The Lease-Option… Could This Be Your New Best Friend?

A few months ago, I had the good fortune of meeting Chris Michaud. 

Chris has extensive expertise in many areas of real estate, including (but not limited to) coaching investors, brokerage, marketing, residential rehab, land development, multi-family, private lending, options, leasebacks and more.

When I first met Chris, he told me about a fascinating strategy he has used to close deals with a creative financing instrument called the Lease-Option Purchase Agreement. I've known about Lease Options for a while, but he helped me to see some of its new applications, and why this strategy deserves some air time here on the REtipster Blog – because it can be an extremely beneficial tool for both parties in many real estate transactions.

Many people fail to recognize the incredible benefits of this type of agreement at first glance, but this type of creative financing arrangement that can be a game changer for many real estate transactions. 

Chris was kind enough to put together a guest post explaining the basics of how they work, so I wanted to share it with you today. Take it away Chris!

The Lease-Option Purchase Agreement is a creative and innovative way to open the doors of opportunity for both the sale and acquisition of real estate.

In many instances, it is seen as more of a “last resort” instead of the preferred solution for property ownership. While many prospective property owners would prefer to “own outright” by utilizing cash, or cash along with a conventional mortgage arrangement – most of these people don't realize that these methods often require a much larger financial investment than a Lease-Option, with substantially more qualification and out-of-pocket costs.

This clever and underutilized method of buying or selling real estate has actually been around for a long time and is used fairly often in the capital equipment and commercial real estate sectors. Why is this method underutilized and ignored in the residential sector? Because its advantages, processes, and risk factors are not well-understood by most buyers and sellers of residential real estate and consumers at large. Even those who do understand the Lease-Option Purchase Agreement don't always fall under the right circumstances to take advantage of this type of instrument.

When properly understood, the Lease-Option Purchase Agreement is an important financing tool that should be understood, so it can be utilized to complete transactions that offer the most benefits to buyers and sellers.

Disclaimer: Anyone who does real estate transactions of any kind needs a real estate attorney. These Lease-Options were utilized by the author for over 20 years, but keep in mind that all states have different laws and this is why you need legal advice in the state you are in. Let YOUR attorney adapt, tweak, discard, ignore or adopt what they wish from this conversation if it’s useful. You should also seek the advice of a good tax attorney to see what kind of tax law applies to your situation.

Lease-Option Purchase Agreement Defined

Lease-Option Purchase Agreements actually consist of a few agreements rolled into one, which is part of what causes confusion for some.

Wikipedia does a nice job of explaining the essence of how it works:

In a lease-option, a property owner and tenant agree that, at the end of a specified rental [lease] period for a given property, the renter [lessee] has the option of purchasing the property.

The full agreement usually consists of a Lease Agreement laying out the terms and conditions of the lease period, and an Option Agreement which explains the terms and conditions of the lessee's option to purchase, and recites any consideration paid, if any, for the right of having the option.

There may also be an additional document including an Escrow Agreement stipulating the terms and conditions that a third-party, often an attorney or trustee, may deliver title to the party who exercises the Option Agreement

The Right Time & The Right Place

Lease-Option Purchase Agreements can be beneficial for many reasons, they are not always the right vehicle to utilize. It's no substitute for good business sense and market savvy. The Lease-Option Purchase Agreement usually makes the most sense to use as a purchase vehicle in circumstances similar to the following:

  • The Buyer/Lessee has had a recent financial catastrophe, causing the conventional and government insured mortgage lender to shy away from them
  • The Buyer/Lessee has had a major medical expense that was uninsured.
  • The Buyer/Lessee has unpaid credit cards or a creditor dispute as a result of a recent divorce.
  • The Buyer/Lessee had a recent bankruptcy caused by unforeseen financial hardship.
  • The Buyer/Lessee recently moved to an area, and they have a good employment and credit record, but not in the present area long enough to satisfy most conventional lenders.
  • The Buyer/Lessee is self-employed and as a result, they under-report their income for tax reasons.
  • Certain income tax or inheritance tax situations sometimes suggest this arrangement in order to save substantial sums of money.

In addition to the above, there are real estate professionals who recommend the Lease-Option Purchase Agreement to Sellers of real estate that has been on the market too long. Often this type of “distressed” property is in a less-than-desirable area where the owner wants more than what the property is worth.

Similar to many seller financing arrangements, the use of a Lease-Option Purchase Agreement will oftentimes give the seller additional room to increase their asking price because of the “easy terms” they are offering to the buyer (and many Buyers/Lessees are willing to pay such a premium).

