Lee’s Notes: Matthew Griffith, my Indianapolis Real Estate Lawyer, has an interesting article on how to properly do a lease-option/rent to own contract.
Lease-Options
(Part 2 of 2)
In addition to the matters discussed in Part 1 of this 2-part article, the following ideas should be considered by landlords and other parties to lease options:
Analyze the Tax Issues:
All rent received will be income when received. All option fees will be income when received. The profit on the sale typically will be capital gain unless the landlord is a “dealer.” If the landlord provides the financing for the purchase, then the landlord can normally defer most of the income tax to the years in which principal payments are received. However, if the landlord is a “dealer” in this type of property for income tax purposes, then all profits will be taxed at ordinary income tax rates in the year of the closing, not the year when principal payments are received.
No Public Notice of the Option:
The holder of an option to purchase real estate does not own an interest in the property itself, but merely holds a contract right to force the seller to convey the property to the holder of the option according to the terms set forth in the option. Thus, the option should never be recorded and, if the tenant/buyer defaults on the lease, the option should not be discussed in the eviction or damages proceedings.
Close the Sale as Soon as Possible:
A potentially dangerous time for the landlord arises after the tenant has delivered notice of exercising the option and before the closing. This is because the tenant acquires an interest in the property by exercising the option but is supposed to continue paying rent until the closing. Any default under the lease at this time may not be sufficient to terminate the option rights unless the documentation of the transaction is clear. The last thing the landlord wants is to be forced into a superior or circuit court, as opposed to a small claims court, to foreclose or forfeit a tenant who has paid only the option fees, is no longer paying any rent, and is unwilling or unable to close on the purchase. One possible solution to this problem is to include language in the option indicating that the option cannot be exercised or is voided automatically in the event of any default under the lease.
Exit Strategies and Credit Problems:
The transaction documents should describe what will happen if the tenant defaults on the lease, fails to exercise the option, or is unwilling or unable to close on the purchase after exercising the option. If the tenant is to use bank financing, then generally the option fees will be forfeited to the landlord if the tenant does not close on the purchase for any reason. However, if the landlord is providing the financing, another credit report should be required immediately prior to closing as a condition of the financing. If the tenant then does not have good credit, the landlord must have the right to refuse to provide the financing. If the deal then does not close because the tenant is unable to find other financing, the tenant is likely to be very upset unless the tenant clearly understood the risks. Of course, there is nothing to prevent the landlord and tenant from negotiating a new deal if the old one does not close.
Necessary Documents:
The following is a document checklist which the landlord/seller may find useful:
Lease Application
Credit Report, etc.
Employment Verification
Bank Verification
Lease Security Deposit
Lead-based Paint Disclosure
Lead-based Paint Booklet
Seller’s Residential Real Estate Sales Disclosure
Option to Purchase
Sample Purchase Agreement
Sample Warranty Deed
*Sample Note
*Sample Mortgage
Notice by Tenant of Exercise of Option to Purchase
*Second Credit Report
Title insurance commitment
Notice by Owner of Changes in Property Condition
Appraisals, inspection reports, etc., as required by lender
Settlement Statement
Signed and recorded Deed
*Signed Note
*Signed Mortgage
Disclosure of Sales Information
Record Deed and *Mortgage
*Mortgagee’s Title Policy
(*used when landlord is providing financing to tenant)
Conclusion:
In general, lease-options can enable a landlord to sell a property at a price on the high end of fair market value to a buyer who presently does not qualify for third party financing but is likely to qualify after the end of the lease term. The landlord can also collect an option fee at the time the lease is signed and additional option fees during the life of the option. The option fees compensate the landlord for keeping the property off the market during the option term and improve cash flow. The tenant gains access to a property worth purchasing and prepays, essentially, a part of the down payment. This gives the tenant a good reason to remain current on the lease and close on the purchase. As with any complicated transaction, changes in the facts and circumstances of a case will cause the need to alter standard form documents, so be alert to opportunities and call this author if you have any questions.
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