Lease option process question - Posted by allen

Real Estate Investing Real Estate Financing
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Posted by JohnBoy on March 26, 2002 at 16:39:11:

Exactly, I know that is what he is saying. I’m saying that is wrong and should be the exact opposite.

In either case there is no sale. There is no renting it back. Unless this is case where he purchased the property from the seller and then leased it back to them with an option to buy. If that is the case then he is lucky the Judge didn’t reclassify his deal as high interest loan violating usury laws.

If this was just some tenant he placed into the property then there is NO just renting it back. Renting it back from what? They would have to had previously OWNED the property to be renting it back.

But rent credits or not, it’s just an option. If the rent credits were a large portion of the rent being paid then that could run the risk of a L/O being reclassified as a sale.

Having no rent credits at all in no way would classify an option as a sale or renting it back for whatever reason.

I’ve talked to another investor in Utah that has been in that state for years and is very well versed in the laws of that state. A very heavy paper player in Utah. He said there is no such law or precedent in Utah saying rent credits must be given in a L/O.

So if he had a case where some Judge ruled this way then there has to be more to it than just rent credits being an issue on this. It makes no sense at all and if anything it would be the exact opposite where by giving rent credits would create more equity in the property for the tenant. With NO rent credits they have nothing but a lease and an option to buy, that’s it.

Again, if this was a deal that involved a seller that sold and then leased the property back with an option then that is where there could easily be a problem. It wouldn’t have anything to do with rent credits though.

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Lease option process question - Posted by allen

Posted by allen on March 25, 2002 at 12:55:14:

Hello everyone,

I have read many of the articles and responses on this board concerning lease optin techniques, and I’m convinced that this could be a profitable avenue to pursue.

I also look forward to being able to help someone get into a property that might not otherwise do so.

My question is this:

If I own a property that I LO to someone, and if I collect 5% of it’s value as option consideration and am able to generate, say, $200 per month cash flow - I was at first glance thinking that this was a good thing.

BUT, on second glance, I see that I will be responsible for property taxes and insurance on the property. Taxes on a 1300 sf house in Raleigh, NC are around $1300 - $1400.
Insurance on this property is around $500 per year.

That’s (as an average for discussion sake)$1800 out of pocket to do this deal. This ccould come from option consideration and / or monthly cash flow, right?

Surely the deal is worthwhile for a number of reasons, but I ask: How do you deal with these costs?

Am I missing something here?

How do you folks doing LO deals handle this?

Is this simply a cost of doing business?

What happens when I create a term of more than a year for my LO to someone?

it seems that the option consideration paid to me would get eaten up over time…

Can you set me straight, please?

Confused,

Allen

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Re: Lease option process question - Posted by JohnBoy

Posted by JohnBoy on March 26, 2002 at 07:02:06:

If your payment including PITI is $1400 per month, then to get a $200 positive cash flow you would need to charge your tenant/buyer $1600 in RENT. From the rent you collect you pay the underlying mortgage payments, taxes and insurance. Any thing left over is your cash flow. There should be nothing in your agreements that state anything about taxes and insurance with your tenant/buyer.

See my response to Mike’s post below.

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Re: Lease option process question - Posted by Mike

Posted by Mike on March 25, 2002 at 13:44:24:

I Put all of Lease Option clients through an escrow company, this solves several issues. One when they go to refinance I have a non biased third party verifying payments made and dates etc… Second I build into the payment the property taxes and insurance for the client. It is their house anyways right? So whatever payment they agree to they need to agree to pay the taxes and insurance as well.

I additon to this Lease options longer than 24 months have a higer unlikely hood of falling apart on you and the buyer not buying the house.Then I just put in a new buyer and the house is paid down even more. A WIN WIN.

Thank you
Mike@4ReaLestateLeads.com

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I think you’re skirting the line here… - Posted by Marcos

Posted by Marcos on March 25, 2002 at 21:54:20:

I think from what you have said you have a very good chance your contract is going to be called a Land Contract, and if the deal goes south you’re going to have to foreclose instead of evict. A few problems I see here:

  1. You have the tenants pay taxes and insurance separate from their rents. You said " So whatever payment they agree to they need to agree to pay the taxes and insurance as well" This will look more like a sale to the judge than a normal lease. It’s just not normal for a lease to have separate taxes and insurance.