With a Lease-Option Purchase Agreement, the Buyer/Lessee will typically pay a non-refundable “option consideration” at the beginning of the Lease term. This is what gives the Buyer/Lessee the right to purchase the property at a pre-defined price prior to the end of the end of the lease term. If this “Option to Purchase” isn't exercised within the time period stated the in agreement, the property’s title rights will simply revert back to the original owner of the property.

Advantages for the Buyer/Lessee

There are several notable advantages for both parties under a Lease-Option Purchase Agreement. The Buyer/Lessee can benefit from the following aspects of a Lease-Option Purchase Agreement:

  • When a Buyer/Lessee doesn't have the sufficient cash resources available to cover a typical down payment and pay for the closing costs of a conventional loan (but they otherwise have good credit and the required income for the loan).
  • It allows the Buyer/Lessee to fix the home price now within the “Option to Purchase” portion of the agreement and avoid any escalation in home value that may occur over time.
  • In many cases, the Buyer/Lessee is allowed to apply a portion of their lease payments toward the down payment or purchase price during the lease term, which automatically builds their equity in the property if they choose to purchase (this benefit would not otherwise be inherent in a regular rental/lease agreement).
  • It allows the Buyer/Lessee to live in the property and experience the neighborhood and community prior to making the ultimate decision to purchase (many Sellers/Lessees view this as a detriment and as such, they will require a substantial “option consideration” as an upfront payment at the signing of the Agreement).
  • It often gives the Buyer/Lessee a greater sense of ownership responsibility and community participation, which is not usually as well associated with normal rent/lease arrangements.

Advantages for the Seller/Lessor

A Lease-Option Purchase Agreement contains a number of advantages for the Seller/Lessee as well. Some were already alluded to above, and there are several more listed below:

  • Vacant or “market worn” properties tend to develop a negative stigma over time, and the Lease-Option Purchase Agreement can be a vehicle to get the property occupied and “sold” faster.
  • The Lease-Option Purchase Agreement can eliminate a “double payment” on a Buyer/Lessee's former property or residence, allowing them to purchase their new property sooner, helping to eliminate much of the stress while moving.
  • In a down market, the Lease-Option Purchase Agreement can fix the price from a downward price spiral, while finding a worthy Buyer/Lessee prospect and helping to eliminate potential negative cash flow or even a negative cash sale in a severely depressed market.
  • The psychology of the Buyer/Lessee is often somewhat different from pure tenancy because the Buyer/Lessee has an equitable interest in any application of lease payments being applied towards equity, together with any value appreciation over the fixed price during the option term, and any non-refundable money they've paid for the option itself.
  • Since title remains vested with the Seller/Lessor until the exercise of the option portion of the agreement, there are distinct tax advantages for the Seller/Lessor that the Buyer/Lessee doesn't receive until the title is vested and becomes vested in the Buyer.

Good Business Sense

A photo by Alejandro Escamilla. unsplash.com/photos/BbQLHCpVUqAIt's worth noting that this type of lease/finance vehicle doesn't have to be limited to the private sector. There are many opportunities for the public sector to rehabilitate distressed properties on the tax rolls in public and quasi-public joint ventures within the broader community where it could be used. From a risk perspective, it may even make more sense than a high risk no down payment mortgage.

The private sector and lending community have long recognized the value of equity building in the purchase of one's home. For many, that means a cash infusion that covers the down payment and closing costs. There is an equal possibility of a prospective Buyer/Lessee producing a little “sweat equity” either directly into the home itself and/or in a traded service possibility. Having a stake in the game saves a great deal of heartache and disappointment later on.

Additionally, there are a number of ways to vest partners into the “equity bond” of a potential Buyer/Lessee purchase. It would be entirely possible for the lease payment schedule to be adjusted to a reasonable degree to match the Buyer/Lessee's needs over the option term in order to accommodate their situation, provided they have a reasonable chance of accomplishing their goal.

Shared equity partnerships with the Seller/Lessee, or investment partnerships seeking tax equity advantages, graduated payment lease payments, direct deposit payment scheduling, dedicated default insurance premiums–even secondary marketing vehicles etc. all offer possibilities of limiting the “risk” factors as much as possible for the equity owner–the Seller/Lessee.

For the Seller/Lessee, it may be wise to have a curriculum for a prospective Buyer/Lessee regarding home ownership, maintenance, and budgeting. A “certification” and/or “graduation certificate” could be utilized to better assure the Seller/Lessor and any vested equity partners that their decision to offer such a finance option is well founded.

Conditions & Limitations

photo-1444427169197-de497742b62dThe Lease-Option Purchase Agreement itself should be reasonable to both parties and should incorporate terms that are enticing enough for the Buyer/Lessee to exercise their option to purchase. In addition, specific conditions and stipulations regarding a particular property can be included, provided appropriate legal counsel is sought.

