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 buyerâ€™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.
In summary, the benefits of lease options are
â€¢ Legal control of the property
â€¢ Ability to claim depreciation
â€¢ Ability to defer gains by 1031x
The downside of lease options are . . .
â€¢ Less money down
â€¢ Less of an incoming payment
â€¢ Continued landlording responsibility
The upside of the CFD
â€¢ More money down
â€¢ Higher monthly income
â€¢ No landlording headache
The downside of the CFD
â€¢ Potential tax hit
â€¢ Transfer tax due at sale
A contract for deed is an actual purchase of a property where the seller essentially holds the financing. A purchase agreement is executed and a closing takes place. In a typical purchase, a Warranty Deed is recorded, whereas a Contract for Deed is recorded in this scenario. The purchaser makes payments to the seller similar to a mortgage payment until the contract terms are satisfied. As with a lease option, a contract for deed can be negotiated several ways. Most typically sellers will require 10-20% down and often there will be a balloon payment at the end of 3-5 years. This is a good option for someone that has a down payment saved, however may not readily qualify for traditional financing and may require additional time to establish credit. The buyer is able to refinance to traditional financing within the term of the contract prior to any balloon payments becoming due. Once the contract is satisfied, a Warranty Deed would then be typically recorded.
With a contract for deed, whether a buyer or seller offering a contract for deed, it is recommended that you have an attorney review the documentation as well as work with an agent who is familiar with contract for deed purchases as there are additional items to take into consideration from a traditional purchase.
If you have specific questions or are considering a contract for deed, I would be more than happy to offer additional assistance.
Minnesota Realty Inc.
A Contract For Deed is an agreement to purchase between a buyer and seller where the seller acts as the "bank". The buyer and seller agree on the general terms- sale price, amount of down payment (as with any kind of financing the more down the better from the "bank's" perspective) the interest rate and monthly payment and the length of the agreement. Depending upon the amount being financed the length will often be 3 to 7 years,sometimes longer . At the end of the term the remaining balance is due-there being almost always a remaining balance or "Balloon Payment" due because most agreements have the monthly payment calculated using a 20 or 25 or 30 amortization schedule. The balance can be paid off by the buyer at any time during the length of the contract without penalty either by refinancing or cash from the sale of the property or other sources of cash the buyer may be able to obtain. When the buyer satisfies the terms of the Contract For Deed by paying off the "Contract" they receive the "Deed". A real estate attorney or a real estate agent could help prepare the documents.
A contract for deed is when the seller actually provides a mortgage for the buyer. The seller becomes like any other lender. The mortgage gets recorded at the county where the property is located and the buyer makes monthly mortgage payments to the seller. The buyer usually puts down a substantial downpayment amount. It's pre-arranged that at some point (usually 3-5 years) the buyer will refinance and pay off the seller for the original mortgage amount. In this case, if the buyer doesn't carry through, the seller gets to keep all of the money paid to them and they revert back as the owners of the property. It's just like the bank foreclosing and repossessing the property when someone defaults on a mortgage with any mortgage company.
Does this help?
A contract for deed is a purchase agreement where the owner lends you the money to buy the home. Typically 10-20% down is required. Interest rate is normally 1-2% higher than you can obtain from a bank. There is also a balloon payment after 3-10 years in which the entire principal becomes due. At that time a mortgage can then be obtained. The catch here is if you stop paying, the contact can be canceled in 30 days and your principle and the home are no longer yours. If you have marginal credit this could be a good way to buy a home. Then you need to reestablish your credit before the balloon payment comes due.