Lease Agreements Between Landlords and Tenants – Part 10
Lease Agreements Between Landlords and Tenants – Part 10
Part 10 of our Lease Agreements series will provide discussions regarding two specialized types of agreements that have the word “Lease” in the document titles.
Lease Option – An “option” is a right given a person to buy, sell, or lease property at a specific price within a specified period of time. A valid option must name a valuable consideration.
A “lease with option to purchase” (often called “lease option” or “rent to own”) is an agreement between a seller and a buyer wherein they simultaneously execute a lease agreement for a specific term, with the agreement giving the lessee an option to purchase the property, but not the obligation to do so. The term of the option need not be the same as the term of the lease, although the option period will usually be less than or equal to the lease period, with less than usually being preferable. For example, the buyer agrees to lease the property for one year and to purchase the property by a certain date before the end of that year.
Lease Purchase – A “lease purchase” is an agreement between a seller and a buyer wherein they simultaneously execute a lease agreement and a purchase contract for a particular property. For example, the buyer agrees to lease the property for one year and to purchase the property at the end of that year. The lease and purchase terms may be contained in a single document or in two separate documents that are cross-referenced.
Lease Option & Lease Purchase
The “lease with option to purchase” or the “lease purchase” can be of value to both a tenant/buyer and landlord/seller. Although some issues are the same for tenant/buyer or landlord/seller, other issues of importance are different depending on whether one is tenant/buyer or landlord/seller. Although the terms “lease option” and “lease purchase” are sometimes used interchangeably, there can be a significant difference between a lease purchase and a lease with option to purchase even though each employs both lease agreement language and purchase agreement language. The usual major difference is that the tenant/buyer in a lease option contract can fail to complete the purchase without risk of a lawsuit for breach of contract, whereas, the tenant/buyer in a lease purchase contract can be held liable for failure to complete the purchase of the property. This difference could be negated by clauses in the contract.
Unless the lease agreement and the purchase agreement parts of the deal are properly written, serious problems can result. While there are many possible problem scenarios, consider the following questions. What would happen if the landlord/seller must evict the tenant/buyer having a lease option? Does the option to purchase survive the eviction? Can the property now be rented to a new tenant or tenant/buyer?
From the point of view of a landlord/seller advantages can include the following:
- The landlord/seller can (at least theoretically) generate extra income because a lease option or lease purchase is usually written with an above market monthly rent with the excess usually applied to the option purchase price.
- Brokerage commissions and other marketing costs related to the sale are usually avoided.
- Because the tenant/buyer expects to end up owning the property, he will (in theory) take better care of the property.
- If the market declines, the landlord/seller may be able to sell at a higher-than-market price, if the tenant/buyer still wants the property.
- In many, perhaps most cases, the tenant/buyer will not exercise the option because he/she won’t have saved the necessary cash for closing the sale or won’t qualify for the necessary mortgage loan. So, if the landlord/seller obtained premium rent, had a good tenant/buyer, and it was not important that the property be sold, the landlord/seller can be ahead of the game.
From the point of view of a landlord/seller, disadvantages of the lease option or lease purchase can include the following:
- The lease option is essentially a unilateral contract unless and until the tenant/buyer elects to exercise his option. That is, the landlord/seller must sell if the tenant/buyer decides to exercise the option, but the tenant/buyer need not buy.
- If the market unexpectedly improves, the landlord/seller may end up locked into a lower-than-market price. This disadvantage can be minimized by limiting the option period, say to one year or, at most, two years.
From the point of view of a tenant/buyer, advantages of the lease option can include the following:
- The tenant/buyer can “try out” the property before committing to owning it.
- The lease option is a unilateral contract unless and until the tenant/buyer elects to exercise his option. That is, the landlord/seller must sell if the tenant/buyer decides to exercise the option, but the tenant/buyer need not buy.
- If the market unexpectedly improves, the tenant/buyer will benefit from buying the property for under-market price.
- Brokerage commissions and other marketing costs related to the sale are usually avoided.
From the point of view of a tenant/buyer, disadvantages can include the following:
- The tenant/buyer will likely pay higher rent because a lease option is usually written with an above market monthly rent with the excess usually applied to the option purchase price. However, the higher rent is not a problem if the excess is credited to the purchase price and the tenant/buyer.
- If the market declines, the tenant/buyer may end up buying at a higher-than-market price, but the tenant/buyer needn’t exercise the option.
Items of Importance
There are a number of issues that must be considered when writing a lease option or a lease purchase contract. Included are the following:
- Both a lease option and a lease purchase must be in compliance with the landlord-tenant law of the state where the property is located.
- Obligations regarding inspection issues – The landlord/seller can reduce risk by requiring all inspections that are a contingency be performed prior to move-in. However, since the tenant/buyer can fail to exercise the option for no reason, this doesn’t guarantee that an inspection issue won’t be the cause of no sale, but it may reduce the probability.
- Maintenance obligations should always be adequately defined in any lease agreement, but it is much more important that all details be covered when doing a lease option or lease purchase, including who is responsible for major repairs during the term of the lease. Be sure to cover such items as replacement of heating/cooling equipment and repair of major damage act-of-nature not covered by insurance.
- There are numerous issues to consider in determining the option price as well as a number of related issues including the rent premium, the portion of rent to be credited toward purchase price, and the length of the option. It is a matter of negotiating mutually acceptable terms.
Both agreements must include all terms related to purchase of the subject property, including the following items:
- Execution date
- Agreed price
- All contingencies being waived by seller (e.g., physical condition at close of escrow) and those not waived (e.g., sale is contingent on adequate lease performance)
- Dates and procedures related to exercise of the option and the purchase for a lease option agreement and for the purchase for a lease purchase agreement
- Type of deed to be given
- All “subject to” items
- Closing costs and adjustments and how to be apportioned
Who Signs
As is important for any legally binding contract, for both lease option and lease purchase agreements it is important that all signatories have legal standing to sign the documents. This means that each signer is of legal age and has mental capacity. It is also important that any addendums or amendments to the original agreement be signed by all parties that signed the original. Finally, when any legal entity such as a corporation, LLC, partnership, or trust is a party to the document being executed, it should be verified that those signing on behalf of the entity be authorized to do so by appropriate entity documentation.
Professional Advice
If structured improperly, a lease option or lease purchase could be considered a sale with possible negative consequences, including but not limited to the following:
- The transaction might trigger the due-on-sale clause of a loan secured by the property,
- The IRS could deny tax benefits of deductible expenses and depreciation and gain would have to be realized in the year of the option rather than the expected year of sale,
- The landlord/seller could be prevented from evicting the tenant/tenant/buyer because the Court considers the transaction to be a contract to purchase rather than a lease option or lease purchase, and/or
- The landlord/seller might become liable for violation of landlord/seller disclosure laws.
As lease option agreements and lease purchase agreements are in some ways significantly different than regular lease agreements, the parties should seriously consider having a competent real estate attorney or a real estate broker with experience in lease purchases and leases options review the transaction documents to be used. If the transaction might involve unusual income tax issues, the parties should consider discussing the transaction with competent tax accounting professionals.
However, although consulting professionals is advisable, the parties must themselves consider all the issues as they relate to the particular property and other circumstances and utilize the professionals as a check that the documentation is legally adequate and that the parties have not forgotten an important issue. The parties should not depend on the professionals to adequately consider every possible issue that might be important to the parties’ situations and desires.