The Lease-Option Purchase Agreement typically defines all or several of the following items:

  • Names and addresses of the parties
  • Legal contractual obligations for maintenance, taxes and utilities
  • Any deposit/consideration given for the lease or option
  • Price, and financial terms and conditions of the lease and option
  • Time period stipulations for both the lease and exercising the option
  • Any cost pro-rations or reimbursements
  • Definition, possibilities and/or cure for any default
  • And about anything else that two parties can legally agree to

Final Words

Often we heard from Buyer/Lessee/Optionee attorneys,

“That’s only a rental agreement, I can’t have my buyer sign that with an Option Fee of 20%, or more.”

In those cases, we would say,

“Fine, find something else, or maybe your attorney would like to finance you.”

The key to these transactions is that they require a fair amount of education for all parties, including attorneys in some cases. In a typical mortgage and often Contract for Deed sale, there are either foreclosure rights or rescission periods, similar in length to a foreclosure “right to cure.” In those scenarios when a Buyer/Lessee fails to make the payments, the onus of the legal costs often rest primarily upon the Mortgagor/Contractor.

In the Lease-Option scenario, the onus is upon the Lessee/Optionee to prove that they should not be evicted for non-payment of the lease payment, or if they want to claim foreclosure/rescission rights. Therefore, a shift of risk occurs to the Lessee/Optionee (where it should be), since they are the ones borrowing/optioning the asset.

chrismChris Michaud is a 30+ year veteran of the real estate business as a real estate investor, broker and industry insider with some lobbying experience at the state and national level. He is a sought after guest speaker and author, was a state REALTOR President-elect, an investor coach and trainer of the RealInvest Profit System. Chris began his real estate career in 1977. He has been licensed in Maine, New Hampshire, and Massachusetts and has held a number of real estate investments and interests throughout the United States and Canada. Be sure to check out Chris's new book (co-authored with John Agostinelli) entitled Easy Money and the American Real Estate Ponzi Scheme.

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  • Owner Finance OKC says:

    Another informative read and as usual, right on the money.

  • Marty says:

    The lease option strategy is definitely one to be given a harder look and there are a lot of really cool variations of it as well, like the “Sandwich lease option”…

    Here in Florida, it definitely has to be 2 separate docs otherwise the “tenant” is not a tenant at all… he’s a buyer and if things go wrong during the lease period and the “tenant” turns out to be horrible and stops paying or destroys the property, you will have a much harder time evicting him if it was all wrapped in a single contract. This is because he would be able to claim equitable interest in the property and the owner would have to do a formal foreclosure to get him out.

    Otherwise, the article itself… IT is very informative but also goes a little “out there” and turns an otherwise rather straight forward strategy into a very complicated piece of writing. In chris’ own words “The key to these transactions is that they require a fair amount of education for all parties” – that is not good!

    Anything that “requires a fair amount of education” in a real estate deal like this, just creates issues. The strategy needs to be implemented in a way that it can be explained and understood, very simply and easily. Otherwise, when either party in a real estate deal becomes unclear, fear of the unknown sets in and the deal could go dead.

    ~ just my $0.02

  • T-Square Properties says:

    Thanks Seth for helping to clarify a more complicated topic. Many of my customers have difficulty understanding what a lease-option purchase agreement is. I’ll be sure to direct them to this article to gain a better understanding.

  • myPlanit says:

    Thank you, Seth, for your detailed take on a possibly overlooked strategy. Interesting to see the benefits of an underused method.

  • Brian Gibbons says:

    This is an info packed article.
    Thanks very much Seth!
    As I coach lease option assignments and sandwich lease options, I caution new folks to not create a “disguised installment sale” with a lease option.
    Here is info from my CPA:
    A. TAX CONSEQUENCES IF A LEASEOPTION IS DEEMED A COMPLETED PURCHASE AND SALE OR A DISGUISED INSTALLMENT SALE

    If This Happens Then There Is No Lease-Option according to the IRS!

    1. To The OptioneeLesseeBuyer – The lease payments are non-deductible, &US, 28 TC 1133, aff’d, 261, F. 2d 176.

    If the property is a rental or business-use property, the buyer will be entitled to depreciation and other property expenses. Also, part of the monthly payments may be allocable to deductible interest, Wilshire Holding Corp., 262 F.2d 51; Revenue Ruling 72408.

    Therefore, the combination of depreciation, property expenses and perhaps interest may approximate the amount of rental payments (especially if you use my Multi-Component Land Residual Method for computing larger depreciation deductions. See Goldmine Section 12-A).

    2. To The OptionorLessorSeller – The tax consequences are generally more detrimental to the seller.

    First off: the seller will forfeit depreciation deductions as they are no longer the equitable owner.

    The lease payments will be part of the selling price.

