LEASE OPTION!!!! OVERRATED OR UNDERSTATED (SELLER/OWNER SIDE)
Shawn AckermanPro Member
Real Estate Entrepreneur · Mid West, East Coast · Member since 2015 · 3k+ posts · 1k+ votesHere we go......As I'm putting in offers I know one of them will eventually be accepted and the deal will close. Had a few snags after having offers accepted recently but it's par for the course.
So when the good deal closes, I would like to lease option the property to a buyer. Actually I would like to do a lease option in a duplex, triplex or 4plex. From what I know lease options have some advantages I.E.
1. Increased rent for the option tenant as you can apply a paper credit of 10% toward purchase down payment. ex. Rent $650 P/M Charge 10% mark up, so $715 P/M .
2. Option tenant will likely take care of the property as there is an "equitable interest" in the property. This can allow for the removal of the property management component freeing up 10-15% of the gross rents to be distributed to another purpose.
3. Keep the purchase down payment if the option tenant does not close on the property at the end of the set term.
4. Allow for the sale of the property at a significant mark up. I.E. purchased for 50K but sell it to the option tenant for 80K on a 3-4 yr term. $2,300 - 3,100 depending on the term.
and on and on and on.......
So, is this an old/outdated strategy or a good strategy for cash flowing rentals? The numbers on the property I'm looking at cash flow around $140 per door after all expenses and debt service without the option.
Any and All input is greatly appreciated
Shawn
@Roy N. I read up a little on the lease option strategy and I did read that the two should be separated. Thanks for reinforcing that for me. Additionally I read that the Option should be subject to the lease. Thus if the lease expires therefore the option is voided by default. I know that the statutes are different in each state so I will definitely consult an attorney before enacting such an agreement. Thanks for sharing.
I'm just looking for some advantages. So from your perspective what would be a good strategy for purchasing a duplex rental property cash? Let's say for 60K cash flowing $140 per door after expenses and debt service?
Shawn, you can't have an option subject to a lease and vice versa
Any judge seeing that will deem it a disguised sale. So will the IRS Tax Court; It is pure guru speak. You give some one a 12 mo lease that is extendable, and a 12 month option. See how tenant performs.
Shawn:
You might want to leverage the BP search function and score the forums for Lease and Purchase Option. Most of the things you list above are outdate and may very well land you in trouble these days:
@Roy N. I like your comments on the conservative and cautionary side, they were well written and it was good to see someone put them out there. @Shawn Ackerman, you are right on with some of your thoughts though. Lease Options are a fantastic way to help both the buyer and seller:
- Buyer can't get financing right away because they are in a new job, or credit is 10-40 points away from a qualification
- Buyer can get credits toward their purchase price; everything is negotiable. Just check with your attorney to review contract(s)
- Buyer gets a free "test drive" on the property, so they know the quirks of the house
- Buyer can also use this as leverage and negotiating power over the course of the option
- Buyer gets the privilege of the seller not being allowed to market the property (for sale or rent) by entering into an option agreement. This benefits the buyer completely, not the seller, especially if you are in an appreciating marketing and your purchase price was set at first option signing.
- Seller can unload a property potentially for more money, however, the place still needs to appraise, so, as the seller, you really can't "take advantage" of the buyer
- Seller get's the "cash flow" from the property prior to option (makes a ROI monthly, which increases overall net profit.
Ultimately, the lease option can be an extremely valuable tool to help both parties, and it is an excellent way to build a solid working relationship with someone. I have done several of these, some are in the works for me, and I have done some for others (acting as the Broker and Property Manager working for the seller and/or buyer(s)) It's really a neat way to tie up a property and for both parties to get what they need, on their terms.
I am in one right now with a fellow BP member, and in our situation it has worked extremely well. He got a property that was appraised at $290k for under $260k. I allowed this to happen because my entry point into the property was solid. My problem was that there were some issues that came up in the past year, that I had to remedy, which significantly reduced what my ROI will be in the end. I feel that my tenant (and future buyer in a few weeks) appreciated me for being the stand up kind of guy that would take care of things and not be "greedy," and hope that I built a great solid relationship with him and his family. Because in the end, I want them to come to me if they ever want to sell, buy, or manage any of their properties in the future, as that is my profession. Hope this helps you, and definitely use the lease option; just make sure you do keep them both separate (as Roy stated), because they are two separate contracts (that can be used in tandem).
Good luck, and if you ever want to bounce of any thoughts, PM me any time!
@Roy N. I read up a little on the lease option strategy and I did read that the two should be separated. Thanks for reinforcing that for me. Additionally I read that the Option should be subject to the lease. Thus if the lease expires therefore the option is voided by default. I know that the statutes are different in each state so I will definitely consult an attorney before enacting such an agreement. Thanks for sharing.