  2. The longer the lease, the more chance it will be called a LC. Longer than 3 years and you’re really pushing it.

  3. Rent credits if not properly used will cause you a problem. By themselves I wouldn’t say much about them. But given that you’re already adjusting for Taxes and Insurance it just compounds the problem. Especially if it comes close to mimicing the natural amortization of the loan.

Bronchick covers a lot of this in his courses. I would recommend you take a course or two before you run into any problems.

Marcos

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Re: Lease option process question - Posted by allen

Posted by allen on March 25, 2002 at 13:56:12:

Thanks for your experience! Your answer brings up benefits I had not considered.

I wonder, in the situation we are discussing, doesn’t this create a situation as far as taxes are concerned? (ie;distinguishing between a “sale” and a “lease”, and how the income is handled?)

uncertain,

Allen

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Re: I think you’re skirting the line here… - Posted by Mike

Posted by Mike on March 25, 2002 at 22:14:27:

First of all I have done nearly 50 deals that way second of all I up the payment to compensate for the taxes and insurance and I don’t say to the customer that they are paying them. Second of all I have bronchick’s course and I have been to his seminar. Thirdly each state law is slightly different and I did take those notices into consideration. In my State Utah none of those considerations apply. I have been to several courses on real estate, and have 5 years as a full time real estate investor under my belt. Although I admit I do not know everything I have studied quit a bit. As far as the rent credits go< i have done it at the request of my title companies, to establish an interest in the title beyond the deposit. This principle is better explained by Claude Diamond. I’m not argumentative mind you just not having the same experience as you have had. The lease option principles of Claude Diamond differ a bit but since both bronchick and Diamond are lawyers I think it is just a matter of legal opinion. Two lawyers frequently have different opinions on the same subject, especially when the state laws (Like Utah) are ambiguous, and vague, in the areas of lease options. Again your point is well stated, why give away money in credits if you don’t have too? And for me I do it for good will as well as strengthening my case in the event of an eviction or purchase. Since I use the anticipated future value of the property in the Lease Option then I still make out ok.

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Re: Lease option process question - Posted by Mike

Posted by Mike on March 25, 2002 at 14:14:20:

Allen,

That is why I use the escrow company, they distinguish the funds collected
as “taxes” “insurance” “Lease Payment” or whatever it is. The only actual
income to me is when the property is sold. The difference I keep because
I make sure that the sales price is high enough so that the option to buy each
month still gives me a substantial profit but is zeroed out in the cash
flow. For example the house sells for $124,000.00 Each month they pay
1200.00 the payment is 900=$300.00 positive right? Wrong $200.00 month goes
to the down they are building up, and $100.00 goes to taxes and insurance.
Net cash flow to me $0.00 they buy the house 2 years later for $124,000.00
minus $200 per month $4800.00 minus option consideration $5k that’s
$9,800.00 from 124,000.00 that’s $115,000.00 net to me minus the payoff .
That number is the profit even though I had $300. positive cash flow do you
follow?

P.S. I still had $200.00 per month that I put in my pocket even though it wasn’t true income until after the house actually sold. I made sure I Increased the price the $4800.00 that they would build up in 2 years so my profit is still in tact.

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Re: Lease option process question - Posted by Tim (CT)

Posted by Tim (CT) on March 25, 2002 at 16:17:57:

O.K. Now you’ve got me confused. If you’ve got a house that has an option price of 124,000 and your monthly payment to cover PITI is 1200, in my opinion, you charge them somewhere in the range of 1400 or 1450 (or, whatever kind of monthly positive cash flow you’re comfortable with that will fit the market). This covers PITI plus puts 200 to 250 in your pocket. That money stays in your pocket. That is positive monthly cashflow.

Also, you say ‘…$200.00 month goes to the down they are building up…’. Are you giving them rent credits? My first question would be, why? If they don’t ask for it, you don’t give it to them. Rent credits should only be used as a last resort to get the deal done if they have issues with the option price or anything else.

In the situation I described above, given a 24 month period with 1200/mo PITI and the t/b’s total monthly lease payment at $1400, total dollars to you would be $4800 (from the 24 months of $200 positive cash flow), plus the upfront $6200 (5% - this could be high but maybe not) non-refundable option consideration. Totaling $11,000. Add to this the difference between the t/b’s option price of 124k and your balance (let’s say it’s 100k). So, total cash into your pocket would be $35000. So, you get money 3 ways, upfront, during the lease period and the cash out at the end.