    If the seller is not a dealer and the property has been held for the required holding period, the payments are capital gain (outside of imputed interest and any depreciation recapture, which are ordinary income).

    The investor-seller can also elect installment sale reporting under IRC 453 and/or, for the cash portion of the arrangement, elect a 1031 exchange.

    *T AX ALERT: Usually the cash portion (such as upfront deposits) in lease/options is not that significant Therefore, if the lease/option is recharacterized as an installment sale, there will be little opportunity (if any) to do a 1031 exchange.

    Reason: The “paper” portion of the transaction does not qualify for a 1031 exchange; only the cash potion does.

    Another negative here, is that the seller will no longer be entitled to depreciation deductions.

    TIP: Any loss on the deemed sale would be ordinarily for rental or business-use property, and capital for land held for investment

    ALERT: For a dealer*, the tax consequences of a gain are more severe in that there will be higher-taxed ordinary income and the ineligibility to defer taxes via installment sale, or a 1031.

    TAX BREAK: On the other hand, any dealer loss would be ordinary for both rentalbusiness-use property and land.

    B. INDICATIONS OF WHEN A LEASEOPTION IS A COMPLETED SALE

    1. The primary indicator that may cause the lease-option to be a completed sale is- rent payments substantially higher than the fair rental value, along with a low option price, Haggard, 241 F.2d 288, aff’g 24TC, 11241; Truman Bowen, 12 TC 466; East Coast Equipment Co, 21 TC 112, airel, 222 F .2el, 676.

    Large upfront deposits can also be another indicator.

    EXAMPLE – LEASE-OPTION THAT IS REALLY A DISGUISED INSTALLMENT SALE:

    CC does a 36 month leaseoption on a $100,000 property which would normally rent for $1,000 a month.

    With the leaseoption there are the following terms:

    $10,000 upfront option payment to be totally applied toward the purchase price;
    monthly payments of$2,200 of which $2,000 is to be totally applied toward the purchase price;

    $18,000 option payment to purchase the property at the end of the 36 months.
    The sum of the $10,000 option deposit, $2,000 rent credit for 36 months, and
    the final option payment of$18,000 equals the total purchase price of$100,000.

    The $200 monthly payment not credited toward the price, is presumably interest

    This example demonstrates that the highly inflated rental forces this transaction to be, in substance, a completed purchase and sale at the time of the execution of the “lease-option”.

    See IRS Revenue Ruling 55-540. (Comment: This one is obvious!)

    2. Another factor that could indicate a completed purchase and sale is where the lease requires the lessee to make substantial improvements to the property and the lessee’s investment in the improvements can be recouped only by exercising the option, Oesterreich, 226 F .2D 798.

    3. Another factor is the intent of the parties, based on the facts and circumstances.

    If the taxpayer can demonstrate that they believed the rent and option price to be reasonable, the lease option arrangement may hold up. Benton, 197 F.2d, 745; Lester, 32 TC, 711.

    C. STRATEGIES TO AVOID RECHARACTERIZATION OF A SALE:

    Where the parties want to avoid having the lease/option recharacterized as a sale, the overall planning strategy is to avoid or minimize the above indicators of a deemed sale as follows:

    1. The rent should be at or near fair rental value. Breece Veneer & Panel Co., 232 F .2d 319.

    Get a written opinion of the rental value from a qualified real estate professional.

    2. Keep rent credits toward the option price to a minimum.
    Generally, 20% or less is considered reasonable.

    3. The option price should be at or near fair market value.
    Get a written opinion of the market value from a qualified real estate professional.
    Breece Veneer & Panel Co., Ibid.

    4. Try not to tie-in substantial lessee improvements with the option exercise.

    5. Do not pass legal (or equitable) title to the optioneelesseebuyer.

    6. Demonstrate that you intend to do a lease-option and that you believe the rent and option price to be reasonable. See Benton, 197 F.2d, 745; Lester, 32 TC, 711.

    7. Use arm’s length lease-option documents along with the counsel of qualified professionals.

    • Seth Williams says:

      Wow, that’s a lot of helpful commentary – thanks for sharing Brian! I wonder – do you think it would it make any difference if the Option Agreement and the Lease Agreement were broken into two separate contracts (rather than being rolled into one), with a simple Memorandum of Lease being recorded at the county level?

      As always, I appreciate your detailed feedback on the subject. Thanks for chiming in!

      • Brian Gibbons says:

        If selling on a lease w option, 2 agreements.
        If buying from a seller (sandwich) 1 agreement. 🙂

        • Chris Michaud says:

          Yes, always 2 agreements; Lease Agreement and separate Option Agreement; in addition, I have added and Escrow Agreement with a pre-signed deed to be released when debt is satisfied in my race-notice state.

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