Steve’s Primer on Lease Options

A lease-option can be a win-win technique for both buyer and seller. Here, Steve explains the details...

What is a lease-option? Rent-to-own?

A lease-option, also known as rent-to-own, is a contract that combines a lease with an option to purchase. Like a normal lease, the tenant rents the property for a specified term (there’s no legal limit, but typically 12 months to four years) and pays a monthly rent. However, the tenant/optionee also gains the right to buy the property.

How is the purchase price set?

The price is agreed on when the lease is signed or is determined in the future by using some objective standard, such as an appraisal or an index system (details on this technique are available from Steve by paid consultation).

What are the benefits to the tenant?

Usually, a portion of the tenant’s rent go towards the purchase. Over the length of the lease, the tenant can save up enough money for a downpayment. Also, if the tenant’s credit history is poor, this gives time for the score to improve in order to qualify for financing.

What are the benefits to the seller?

The property is rented by a tenant who is interested in taking care of it, the rent is often higher than without an option, the seller often receives an up-front non-refundable option fee from the tenant, and if the tenant decides not to purchase, the seller can repeat the process.

How much rent is credited towards the purchase?

The credit is negotiable but is typically around 25% of the rent paid.

What is an option fee and how much is it?

The tenant/optionee pays the seller an up-front fee for the right to purchase the property in the future. The fee is usually non-refundable, applies to the purchase price, and typically ranges from 1% to 2% of the purchase price. Of course, all terms of the agreement, including the option fee, are negotiable.

How does the seller know if the tenant will purchase or not?

The purchase option has an expiration date. If the tenant/optionee intends to purchase, the tenant must notify the seller before the option expires. The agreement should state how the seller is to be notified. If the tenant does not exercise the option on time, the seller should give the tenant a written notice stating that the right to exercise the option has been lost. Also, the agreement will state by when the purchase must be completed.

Can the seller revoke the option before it is exercised?

No. The seller is obligated to honor the option. The tenant, however, is not required to exercise the option.

Once the option is exercised, has a contract of sale been created?

Yes. Exercise of the option creates a binding contract of sale, and the parties become seller and purchaser. The tenant/optionee must then pay the remainder of the down payment and costs, secure financing and close on time.

What are typical clauses in lease-option agreements?

The agreement should, at a minimum, discuss:

• the purchase price
• the down payment at time of exercise
• the amount of option consideration (non-refundable payments towards the down payment)
• the length of the lease term
• the amount of the monthly rental payment
• the amount of the rental payment to be credited towards the purchase, if any
• when and how the option must be exercised
• when the sale will close
• what happens if the option is not exercised.

It is also a good practice to agree on the other terms of sale when they enter into the lease-option agreement. Steve has a "Residential Lease With Purchase Option" which also contains provisions regarding assignability, arbitration, commissions, and other terms of sale.

Steve’s form requires that the option be exercised in writing, specifically by delivering to the landlord/optionor a written notice of exercise. It also gives the parties the opportunity to require the tenant/optionee to open escrow and deliver signed escrow instructions and a copy of the notice of exercise to the escrow holder in order to exercise the option. It would also be possible to require the tenant/optionee to tender the entire down payment at the same time as exercising the option.

What other provisions might be included in a lease-option?

Here are some common ideas:

• Who will handle maintenance during the lease term.
• Whether and under what circumstances the tenant/optionee can make alterations.
• The landlord/optionor should also make sure that all disclosures required in connection with the sale are made and should determine whether the lease agreement falls within any local rent control ordinance.
• An adequate security deposit.
• Provisions for restitution for damages that exceed the deposit.
• Requiring the tenant/optionee to prequalify for a mortgage, thus improving the chances that the transaction will close if the option is exercised.

What precautions should a tenant/optionee take?

The tenant/optionee should consider:

• A property inspection (before the lease-option is signed). If any repairs are needed, it can be negotiated who will pay for them.
• Checking to make sure that no liens are recorded against the property which would prevent it from being sold.
• During the course of the lease, making sure that the mortgage and taxes are being paid so that the property doesn’t fall into foreclosure or become subject to a tax sale.
• Since the option funds are generally non-refundable, being certain before entering into the lease-option that s/he will have enough money to make the down payment when required and will qualify for any loan needed to finance the purchase.

