Lease/Option Versus Contract for Deed
BATTLECALL GUEST EXPERT: Attorney William Bronchick Of
LegalWiz.com
Many mortgage and
real estate 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
In summary, the
benefits 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!
Discuss this topic in the Warrior Discussion Forum...what do you think?
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