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makes perfect sense, THANK YOU!!! (NT) - Posted by allen

Posted by allen on March 25, 2002 at 14:30:33:

NT

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Re: Lease option process question - Posted by Mike

Posted by Mike on March 25, 2002 at 16:24:31:

No In the scenario I was talking about, the underlying payment was $900.00 per month. Then I jack the price up 3 to 5% to account for inflation then discount it back in rent credits. Sure you don’t have to offer rent credits but I do. I have found that offering rent credits phsycholigically builds more value each month for the buyer and makes it harder to walk away for them. Also some states if you don’t offer rent credit every month it is not legally a Lease option agreement. THere is also an argument to get the non refundable option money back in court if they don’t get the rent credits too, as the tenants attorney will call it a security deposit as you offered nothing of consideration for the property, Even offering $25. per motnh helps lock this in

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WRONG!!! - Posted by JohnBoy

Posted by JohnBoy on March 26, 2002 at 06:49:51:

There is NO state that I know of that says you MUST offer rent credits to make it a valid lease option! Absolutely false and ridiculous! You have that all backwards! Actually, by offering any rent credits you can run the risk of having the lease option reclassified as a sale!

But since you claim some states say otherwise, then list the name of ONE state and provide the statue that says this. I’m betting none exists!

You stated:

“”“As far as the rent credits go< i have done it at the request of my title companies, to establish an interest in the title beyond the deposit.”“”

This is WHY you DON’T want to do that! You don’t want to establish any interest in title to your tenant/buyer! That’s what can cause your L/O to be reclassified as a sale! That can cause your eviction to be thrown out and a Judge forcing you to go through a judicial forclosure! These are the things you want to AVOID at all costs!

In your other post you stated:

“”“Each month they pay 1200.00 the payment is 900=$300.00 positive right? Wrong $200.00 month goes to the down they are building up, and $100.00 goes to taxes and insurance. Net cash flow to me $0.00"”"

WRONG!

If the PITI payments are $900 and they pay you $1200 then your cash flow IS $300 per month.

Now if you are saying your agreement states $200 of their rent is credited towards the “down payment” NO MATTER WHAT…then you are playing a dangerous game!

ANY rent credits offered should ONLY be applied towards the purchase price IF, AND ONLY IF, the optionee exercises the option. That means rent credits don’t get applied until they FIRST EXERCISE THE OPTION! They are not applied each month up until they decide to exercise the option or not. FIRST they MUST exercise the option BEFORE ANY credits are ever applied. THEN, and ONLY THEN, at that time rent credits based on X amount of rent paid each month previously shall apply towards the “Purchase Price”. NOT the down payment!

The other problem where you say:

“”“Wrong $200.00 month goes to the down they are building up”“”

This is WRONG! You should NEVER state anything about monies going towards their down payment. They are only leasing with an option to buy. They aren’t BUYING until after they exercise the option. So there is NO down payment in a lease option, only on a sale when you actually are buying something. Any rent credits should only be applied towards the PURCHASE PRICE! Not towards a down payment. If you apply it towards a down payment and they decide NOT to buy then you may end up having to refund them all the monies you applied towards their down payment. If they don’t actually BUY the property in the end then there would be no down payment and if your contract is stating they have been paying towards a down payment you may have to give it back since they are not going to buy in the end, even though your contract may say its non-refundable. It’s not something I would care to have to try and defend in court, so why even risk it when you can use proper wording to avoid it all together???

So the problem with your method of claiming the $200 isn’t true income until after the property sells is seriously flawed. If everything goes smoothly then you can get away with it. But if a tenant ever wants to take you to court over this you could end up having to refund them that $200 per month because of the way you’re structuring this and claiming it isn’t income recieved until after the property sells. If it ain’t income according to your contract with the way it’s written, then it’s just a deposit being held until they buy, even though you may spend it, but you may end up having to give it back!

You are trying to create hoops to jump through for tax purposes to defer claiming the income and have your cake and eat it to by trying to say it’s non-refundable money being applied towards the down. Somewhere alomg the line you are going to get caught up in this where it’s going to come back to haunt you.

So if the payments are $900 PITI, and the income from rent is $1200, then your income IS $300 per month whether you give any rent credits or not!

The lease should be separate and the rent listed in the lease should state the rent is $1200.

The option agreement is separate any rent credits should be stated in the option agreement. That’s two separate contracts and two separate transactions. So you can’t claim the rent credit given in the option agreement to offset the actual rent amount stated in the lease. Two separate contracts that have NOTHING to do with each other, IF properly structured.

