the equitable mortgage:

1. Use separate agreements. Give your tenant a lease and a separate option agreement. Make certain the lease does not refer to the option. More than 75% of the time, the tenant loses his paperwork. You don’t show any option agreement to the court until the judge asks for it.

2. Keep your term short. Do not give tenants more than a one-year lease option at a time. If the tenant insists on three years, give him a one year with two rights to renew. Draw up brand new leases and option agreements each time he renews. If you give a cumulative rent credit, raise the purchase price each time.

3. 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.

4. Pay the taxes and insurance. Do not let the tenant pay the taxes and insurance. This makes it look like a sale.

5. Don’t give large rent credits. The more “equity” the tenant has, the more likely a judge will favor an equitable mortgage

6. Watch your language. Refrain from using the words “credit,” “seller,” and “buyer” in your agreements. Instead, use the words “non-refundable option,” “landlord,” and “tenant.”

Sell your option for capital gains treatment

If you lease option, then sub-lease option, we call this a “sandwich.” When your subtenant is ready to buy, you simultaneously “buy and flip.” This profit is taxed as ordinary income.

If you held the option more than a year, you may qualify for capital gains treatment. Instead of selling the property, sell your option and let your subtenant exercise it directly from the owner.

Take a loss on your personal residence

As you may know, you cannot write off a loss on the sale of your personal residence. However, if you lease option the property you may be able to convert it to a rental and take a capital loss when the buyer exercises.