Are there any risks to a tenant/optionee?

The potential renter/buyer should consider:

• Does the landlord actually own the property?
• What if the landlord misses a mortgage payment or the property is repossessed?
• What is the condition of the property?
• What if the property value decreases from when the contract was signed?
• Will you be able to qualify for financing when it’s time to purchase?

Are there any risks to a landlord/optionor?

The potential landlord/seller should consider:

• Is the tenant creditworthy?
• What if the renter misses a rent payment?
• What if the property value increases from when the contract was signed?
• Will the tenant qualify for financing when it’s time to purchase?

Who should pay for property insurance during the lease term?

This is negotiable. However, it is usually best for the landlord/optionor to continue paying for insurance on the property because the landlord/optionor is considered responsible for risk of loss if there is any damage to improvements on the property from most outside causes. Consider requiring the tenant to have renter’s insurance, too.

Once the tenant/optionee exercises the option, the tenant/optionee becomes a "buyer in possession of the property" and carries the risk of loss to the improvements. Therefore, after exercise, the tenant/optionee should carry insurance on the property. In any case, the parties should make sure that their interests in the property are adequately insured at all times.

Does a lease-option allow a lender to accelerate its loan?

Yes, entering a lease-option can trigger an acceleration of the loan! In other words, the lender can "call the loan due" right away, so handle with care!

What happens to the option when the lease expires?

Generally, the purchase option in the lease expires when the tenancy terminates unless the agreement says otherwise.

What if the lease expires but the tenant stays and continues to pay rent?

In this situation the tenant/optionee is usually considered to be a "holdover tenant" and simply continues on the terms and conditions of the original lease, however the purchase option expires and cannot be exercised.

What if the tenant goes into default on the lease?

If the tenant/optionee goes into default on the lease before exercising the option, the landlord/optionor may evict the tenant.

A tenant/optionee probably cannnot exercise the option if they are in default under the terms of the lease, but at the time of this writing there are no reported California cases. Of course, the lease-option agreement itself often addresses this issue; some provide not only that the tenant/optionee has no right to exercise the option when in default, but also that the tenant loses the option if the lease has been in default a specified number of times during the preceding 12 months, whether or not the defaults have been cured.

What if the tenant chooses not to exercise the option?

The tenant/optionee is not entitled to a return of any of the option consideration unless the agreement says so. As noted above, the option consideration usually is non-refundable. Steve’s form is consistent with this rule, providing that if the tenant/optionee doesn’t exercise within the specified period, the option is terminated, all rent, option consideration, and improvements made by the tenant are retained by the landlord/optionor, and, upon request, the tenant/optionee will sign a written release.

What if the option is exercised but the optionee can’t close?

If the optionee fails to obtain the financing necessary to close the transaction for any reason, including if the property doesn’t appraise, the tenant/optionee is not entitled to a refund of the option money.

Once again, the option money is considered separate consideration for the right to decide to purchase the property. It is not "earnest money" to be returned to the buyer upon the failure of a contingency rather it is a payment simply for the option to purchase.

Can a lease-option be assigned?

Generally, yes. A lease-option is binding upon successors to both the landlord/optionor and the tenant/optionee. Thus, if there is no restriction in the lease against assignments and the option provides for a cash payment of the purchase price, a tenant/optionee’s assignee also receives the option to buy and the landlord/optionor is obligated to sell to the assignee upon exercise of the option.

However, if the landlord/optionor is relying upon the personal credit of the tenant/optionee (such as by carrying part of the purchase price secured by the property) there are legal cases that suggest that the option might not be assignable to a third person without the landlord/optionor’s consent. Similarly, anyone who purchases the landlord/optionor’s interest with notice of the existence of a lease-option receives the landlord/optionor’s interest subject to the tenant/optionee’s right to exercise the option and complete the purchase.

What if the landlord dies before the option is exercised?

The tenant/optionee still has the right to exercise the option and enforce it against the landlord/optionor’s estate by specific performance.

Can the tenant deduct any mortgage interest?