If the OPTION agreement states $200 for rent credits then it should state rent credits shall be applied IF, and ONLY IF, the option is exercised. Otherwise NO credits are ever applied otherwise!

Also, all the rent credits won’t be applied by the lender. The lender will only allow any amounts that EXCEED the fair market rents for the area to be applied towards the buyer’s down payment. NOTE: That is the LENDER that allows any rent credits and any option money paid to be applied towards their down payment. That is between the lender and the buyer as to how they will allow anything to be credited and applied, NOT ME! My contract states NOTHING about any down payment, period! The words “down payment” are not even mentioned in my contracts. They are NOT buying. They are only leasing with a separate option to buy. So any money paid up front is listed as non-refundable option consideration and any rent credits are applied towards the “purchase price”, IF and ONLY IF, the option is exercised, period!

Also, to avoid the risk of having the option consideration called a security deposit, you should get at least $100 as a security deposit that is stated in the lease agreement. The option money is stated in the separate option agreement so there is no confusion as to what that money was for!

Also, the more you allow as rent credits the more risk you run of having the L/O reclassified as a sale. So if you give rent credits you should keep them to a minimum to avoid more risk of having the L/O classified as a sale should you end up in court with a tenant that decides to get an attorney to protect their interest.

So lets say my pay off was going to be $100k in 2 years. I L/O the property for $124k. My total payments are $900 per month which includes taxes and insurance. I charge my tenant $1200 RENT in the lease agreement. My cash flow is $300 per month period! If I offer $200 in rent credits in the option agreement IF they exercise the option, my cash flow is STILL $300 per month! The rent credits are only OFFERED to be given IF the exercise the option. So in order to get the credits they must first exercise the option before they are even applied towards the purchase price. If they don’t exercise the option then no rent credits are forfeited because none were ever given in the first place. They must first exercise the option before they even apply!

The only reason the rent credits are even OFFERED to be applied based on X amount of rent paid each month ON TIME, is for an extra incentive to get them to pay the rent on time each month.

So basically the way the rent credits work is, $200 of the monthly rent shall be applied towards the purchase price, IF you paid that months rent on time, AND, IF you exercise the option, THEN and ONLY THEN shall the rent credits be applied towards the purchase price.

So since my tenants are NOT getting any rent credits applied until AFTER they exercise the option, then there is no way I could get away with claiming the $200 per month as not being income until the propery is sold or the option expires, which ever comes first.

The way you are saying you are doing this has the risk of having your L/O reclassified as a sale and could have potential tax problems. Not to mention the risk of having to refund the TENANT all their money you claimed was already given to them as a credit before ever exercising the option!

You may have done 50 deals this way, but how many have you had go bad where the tenant hired an attorney and tried to fight this in court?

Based on the way you explained it here and if I were your tenant knowing what I know now, and if I had a problem where I couldn’t pay and you went to evict me…guess what? I’d be in court claiming equitable interest because of all the option money I paid and all the rent credits I had coming according to my contract (compliments of YOUR title company because they told you to do it that way, LOL) and I’d be claiming this bogus L/O of yours was nothing but a covered up sale taking place because you just wanted to avoid paying taxes on the income you were making off my payments! Oh what a messy court battle it could turn into for you in the end! You may end up having to foreclose instead of a simple eviction. Or you may at least be require to refund me all my money paid as option money and rent credits since I’m not going to be BUYING the property now. Or you could end up in a bigger mess with the IRS because of the way you structured this! Or a combination of everything. Who knows how the Judge will rule. But there is case law established on having L/O’s reclassified as sales and that could be used against you to prove a case regardless of which state you live in!

Structure the deals properly and allow yourself the best possible protections to limit all your risks! Try to get cute by cutting corners, using wrong language in your contracts, and trying to avoid taxes by deferring them for a year or two is going to add more risk on your part. Sooner or later it will catch up to you. It’s not a question of WILL it ever happen…if you keep doing it then it’s just a question of WHEN!

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Which States??? - Posted by Marcos

Posted by Marcos on March 25, 2002 at 21:58:36:

Which states mandate that you MUST have rent credits every month? And if you don’t have them, what is it recharacterized as? This is a new one to me.

Marcos

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Re: Lease option process question - Posted by Tim (CT)

Posted by Tim (CT) on March 25, 2002 at 16:31:44:

So, you’re saying the $900 is only a principle and interest payment? Why wouldn’t you put the entire PITI into one big payment from the t/b?

I can see how offering rent credits might psychologically help get the deal done. But, I wouldn’t give more than $100/mo. Seems like you’re giving alot of money away that you may not even need to do.

