Rent to own question?

14 Replies

I am thinking about purchasing a house for one of my tenants that needs a bigger place and wants to own their own property. I am thinking of buying a home, renting it to them on a rent to own basis for three years and collecting a large down payment. Then I would hold the mortgage for the next 10 years. Does this sound logical? I have 6 rentals right now and only about 50% of their value is loaned, so I would be able to just take a line out to purchase the home to offer as rent to own. This sounds simple but I am afraid I am missing something. Your help would be appreciated.

@Daniel DeMarco

Before discussing the mechanics of such a deal (lease + purchase option) you need to vet your tenant even more thoroughly than you did when they applied to rent from you.

Your, and your tenant's, goal here should be to exercise the purchase option before expiry (1-3 years) and be able to a) place a mortgage with a traditional lender or b) place an initial mortgage with you (3 - 5 year term) and refinance with a traditional lender afterward.

Some folks will carry the tenant's mortgage over the entire amortization, but it may not be your best use of funds to do so.

The key things you need to consider:

  • the lease and the purchase option are separate contracts and the performance of one cannot be tied to the other.  This means no extra rent applied towards a downpayment (which is financing) as part of the lease and no rent incentives tied to the exercise of the purchase option.
  • you need to ensure your tenant / buyer is capable of affording the house and obtaining a mortgage (from a traditional lender) when/if they exercise the purchase option;
  • the option consideration could be the downpayment (this may no longer be true under Dodd-Frank and/or SAFE act ... best to ask someone like @Bill Gulley ) in which case you do not want to make it too large (3 - 5%).  Alternately, there could be a small option fee (for the right to purchase at a predetermined price in the future) and the downpayment proper is due at the point of exercise.   My advise would be to stay away from financing the option fee / downpayment - let the tenant save their own down payment.  If you do plan to accept either in instalments there may be tax and regulatory considerations (another Bill question).
  • when the tenant does exercise the purchase option and you will be holding the initial mortgage, use a third-party servicer (this is likely a legal requirement).  Using a registered mortgage servicer will allow your tenant/buyer to establish/improve their credit history which will improve their possibility of being able to refinance with a traditional lender at the end of the initial mortgage term.
  • you need to ensure that the purchase price is fair - the option will either set the price (1 - 3 years out) now or there will be wording which will require an appraisal at the time of exercise and the price set accordingly.  You do not want to inflate the price at which you are selling (predatory practice).

I'm sure there is much more - we have only used lease + option deals when we have not other means to divest a property (or when helping a family member) and they are not a mainstay of our business.   @Doug Pretorius would be a good person to consult as "rent-to-own" is in his wheelhouse.

https://www.biggerpockets.com/forums/83/topics/234...

Is your plan logical? No, not today it isn't. 

You would do better by taking your money to a mortgage broker give it to them and let them make a loan to your tenant. 

With new accounting rules along with the IRS, option contracts are changing too, don't use them in a casual manner without understanding the tax treatment, equity established, foreclosure requirements, limitations of a tenant with contracting for repairs or doing repairs, due on sale issues, end financing requirements and what the CFPB sees as predatory practices. 

Many strategies can't be done as they were a year or two ago, Rent-To-Own is one of them and is dead on arrival as to credits toward a purchase price. :) 

Rent to own is a popular method, you could use this first buyer as a segway into doing more deals. However, usually with Rent to Own, an investor will offer to buy a house from a motivated seller and then do a sublease to a third party who wants to eventually own their own home, you could do this with your tenant. Collecting down payments and a stipend on top of the rent to be applied for a mortgage, and the advantage of not being responsible for maintenance or CapEx because the leasee is trying to be the home owner.

A good resource for this kind of deal is Kevin Amolsch who has an ebook called the 45 day investor, it's all about rent to own, check out 45dayinvestor.com (I'm not affiliated with him i just found his book helpful for rent to own.)

Best of Luck!

Originally posted by @Ben Biggs:

Rent to own is a popular method, you could use this first buyer as a segway into doing more deals. However, usually with Rent to Own, an investor will offer to buy a house from a motivated seller and then do a sublease to a third party who wants to eventually own their own home, you could do this with your tenant. Collecting down payments and a stipend on top of the rent to be applied for a mortgage, and the advantage of not being responsible for maintenance or CapEx because the leasee is trying to be the home owner.

