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By James A. Gage
The lease option and the contract for deed are both
popular methods of creative financing. However, that's where
the similarities stop.
First, let's start with the lease option. A lease option
is not a sale it is a standard rental agreement with an
added perk (the opportunity to purchase). A lease option
actually consists of two separate and very different
agreements - the lease and the purchase option. The lease is
the written agreement under which the property owner allows
a tenant to use the property for a specified period of time
in exchange for the payment of rent. In the option contract,
the seller gives the buyer the exclusive right (or option)
to purchase this leased property. Typically the price is set
at the time the lease is written, and usually the "option"
period is the same as the length of the lease - but this can
change especially if you are an investor.
Keep in mind, a lease, just like a sales contract is a
"two-sided" agreement. Both the landlord and the-tenant are
legally bound to the contract. An option contract, on the
other hand, is "one sided". The seller gives the "option",
but the buyer is not legally bound to take it. , .
For tax purposes, a lease option is treated the same as
any other lease until the option is exercised, then it would
be considered a sale.
A contract for deed is a sale. The seller holds legal
title to the property as security for payment, while the
buyer has "equitable" title. This 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
typically cannot use it as collateral for a home equity
loan. When the buyer pays the full amount due under the
contract, the seller delivers legal title to the buyer. For
tax purposes, the IRS generally treats a contract for deed
as a sale, which means the buyer has the tax benefits of
ownership. 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 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- not where you want to be as an investor.
Which one
works best?
To determine which way to go you will need
to consider many factors, such as the buyer's situation, the
market, and what you need at that time.
Contract for deed has a major downside,
you may have to foreclose, which could take a lot more time
(and money) than a simple eviction. Also, the entire balance
paid on the contract will be due as a capital gain, which
could mean a big tax hit if you have a low basis in the
property
With a lease option, you, (as the
landlord/seller), maintain legal control of the property
with the ability to claim
depreciation and to defer gains by 1031 exchange. But, along
with all these benefits of ownership, you still have all the
burdens of upkeep and landlord duties. You want to structure
your agreement to ensure that if the tenant fails to
purchase the property, you get to keep the non-refundable
option money payment and any additional rent that was paid
for the option.
Most renters would like to buy, but lack
of cash or credit is holding them back. The typical tenant
wants to plant flowers and wallpaper, but only to their own
home.
Investors like upfront cash and steady monthly income with
minimal hassle, but don't want to take a chance on just any
credit problem off the street. Therefore, I believe that
Lease Purchase AKA Rent To Own is by far a superior way to
control real estate, whether a investor or someone looking
for a residence.
The aim of this article was to give the
reader a basic understanding of the contract for deed Vs
lease option approach to real estate hopefully I have
accomplished that in the context of this article.
"You are who you are and where you are because of what you
have put into your mind."
For more information or pricing please do not hesitate to
call or e-mail. I can be reached at (508) 595-9567.
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