Difference Between a Land Contract and a Lease Option

Both lease with an option to purchase and land contracts have been available to investors as sales techniques for many years. Because both of these are creative sales techniques, the contract variations and possible nuances are almost endless. However, there are two important considerations that investors need to be aware of before spending time, money, and energy pursuing one in favor of the other. First is a clear contract structure difference between a land contract and a lease option that some investors don’t always distinguish between. Second are the new wrinkles introduced when provisions of Dodd-Frank took effect in January, 2014.

The information in this article is NOT intended as legal advice. It is for educational purposes only. Nor is it intended as specific or detailed advice because we do not have any information specific to your situation. There may be other matters not included in the article which can impact your particular situation. Always seek legal advice regarding your unique situation.

Contract Structure Defines the Difference Between a Land Contract and a Lease Option

The difference between a land contract and a lease option is defined by the way the contract is written. The most significant difference is the buyer's ability to acquire equity in the property. The land contract is an outright sale of the property that includes the buyer beginning to build equity immediately through a combination of the down payment and monthly mortgage payments.

A lease with the option to buy is NOT an outright sale of the property. The option fee is not a down payment. The option fee entitles the potential buyer to exclusive rights to make the purchase within the time allowed by the option contract. This is a very important provision of the contract that must be written properly so that legal courts don’t interpret it as equity in the property. It is also a very important difference between a land contract and a lease option.

Another key distinction between the two contracts is the difference between the amortization schedule and the lease option period. An amortization schedule is only associated with a land contract and a lease option period is only associated with a lease with option to purchase contact. Among other things, an amortization schedule defines how many years the installment payments are spread out (balloon payments may or may not be involved). Each installment payment builds equity in the property for the buyer. The lease option period only defines the amount of time the potential buyers has exclusive rights to purchase the house. There is no buyer equity involved with a lease option period.

Many variations can be included in both of these contracts based on the needs and agreements between the buyer and the seller. Neither of these are the standard purchase agreement typically available from real estate brokers. The land contract and lease with option to purchase contract should both be written by real estate attorneys familiar with applicable state laws as well as the Dodd-Frank Consumer Act.

Dodd-Frank Difference Between a Land Contract and a Lease Option

The Dodd-Frank act is complicated for many types of businesses and in many ways. Of particular significance to real estate investors is language related to seller-financing. In short, it complicates the land contract much more than the lease option (it need not complicate the lease option). In fact, it has no impact on the lease option as long as you don’t apply any of the monthly rent towards buyer equity in the house.

What the Dodd-Frank regulations do is treat anyone (including investors) who originates a residential mortgage as a “mortgage originator”. This means the seller-financer must have a mortgage broker license or engage the services of a licensed mortgage broker. The key is offering mortgage options other than seller-financing. There are exceptions to the regulation known as the “one-property exception” or the “three-property exception”. This is where it becomes complicated for investors using a land contract. Additional expenses and conflict of interest both become real concerns and the penalties of violating Dodd-Frank regulations are severe.

Contrast this with the lease with an option to purchase and the advantages are clear. As an investor, you want the buyer to obtain an independent mortgage rather than seller-financing. Through the lease option, you receive all of your profits at closing rather than as installments strung out over many years. You avoid any potential conflict of interest when the buyer takes out a third party mortgage (probably through their own mortgage broker). Additionally, you don’t face the difficult, costly, and time drawn out process of foreclosing if the buyer stops making payments. With the lease option, you can evict tenants who fail to pay the rent. Once they complete the purchase, failing to make the mortgage payments becomes the problem of the third party mortgage holder. You have all of your profit to move onto the next investment deal.

These are the most important but not the only differences between a land contract and lease option. These differences make it clear why I favor the lease option over the land contract.