A good resource for this kind of deal is Kevin Amolsch who has an ebook called the 45 day investor, it's all about rent to own, check out 45dayinvestor.com (I'm not affiliated with him i just found his book helpful for rent to own.)

Best of Luck!

Ben, I do hope you will visit the new regulatory issues we are now under and understand that things have changed, if you read my post above and went to those links, you could seer the issues.

You can now burn your guru books, and a dealer, investor, operator now getting into these crediting matters conducting business will be in violation of federal law. There is no magic pill, if credits of any kind are credited to a sale price it is a financing agreement.    :)

@Roy N - Why do you not tie the agreements together at all? I do understand having two separate contracts, but I do put a clause in my lease options saying that it is null and void if they are no longer a resident of the property. Maybe that's not a good idea, but it would prevent them getting evicted for a non financial reason but somehow still not having defaulted on the lease option. Probably a VERY unlikely scenario to have "killed one" without killing the other but just a precaution. Thanks for any feedback you have on that. 

@Kenneth LaVoie

Here you keep them separate with no performance incentives to prohibit any chance of running afoul of the CRA and having them decide you are either financing or performing an instalment sale.   From my readings on BP, there are similar motivations in the U.S.A. with Dodd - Frank and Safe Act (@Bill Gulley this is your sandbox).

I had not considered your scenario, though I agree it is improbable.  Linking cancellation/forfeiture of the option contract to a prejudicial termination of the lease is still tied performance.   I would also be concerned that it could be construed as predatory depending upon the judiciary.  Perhaps if the cancellation involved the refund of most/all of the option fee.  This would be a good question to take to an attorney who is versed in the new regulatory paradigm.

Originally posted by @Daniel DeMarco :

I am thinking about purchasing a house for one of my tenants that needs a bigger place and wants to own their own property. I am thinking of buying a home, renting it to them on a rent to own basis for three years and collecting a large down payment. Then I would hold the mortgage for the next 10 years. Does this sound logical? I have 6 rentals right now and only about 50% of their value is loaned, so I would be able to just take a line out to purchase the home to offer as rent to own. This sounds simple but I am afraid I am missing something. Your help would be appreciated.

 Daniel a renewable lease every 12 months, giving a ROFR right of first refusal, bringing the tenant to a mortgage broker, and helping them qualify with a FICO coach like www.upgrademycredit.com

Is simplest way to sell with renting first.

Use a lawyer for the ROFR and lease

I just came across this thread and since my name is mentioned above and I disagree with some of what is said I wanted to chime in. @Brian Gibbons , I love what you are saying and think this might be the best way to do this.With that said it is not how I chose to do this for my business.I speak with attorneys on a regular basis and there is some gray here.The way I understand it is that a RTO is clearly financing if you are applying a portion of the rent to a down payment (and not returning it if they done buy). With that said, it is not financing if a portion of the payment is applied to an option price should the tenant choose to exercise their option.It is very important how you write this in your agreement.

Every time I post something controversial someone responds to me telling me I don't know what I am talking about so let me try to be as clear as possible.I choose to use RTO in my business based on advice from my attorney for my situation.You should use your own attorney for your own situation and not believe everything you read in a post like this.

Hi  

@Kevin Amolsch  

Alot of attorneys do not know Dodd Frank, TILA, Safe Act, RESPA, etc.

If you finance an option, even at no interest, it is a financing arrangement.  Get a RMLO to look at the deal.  

I know of 1 investor in TX buying with private lender 1st mortgages, and selling on wraps, no due on sale clause on the private mortgages, and doing 100s of them.

Your RMLO should guide you (unless you have a lease and an option fee paid in full at move in, not financed.)

@Bill Gulley

@Kevin Amolsch good advice to do what your legal advisor suggests!  

I have never used this strategy before, but have spoken to my attorney about the possibility of it.  He recommends that a property purchased in this manor (I'm the buyer) should be held in a trust for best protection of both parties.  Just another caveat.    

