Lease/Option 101
by Bill Bronchick
Tax Implications of Lease/Options
The lease/option strategy is a great way to leverage your real estate
investments because it requires very little cash. The lease/option is more of a
financing alternative than a financing strategy because you don’t own the
property. The basic lease/option strategy involves two legal documents, a lease
agreement and an option. A lease gives you the right to possess the property,
or, as an investor, to have someone else occupy it. If you can obtain a lease on
a property at below market rent, you can profit by subleasing it at market rent.
An option is the right to buy a property. It is a unilateral (“one-way”)
agreement wherein the seller obligates himself to sell you the property, but you
are not obligated to buy. By obtaining the right to buy, you control the
property. You can market the property and sell it for a profit. The longer you
can control the property in an appreciating market, the more value you create
for yourself. By combining a lease and an option, you create a lease/option.
Financing Alternative
The two primary objectives of the real estate investor are cash flow and
appreciation. You don’t need to own a property to make cash flow or benefit from
appreciation. A lease entitles you to possession, which allows you to make cash
flow. An option gives you the right to buy at a set price, which allows you to
benefit from future appreciation.
Lease - The Right to Possession
Under a lease agreement, the lessor (landlord) gives the lessee (tenant) the
right to possess and enjoy the property, which is one of the most important
benefits of real estate ownership. The lessee is usually not responsible for
property taxes and major repairs. Once you have the right to obtain possession
of property, you can profit by subletting or assigning your right to possession.
Sublease
A sublease is a lease by a tenant to another person (subtenant) of a part of the
premises held by the tenant under a lease. The sublease can be for part of the
premises or part of the time period. For example, if the tenant has a three-year
lease agreement with the landlord, he can sublease the rental unit for two
years, or sublease part of the unit for three years.
Assignment
An assignment is a transfer to another of the whole of any property or any
estate or right therein. As with a sublease, the master tenant is not relieved
from liability for obligations under the lease. However, the assignee of a lease
is in contract with the landlord, and thus the landlord can collect from the
assignee or the master tenant for nonpayment of rent. Assignment and subletting
are always permissible without an express provision in the lease forbidding the
tenant from doing so. As a tenant/investor, it is imperative that there are no
anti-assignment or anti-subletting clauses in your lease with the owner of the
property.
More on Options - The “Right” to Buy
A real estate sales contract is a bilateral or two-way agreement. The seller
agrees to sell, and the purchaser agrees to buy. Compare this agreement with an
option; an option is a unilateral in which the seller is obligated to sell, but
the purchaser is not obligated to buy. On the other hand, if the purchaser on a
bilateral contract refuses to buy, he can be held liable for damages.
A bilateral contract with contingency is similar to an option. Many contracts
contain contingencies, which, if not met, result in the termination of the
contract. Essentially, a bilateral contract with a contingency in favor of the
purchaser turns a bilateral contract into an option in that it gives the
purchaser an out if he decides not to purchase the property. Though the two are
not legally the same, an option and a bilateral purchase contract with a
contingency yield the same practical result. The receiver of the option
(optionee) typically pays the giver of the option (optionor) some non-refundable
option consideration, that is, money or other value for the right to buy. If the
option is exercised, the relationship between the optionor and optionee becomes
a binding, bilateral agreement between seller and buyer. In most cases, the
option consideration is credited towards the purchase price of the property. If
the option is not exercised, the optionee forfeits his option money. An option
can be used to gain control of a property without actually owning it:
A speculator who is aware of a proposed development can obtain options on
farmland and then sell his options to developers.
To take advantage of appreciation in a hot real estate market, an investor can
use a long-term option to purchase property.
To induce timely rental payments, a landlord can offer the tenant an option to
purchase. There are literally hundreds of ways that an option can be structured
and every detail is open for negotiation between the optionor (seller) and
optionee (buyer).
An Option Can Be Sold or Exercised
An option, like a real estate purchase agreement, is a personal right that is
assignable. If you were able to obtain an option to purchase at favorable terms,
you could sell your option. The assignee of the option would then stand in your
shoes, having the same right to exercise the option to purchase the property. As
with a lease, an option is freely assignable absent an express provision in the
option agreement to the contrary.
Alternative to Selling Your Option
Rather than sell your option to purchase, you may wish to exercise the option
yourself, then sell the property to a third party buyer in a double closing, as
described in chapter five.
The Lease/Option
A lease/option is really two transactions: a lease and an option to purchase.
Under a lease, a tenant may have the option the buy the property. The option
itself can be structured in various ways. For example, the option may be that of
a right of first refusal in the event the landlord intends to sell the property.
The option may also be an exclusive option for the tenant to buy at a certain
price. When combined with a lease, a purchase option may also include rent
credits, that is, an agreement that part of the monthly rent payments will be
applied to reduce the purchase price of the property. There are literally
hundreds of ways that an option or lease/option can be structured and every
detail is open for negotiation between the landlord and tenant.
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.