by Attorney William Bronchick (legalwiz.com). 
For more information go to legalwiz.com .

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.

Financing Alternative

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.

Sublease

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.

Assignment

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.

Side Note: Famous Option Story

The most infamous option-financing story is how the United Nations found its way to New York City. In the mid 1940’s William Zeckendorf, a now infamous developer, took options on multiple waterfront lots on the east side of Manhattan. At the time, the properties were primarily being used for slaughterhouses. Zeckendorf’s option price for the lots was $6.5 million. With the help of the Rockefeller family, the U.N. purchased the property from Zeckendorf for $8.5 million.

The 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 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.

Lease/Option vs. Contract for Deed

Many investors are generally familiar with the concepts lease option and contract for deed (aka “installment land contract”). Many investors confuse the two, and this article will help you understand the tax, legal, and practical issues between the two.

Lease Options

First, let’s start with the lease option, which is really two things, a lease and a purchase option. A lease is a contract for the use and possession of land, creating a landlord/tenant (or “lessor/lessee”) relationship. 

A purchase option is a unilateral agreement wherein the optionor (“seller”) agrees to give the optionee (“buyer”) the exclusive right to the purchase the leased premises. The option price is generally set at a fixed price at the inception of the lease, although it does not have to be. At any time during the option period (which generally corresponds to the lease period), the tenant can exercise his option to purchase.

An option is not the same as a regular purchase contract, which is a bilateral agreement. A bilateral contract legally binds both parties to the agreement, whereas an option only binds the seller. An optionee is not bound to buy; it is his option do so (or not to do so).

A lease with option arrangement is not a sale, but rather a landlord–tenant relationship. In rare cases, a court may re–characterize the transaction as a sale if it looks like a sale. Furthermore, the IRS does not classify a lease option as a sale until the option is exercised (see, Tax Court Memorandum 1999–11).

Contract for Deed

A contract for deed (aka “installment land contract”) is an agreement wherein the buyer makes installment payments on an arrangement similar to an automobile financing. The seller holds legal title to the property as security for payment, while the buyer has “equitable” title. When the buyer pays the full amount due under the contract, the seller delivers legal title to the buyer.

Equitable title gives the buyer the right to live in the property, improve it, rent it and otherwise enjoy all of the benefits of ownership. However, since the buyer does not have legal title, he cannot use it as collateral for a home equity loan (although in some states, banks will lend against an equitable interest in a contract for deed).

The IRS generally treats a contract for deed as a sale, which means the buyer has the tax benefits of ownership. Thus, the payments of interest that are made by the buyer in possession are deductible as “mortgage interest,” even though the buyer does not have legal title to the property. A contract for deed seller must report the transaction as an installment sale on form IRS Form 6252. Once sold, the seller cannot claim depreciation or any other tax benefits of the property. If the buyer defaults on the contract and the seller exercises his legal option to reclaim the property, the tax code treats the transaction as a foreclosure.

The legal process for repossession of the property is not entirely clear in every state. Some state statutes (e.g., IL, TX & PA) clearly spell out the process, which is somewhat more involved than an eviction, but clearly less burdensome than a full–blown foreclosure. In most states, the process is not clearly defined, so courts deal with a buyer’s default on a case–by–case basis.

Which is Better?

In summary, the lease option is a landlord–tenant relationship until the purchase is complete; the contract for deed is a sale at the inception of the agreement. In rare cases a court may re–characterize lease option transaction as a contract for deed, but this is limited to situations where the transaction looks like sale (as in the case of a long–term lease option with a declining balance purchase price).

Which formula is better? It depends on the situation and your goals.

A lease option transaction is not a sale, so you will benefit from market appreciation if the tenant declines to exercise his option to purchase.

A contract for deed sale will allow you to get more a down payment from the buyer, since it “feels” more like a sale. In higher–priced neighborhoods the rents may not command enough rent to cover your underlying mortgage payments.

A contract for deed sale will allow you to collect interest payments, which are generally more than you could collect in rent. On the other hand, a property sold is already sold for tax purposes; thus, you cannot use a 1031 tax–deferred exchange on a property sold by contract for deed when the buyer pays off the debt balance. The entire balance paid on the contract will be due as a capital gain, which can be a huge tax liability if you have a low basis in the property. Furthermore, a defaulting buyer on a contract for deed is generally harder to get out of the property, particularly in a court proceeding.

Summary on the Pros and Cons of Each

In summary, the benefits of lease options are…

• Legal control of the property
• Ability to claim depreciation
• Ability to defer gains by 1031x

The downside of lease options are…

• Less money down
• Less of an incoming payment
• Continued landlording responsibility

The upside of the CFD is…

• More money down
• Higher monthly income
• No landlording headache

The downside of the CFD is…

• Potential tax hit
• Transfer tax due at sale

You must decide on a deal by deal basis which transaction works best for you in terms of work involved, tax issues and, most importantly, cash flow. And, be flexible and know how to do both types of transactions; you can buy on a contract for deed, then re–sell on lease with option. You can buy on lease/option, sell on lease/option. You can buy on contract for deed, then rent the property out. There are multiple strategies you can use and the more you learn the more you earn!

Lease Option Tips and 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 from doing many lease/options deals over the years.

Protecting Your Option

Lease/options are great, except when the seller decides not to live up to his end of the bargain. Sure, you can always sue the seller to force him 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 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.

Here are some tips for avoiding the 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 than 75% 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 him a one year with 2 rights to renew. Draw up a brand new lease and option agreement each time he renews. 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 "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.

by Attorney William Bronchick (legalwiz.com). 
For more information go to legalwiz.com .

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