No. While leasing, the tenant is not entitled to the mortgage interest deduction because the lease-option agreement does not give the tenant/optionee any ownership in the property. Only a party who is obligated to pay interest (i.e. is a borrower on mortgage) and pays interest is entitled to deduct it. Since the tenant/optionee is not legally obligated to pay the mortgage, the tenant/optionee cannot claim any mortgage interest deduction.

Can a lease-option agreement be treated as a sale by a court of law?

Yes. If a court believes that the true substance of the transaction is a sale, it will treat it as such. The test is whether, under the circumstances, the tenant/optionee must exercise the option or lose a valuable equity in the property. If this is so, the transaction might be ruled to be a sale.

For example, if the tenant/optionee pays an unusually large option consideration and/or makes large periodic payments that apply to the purchase price, a court might decide that the transaction is not a lease but in effect a contract of sale paid in installments, including a balloon payment at the end.

How is a real estate broker compensated for a lease-option?

As with other transactions, compensation is negotiable. Since there are two transactions, a rental and possibly a sale, typically a broker is paid a commission on the rental, like a leasing agent, and a separate commission on the sale, if the sale is completed. The parties should agree in advance on who pays the commission, however each local area has procedures that are customary.

When are the brokers’ commissions actually paid?

Most standard form agreements specify how much and at what time the commissions will be paid. Usually the commission for the lease is payable upon execution of the lease-option agreement, and the commission for the sale is payable upon recording of the deed.

Should a lease-option be recorded?

It depends. On one hand, recording protects the tenant by putting the world on notice that the landlord/optionor has conveyed an interest in the property and thus prevents the landlord from granting lease-options to several tenant/optionees simultaneously. On the other hand, recording could be a risk to the seller because it might put a lender on notice of the transfer and enable the lender to accelerate its loan, based on a "due-on-sale" clause.

Must the optionee be given property disclosures?

Yes, if the property is a residential dwelling containing 1-4 units, unless it is an exempt transaction, the state-required "Transfer Disclosure Statement" must be given to the tenant/optionee before the option is signed (unlike the rule for sales).

What about the "Agency Disclosure"?

The lease-option agreement itself does not require the Agency Disclosure or Confirmation of Agency. However, a sale pursuant to the option will trigger FIRPTA and California Withholding. The title company/escrow officer will help you comply with this rule.

What if a single tenant marries then exercises the option?

If a single person enters into a lease-option, then gets married, then exercises the option, the single person can hold title as separate property because the single person obtained the right to buy the property while single.

However, if community property funds are used to purchase the property, the property will probably be considered community property. The spouses should carefully consider how they wish to hold title, whether as community property, joint tenancy, or some other way.

Is a lease-option the same as a "right of first refusal"?

No. A lease-option gives the tenant/optionee the right to decide to purchase the property at the tenant/optionee’s election. The tenant can tell the owner, "I’m going to purchase the property." A right of first refusal, on the other hand, merely gives the tenant priority over other buyers. If the landlord decides to sell, the tenant must be given the opportunity to buy before the property is offered to anyone else.

Like a lease-option, the enforceability of a right of first refusal in a lease depends on the continued enforceability of the lease. In other words, if the lease is terminated, the tenant’s right of first refusal also terminates.

What facts trigger a tenant’s right of first refusal?

The answer depends on the specific terms of the lease. Usually, once the landlord decides to sell, the tenant must be given an opportunity to offer to purchase the property. If the landlord attempts to sell to a third person without giving the tenant an opportunity to buy, this would be a breach of the lease.

In most cases, the lease gives the tenant a right to purchase the property on the same terms and conditions as offered by a third-party purchaser. This type of right of first refusal is enforceable even though no price and terms are specified. Thus, unlike most contracts, which are not enforceable if the terms are not certain, a right of first refusal in a lease always leaves the price and terms to be determined by subsequent events.

Where can I get more information on lease-options?

If you are ready to buy or sell on a lease option plan, give Steve a call. If you require advice specific to an existing lease option, please consult a real estate attorney.

Important disclaimer: This is general information, not tax advice. Federal and state tax laws change frequently. We are not tax or legal advisors. Please consult a qualified tax or legal professional before acting on anything described here.

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