Lease Option Tips & Strategies
by Bill Bronchick
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:
- 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.
- 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.
- Record a Mortgage. Typically a mortgage is recorded to securepayments 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
lienholder, 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.
Bio:
William Bronchick, CEO of Legalwiz Publications, is a Nationally-known attorney,
author, entrepreneur and speaker. Mr. Bronchick has been practicing law and real
estate since 1990, having been involved in over 600 transactions. He has
appeared as a guest on numerous radio and television talk shows including CNBC
Power Lunch. He has been featured in Who's Who in American Business, Money
Magazine, the Los Angeles Times and the Denver Business Journal. William
Bronchick has served as President of the Colorado Association of Real Estate
Investors since 1996.