One of the most effective but least understood home sale techniques is the lease with option to purchase. This method is a variation of the well-known land contract (called a contract for deed or installment land contract of sale in some states). The lease-option home seller holds legal title, but the tenant-buyer has possession and often has many ownership rights. t
The short-term lease-option. One variety of the lease-option is the short term type. This is a sales technique that (1) moves the buyer into the home, (2) gives the buyer time to either raise cash for a down payment or await favorable mortgage financing and (3) provides the seller with immediate cash from rent and usually nonrefundable "consideration for the option" money.
This option money isn't taxable to the seller until either the option is exercised (then it's long term capital gain) or the option expires (then it's ordinary income).
A short term lease-option is usually one to three years, but it can be shorter or longer. The tenant-buyer's rent is often either fully or partially credited toward the agreed sales price when the purchase option is exercised. If the buyer doesn't complete the purchase, he loses the rent credit and any consideration paid to buy the purchase option.
However, there are several potential problems with short-term lease-options.
(1) The realty agent usually prefers to receive his sales commission immediately, rather than waiting for the option to be exercised. However, this problem can be solved by using the buyer's option consideration money to pay at least part of the agent's fee when the option is created. Any commission balance can be paid when the tenant-buyer completes the purchase.
(2) A title check should be made to verify that the seller owns marketable title to the property. This is no assurance that he can deliver good title in the future, but the seller would be liable to the buyer if title later proves to be defective.
(3) If the tenant-buyer records his lease-option, the title is clouded if the tenant doesn't exercise the option. Therefore, most lease-option sellers prohibit recordation.
(4) The purchase price in the option is usually the home's market value on the date the lease-option is created. But if the option runs for more than 12 months, the seller often insists on increasing the purchase price to the home's expected appreciated market value.
In many areas, homes go up in value 10 percent to 15 percent annually. But leaving the option purchase price open to future appraisal usually encounters buyer resistance. The purchase price should be set in the lease-option, even if it is on an escalating scale based on anticipated price increases.
(5) Financing terms should be specified in the lease-option to protect the buyer in case new mortgages prove to be unavailable or very costly at the time of option exercise. This can be done by providing that if a mortgage on specified terms cannot be obtained, the seller will finance the sale until other financing becomes available.
The long-term lease-option. The purpose of a long-term lease-option are to (1) retain an old existing low interest rate mortgage on the property and (2) give the seller an immediate installment sale.
If the old mortgage has a legally enforceable due-on-sale clause, the long-term lease-option inhibits the lender's opportunity to accelerate because there is no immediate title transfer. Some mortgages state that a lease-option is the equivalent of the title transfer, but lenders haven't tried to enforce such clause because of the difficulty of proof.
The title deed and fire insurance policy stay in the seller's name, so the lender rarely learns of the sale.
Using a long term lease-option, usually 30 years or longer, the seller-landlord and the buyer-tenant specify that they intend an installment sale for income tax purposes. The buyer's "rent" is stated in terms of principal and interest, so he can obtain normal income tax deductions. A promissory note, secured by the lease-option, is used.
The long-term lease-option usually specifies that the tenant-buyer may obtain the deed anytime by converting his upaid installment sale balance into a mortgate or trust deed secured by the property. If he does this, but the old "due-on-sale clause" mortgage isn't paid off or refinanced, the buyer runs the risk of the lender's calling the loan.