Thanks for the replay Brian.  The funny thing is that Chris Dodd and Barney Frank dont understand the Dodd Frank.  How can anyone else? There is much more to it than I posted in my comment but a lease is not financing so I am not sure why you would suggest collected it in full up front is the way to go.  I do agree that a good mortgage loan officer can help but I have not found that they are better to consult with than a good real estate attorney.  Both are licensed to help with owner financing.  In any case my point was simply to not trust everything you hear and that each person needs to do what is best for them based on the advice they get from their advisers.    

@Kevin Amolsch

Well, have your attorney contact me, I advise attorneys often on financing matters.

Next issue, an option may not have any condition of performance required by an optionee (buyer). If an optionee is required to do anything to maintain the right to purchase, such as pay rents on time, you don't have an option, you have an installment sale or a sale contract.

The heading of a contract at the top margin does not define what type of contract you have, you don't just declare you have an option, the intent of the contract and the terms will define what you have.

The intent of a sale is spelled out in the Tax Code with the IRS, it is based on international accounting requirements, look up asset recognition of real estate options.

The IRS is not some lonesome dove, all agencies under the Executive and Judicial Branches work in concert, in other words, if the IRS determines requirements all agencies and courts will utilize the same requirements to make their determinations.

These "intent" rules go into effect this year, 2016. My guess will be that most attorneys who do smallish real estate transactions won't be aware of the new requirements, those dealing in multi million dollar transactions are much more likely to be aware as they probably work with CPAs. 

Use to be that only public corporations were required to follow GAAP accounting requirements, that changes under the new laws that all option contracts made with terms greater than 12 months fall under GAAP, regardless of who the parties are, even mom and pops. 

Doing renewable 12 month terms will not be circumventing the requirements as there is the intent card that will be played.

Dodd Frank doesn't apply to commercial financed options, it clearly applies to consumer financed options when the option price is applied to the sale price. 

It is customary, but not required, that an option price is credited to the sale price so following custom with a consumer tenant you'll have a financing agreement subject to the Act.

If you so much as mention "rent to own" in your contract, the intent found will be a sale contract and/or an installment sale. There are also rules for an agreement to be an installment sale, if those are not met, you'll have a sale contract. 

This is important because the type of contract you have determines the accounting and treatment of all funds. You can agree all day long, blue in the face, that an option price is non-refundable, but it depends  on the determination of the contract as to how funds will be treated, that trumps any intended treatment. 

In a Florida case an investor thought he had an option, it was determined by the court to be a sale contract and the buyer was then entitled to all funds paid under the contract! Surprise! Don't screw around with federal laws!

Most have heard the phrase "they threw the book at him", when you have a violation of law you'll usually be violating several related laws, especially in finance.

You can also take all your creative financing and option guru books that are out there and enjoy a big bond fire, because none of them will be addressing the new laws.

It's up to the client to find professional advice, it's up to you to determine if that council is current with the matters at hand, most aren't with real estate option contracts. These changes are the product of over  50 years of debate while nothing ever really changed, and opinions during the past were pretty clear cut and well established, but that has now changed. So, what you think you may know about options and installment contracts can probably be tossed out the window, you need to learn all over again. That goes for attorneys too!

Lastly, you must prove or show that your intent is not a sale because it will default to being a sale if the intent otherwise is not clearly stated and justified! See you in school!  :)  

As an interesting aside when a prospective renter picks a home, there is a company that will buy the home outright, make any necessary repairs, and then rent it to them. They rent it on a year to year basis with a max term of 5 years. At the end of any year on the lease, they can walk away with no further obligation.

Requirements are they need to have a combined income of $50,000/yr+, and a FICO score of 525+.

Homes that qualify have to be in a good school district, and can go up to $550,000.

It takes 2 months rent deposit to start.

Then, at any time when they can finance it, with their choice of outside mortgage companies, they buy the home from the company.

The selling price escalates 5% per year. 

Since homes in many areas have been going up about 5-10% per year, that's not a bad deal.

This company has purchased $1.5 billion in homes so far, and has $1 billion more to invest.