Lease/Option vs. Contract for Deed
by Bill Bronchick
Many investors are generally familiar with the concepts lease option and
contract for deed (aka “installment land contract”). Many investors confuse the
two, and this article will help you understand the tax, legal, and practical
issues between the two.
Lease Options
First, let’s start with the lease option, which is really two things, a lease
and a purchase option. A lease is a contract for the use and possession of land,
creating a landlord/tenant (or “lessor/lessee”) relationship. A purchase option
is a unilateral agreement wherein the optionor (“seller”) agrees to give the
optionee (“buyer”) the exclusive right to the purchase the leased premises. The
option price is generally set at a fixed price at the inception of the lease,
although it does not have to be. At any time during the option period (which
generally corresponds to the lease period), the tenant can exercise his option
to purchase.
An option is not the same as a regular purchase contract, which is a bilateral
agreement. A bilateral contract legally binds both parties to the agreement,
whereas an option only binds the seller. An optionee is not bound to buy; it is
his option do so (or not to do so). A lease with option arrangement is not a
sale, but rather a landlord–tenant relationship. In rare cases, a court may
re–characterize the transaction as a sale if it looks like a sale. Furthermore,
the IRS does not classify a lease option as a sale until the option is exercised
(see, Tax Court Memorandum 1999–11).
Contract For Deed
A contract for deed (aka “installment land contract”) is an agreement wherein
the buyer makes installment payments on an arrangement similar to an automobile
financing. The seller holds legal title to the property as security for payment,
while the buyer has “equitable” title. When the buyer pays the full amount due
under the contract, the seller delivers legal title to the buyer. 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 cannot use it as collateral for a home equity loan
(although in some states, banks will lend against an equitable interest in a
contract for deed).
The IRS generally treats a contract for deed as a sale, which means the buyer
has the tax benefits of ownership. Thus, 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 form 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.
The legal process for repossession of the property is not entirely clear in
every state. Some state statutes (e.g., IL, TX & PA) clearly spell out the
process, which is somewhat more involved than an eviction, but clearly less
burdensome than a full–blown foreclosure. In most states, the process is not
clearly defined, so courts deal with a buyer’s default on a case–by–case basis.
Which Is Better?
In summary, the lease option is a landlord–tenant relationship until the
purchase is complete; the contract for deed is a sale at the inception of the
agreement. In rare cases a court may re–characterize lease option transaction as
a contract for deed, but this is limited to situations where the transaction
looks like sale (as in the case of a long–term lease option with a declining
balance purchase price).
Which formula is better? It depends on the situation and your goals. A lease
option transaction is not a sale, so you will benefit from market appreciation
if the tenant declines to exercise his option to purchase. A contract for deed
sale will allow you to get more a down payment from the buyer, since it “feels”
more like a sale. In higher–priced neighborhoods the rents may not command
enough rent to cover your underlying mortgage payments.
A contract for deed sale will allow you to collect interest payments, which are
generally more than you could collect in rent. On the other hand, a property
sold is already sold for tax purposes; thus, you cannot use a 1031 tax–deferred
exchange on a property sold by contract for deed when the buyer pays off the
debt balance. The entire balance paid on the contract will be due as a capital
gain, which can be a huge tax liability if you have a low basis in the property.
Furthermore, a defaulting buyer on a contract for deed is generally harder to
get out of the property, particularly in a court proceeding.
Summary on the Pros and Cons of Each
The Upside Of Lease Options Are...
- Legal control of the property
- Ability to claim depreciation
- Ability to defer gains by 1031x
The Downside Of Lease Options Are...
- Less money down
- Less of an incoming payment
- Continued landlording responsibility
The Upside Of The CFD is...
- More money down
- Higher monthly income
- No landlording headache
The Downside Of The CFD Is...
- Potential tax hit
- Transfer tax due at sale You must decide on a deal by deal basis which
transaction works best for you in terms of work involved, tax issues and, most
importantly, cash flow. And, be flexible and know how to do both types of
transactions; you can buy on a contract for deed, then re–sell on lease with
option. You can buy on lease/option, sell on lease/option. You can buy on
contract for deed, then rent the property out. There are multiple strategies you
can use and the more you learn the more you earn!
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.