Also, I believe if you’ve stated, in your contract, that the monies you’re getting upfront is ‘non-refundable option consideration’, how can an attorney say it’s a security deposit? It say in the contract ‘non-refundable option consideration’. As long as you never call security deposit, there shouldn’t be any confusion.

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Re: WRONG!!! - Posted by Mark in OKC

Posted by Mark in OKC on March 26, 2002 at 17:46:42:

JohnBoy:

Would it be possible to obtain your lease form and your option form. I have been looking on this site and have visited others to obtain a lease/option form and keep coming up empty. I have one of Sheets but it seems to be lacking. From what you have said and others we need to have two separate forms, one for the lease and one for the option.

Thanks for any help or guidence. You can email me also at Sonicmark@msn.com

Best,

Mark in OKC

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Re: WRONG!!! - Posted by Mike

Posted by Mike on March 26, 2002 at 11:05:56:

I responded to this to another person already. While their is no specific state statute in the State I am in a leas option contract that does not have monthly consideration being offered can be considered just a straight purchase contract with the buyer renting back until they get there financing. If they quit paying rent they would legally have the 30 days to be in default before I could even start the eviction proceedings. If I offer them a rent credit each month then (In the State of Utah) mind you I can file eviction after the rent has been due for 5 days and remains unpaid. (This is established case law in at least the 4 counties I work in) I am not sayign that this is a blanket way to do it in the U.S. But i have discussed this thorughly with my attorney, as well as Claude Diamond, (An attorney), and although him and Bronchick disagree on some definitions of the law (As many lawyers do disagree on many issues regarding case law vs statutory code. I have done over 50 Lease option deals over the past 5 years and I have not yet had a claim to the level that you are talking about. THe only issue I have had is that a tenant quit paying and because I had offered no rent credit ot the tenant I was ordered to give the buyer 30 days to cash me out before I could begin eviction, whereas now that I offer that I can start eviction immediately, after the due date of the rent stated in my agreement. I am in agreement of the general principle you are talking about, and I always advise people to talk to an attorney who is an expert in his/her field. Oftetimes they know of things that can be very specific to the state that they live in. Whether it be case law or Statutory provisions.

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Thank you JB - Posted by Marcos

Posted by Marcos on March 26, 2002 at 07:24:40:

I was trying to argue this last night and was too tired to think straight. I figured you would see it sooner or later though.

Thanks,

Marcos

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Re: Lease option process question - Posted by Doc

Posted by Doc on March 25, 2002 at 19:07:51:

Would it be of value to : instead of getting a $5,000 option consideration, get a $4,000 Option consideration and a $1,000 security deposit. That way, if it does go south and they want to sue, the “security deposit” is already spelled out and not subject to legal interpretation?

Just a thought.

Doc

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JohnBoy is right on this one. - Posted by William Bronchick

Posted by William Bronchick on March 26, 2002 at 16:10:55:

Johhny from Utah, I must say from experience in court that this is not the case. Several tenants in several states have made this argument unsuccessfully.

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Re: WRONG!!! - Posted by JohnBoy

Posted by JohnBoy on March 26, 2002 at 11:28:42:

This still makes no sense at all. What about when doing a straight option on a property where there is no lease involved? There would be no rent credits because there is no lease involved. Why should the fact a lease is involved where the person has an option on the same property be any different? There is no difference.

What you are describing would be the opposite. If there are rent credits involved then it would make more sense to allow the tenant 30 days to exercise the option because of the equitable interest they have built up in the property. If there is no rent credit then there is no additional interest in the property and the tenant would be treated as such, just a tenant.

Can you site any of these specific cases in those counties that went to court on this? Seems to be someone is probably misunderstanding the case wrong. I’d be curious to see what these cases said.

An OPTION agreement is just that, an OPTION to buy. It’s not a purchase agreement. I don’t see where having rent credits involved would help to prevent it from being considered a sale Vs. an option. It just makes no sense at all. It would be the other way around. Rent credits would be something to use to construe the option as being a sale.

If you don’t know what any the cases are you are referring to then ask your attorney to give you that information. I really would like to see those cases since this makes absolutely no sense.

Are you using separate agreements or are your agreements a lease with an option tied together within one agreement?

If they are separate agreements they the option would be separate from the lease altogether. How can you claim the option is a sale if there is no lease involved within the option agreement itself? They are two complete different contracts that have nothing to do with each other.