I'm just looking for some advantages. So from your perspective what would be a good strategy for purchasing a duplex rental property cash? Let's say for 60K cash flowing $140 per door after expenses and debt service?
@Rick Santasiere I really appreciate you breaking down from your practical experience how the option can work on both sides as I'm only looking at it from my perspective. I'm going to do some more reading up on it and take a look at the Wisconsin Statute on lease options. Thanks again!
It's in here somewhere. I'll find it lol!
https://docs.legis.wisconsin.gov/statutes/statutes/846/30
@Roy N. I read up a little on the lease option strategy and I did read that the two should be separated. Thanks for reinforcing that for me. Additionally I read that the Option should be subject to the lease. Thus if the lease expires therefore the option is voided by default. I know that the statutes are different in each state so I will definitely consult an attorney before enacting such an agreement. Thanks for sharing.
I'm just looking for some advantages. So from your perspective what would be a good strategy for purchasing a duplex rental property cash? Let's say for 60K cash flowing $140 per door after expenses and debt service?
Shawn, you can't have an option subject to a lease and vice versa
Any judge seeing that will deem it a disguised sale. So will the IRS Tax Court; It is pure guru speak. You give some one a 12 mo lease that is extendable, and a 12 month option. See how tenant performs.
Ahhh, yes, the old lease-option stuff.
Welcome to 2016!
I know how much real estate investors or operators love to visit guru sites, listen to us old guys on deals of the past, the old Rent-To-Own stuff, but you can take all that now (except the two different contracts, a lease and a separate option) and throw it out with your bell bottom slacks, leisure suits and platform shoes. (if you even know what those are, LOL, think disco).
It's not just Dodd-Frank, for the conspiracy theorist you can start looking to other government agencies joining in with the CFPB and HUD. Just as the FBI used accounting and tax laws to nail Al Capone, the IRS has joined in making the lease-option much more interesting.
What's new and how did they do it?
It actually started with the International Accounting Standards Board adopting new accounting rules to recognize assets and liabilities, then adopted by the US Financial Accounting Standards Board which in turn was made a requirement by the IRS.
While it use to be that only public companies were required to follow Generally Accepted Accounting Principles (GAAP), this year all real estate operations must comply, that means any mom and pop landlord, any whizbang investor dealer or any else that sells dirt.
This aspect has everyone dealing with leases and/or option contracts and any other sale giving consideration to accounting for such operations, banks/lenders, settlement agents, appraisers as well as investors.
The accounting requirement now hinges on the intent of a sale, if the intent is to sell or purchase, the accounting must recognize the transaction as a sale or an installment sale. This effects the lease-hold interest, equity of a buyer, depreciation of the seller at the time of contracting, adjustments must be made to the asset, liability and capital accounts reflecting the proper treatment of the sale. Residential or commercial, it doesn't matter.
It's a lot like a parade, first the Grand Marshal and the politicians go by, then the bands and floats, then the horses and after that, some more bands and the bands never want to be behind the horses because stuff happens.
Well, accounting leads this parade, followed by the IRS, then other agencies follow the IRS then applicable laws with investors and operators following behind. Don't follow that?
Put another way, if the IRS sees a transaction as a sale, then so does the CFPB, HUD, TILA, the ALTA folks, FDIC, Treasury, AAI, Fannie and her friends, if it's taxed as a sale, it's a sale. Your state laws will follow and you'll be investing or operating at the back of the parade.
Before you get excited, you need to know that this stuff only effects a lease-option to purchase that has a term of more than 12 months. The recognition of assets is irrelevant within 12 months. But, that doesn't mean a deal still isn't going to be evading the intent of the transaction being a sale.
As Brain mention, the judge will be looking at your deal as a sale. But, that means you have to be in court, so long as you stay out f court......no problem, right?
Not really, if your optionee buyer goes to get a loan, the deal is going to surface and the lender will be looking at as a sale, then the appraiser, then perhaps FHA or Fannie, here comes the parade.
If you go the eviction route, you'll see a judge, then they will most likely tell you to foreclose. No security agreement, well, that just means going the judicial route seeing another judge. Are there any state taxes`due from your sale? Let's not open that box because it will lead to federal taxes!
Now, back to intent of the transaction; Can you still do a lease-option to purchase without showing the intent a sale? Yes, but there are hoops to jump through the tests of intent and your option contracts will need to meet those tests.
Don't think for a second that last year's Big Daddy's Guru Lease-Option form meets the test, it won't!
If you're going to do lease-options to purchase, I suggest you find a good accountant and an attorney. I'd also suggest you stop looking at guru ploys taught that are outdated.
Look on the bright side, it's the changes that come along that make this business interesting, staying compliant means keeping up! :)
@Shawn Ackerman I looked into it in my area (Philly), and a lawyer friend told me to stay away from it. His experiences were all bad with the lease option. I even talked to a realtor who didn't recommend it based on their experience. I wish more entities (e.g. real estate companies) were doing it, but the way it was described to me seemed to good to be true. And you know the old saying...
@Jason Brown and @Bill Gulley, Thank you so much for the input gentlemen.
I would love to hear some lease-option stories that worked well? Anyone out there have this work out in the interest of buyer and seller (I am an eternal optimist:) ? @Bill Gulley, excellent feedback for sure. I was not aware there was so many requirements with Dodd Frank, and IRS and such. I am glad I see my accountant next month to discuss how to properly report my gains (even though they aren't as huge as I'd like) Love BP, thanks all for the chat!!
an alternative to lease with option is a lease with ROFR (right of first refusal)
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Thanks Brian! I have heard the term, glad you mentioned it was an alternative. I assume I will be able to tell the differences. Thanks again!
Hi Bill, in one blog you suggest the option contract is a replacement for the P&S for wholesalers, then in the LO threads the option contract is the 3rd rail.
Can you explain how an option contract in a Lease and an option can be constructed to be without the equitable interests and IRS deamed sale problems?
@Brian Gibbons since you seem to be the resident expert on the subject, Will the ROFR totally mitigate ones risk of litigation? @Rick Santasiere and @Curt Smith thanks for keeping the conversation going gentlemen.
Hi Shawn,
"totally mitigate ones risk of litigation" lol REI is full of lawyers!
You need a good attorney in REI, and always have paperwork that if were placed in front of a judge, they would seem it was a fair arrangement.
Hi Bill, in one blog you suggest the option contract is a replacement for the P&S for wholesalers, then in the LO threads the option contract is the 3rd rail.
Can you explain how an option contract in a Lease and an option can be constructed to be without the equitable interests and IRS deamed sale problems?
You must be missing the point of one contract being used with two different strategies, a wholesaler will be selling in 90 days or less, right? A wholesaler using an option doesn't take on the promise to buy they have the right to buy and they can assign that right. Here, we are talking about longer holding periods with a lease and an option, two different worlds. :)
@Brian Gibbons, Can you provide some more detail on this risk exposure difference between having a standard lease (with the ROFR) or having a lease, along with a lease option to purchase? My attorney had advised me that I have two separate agreements. He created a boilerplate for me on the lease option, and I simply used my personalized lease for the rental side, referencing the "option terms" next to the monthly rental amount:
". $125/month will be applied to down payment if purchase option is executed. If rent payment is not made on or before the first of each month, this will be reduced by $10/day."
Basically, my lease makes no reference to the option except for the above statement, but the lease option agreement states all the "meat" of the deal for the lease option. You also mentioned the IRS, and I always try and work within all the parameters provided by my accountant, but I don't think my accountant is a true real estate guy either. Any info on this would help as an audit is not something I want to be part of. I really like my accountant, and would rather stick with him because he has been with me since I started investing in real estate in 2010.. Thanks in advance.
@Brian Gibbons, Can you provide some more detail on this risk exposure difference between having a standard lease (with the ROFR) or having a lease, along with a lease option to purchase? My attorney had advised me that I have two separate agreements. He created a boilerplate for me on the lease option, and I simply used my personalized lease for the rental side, referencing the "option terms" next to the monthly rental amount:
". $125/month will be applied to down payment if purchase option is executed. If rent payment is not made on or before the first of each month, this will be reduced by $10/day."
Basically, my lease makes no reference to the option except for the above statement, but the lease option agreement states all the "meat" of the deal for the lease option. You also mentioned the IRS, and I always try and work within all the parameters provided by my accountant, but I don't think my accountant is a true real estate guy either. Any info on this would help as an audit is not something I want to be part of. I really like my accountant, and would rather stick with him because he has been with me since I started investing in real estate in 2010.. Thanks in advance.
That is tied performance between the lease and the option. It is also a form of financing.
Rule 1: A lease is a lease. An option is an option. Two separate, non-related, agreements. Think of them as being with two different people.
@Roy N. So, while I could have references to each, there should not have been a "link" to both, I think I follow. So I should have structure it as a straight up lease (not mentioning the option at all), and the lease option, not mentioning the lease portion at all?
You can not intertwine the 2.
Give a lease and have the tenant take possession.
Next day sign an option to purchase.
Neither refers to the other.
See the importance of a properly drafted ROFR.
@Roy N. So, while I could have references to each, there should not have been a "link" to both, I think I follow. So I should have structure it as a straight up lease (not mentioning the option at all), and the lease option, not mentioning the lease portion at all?
Two separate agreements as if they are with two separate people. If you were selling me an option to purchase the property, you would not tie it to your tenant's lease.