Posted by JohnBoy on July 08, 2003 at 22:07:51:
Using a separate lease agreement and option agreement are highly recommended. Rent credits are not a problem as long as you use proper wording.
Lease Options - Bogus? - Posted by Kevin
Posted by Kevin on July 08, 2003 at 15:22:06:
I came across this article on another site. Am I reading this correctly in that it is saying that Lease Options are really Land Contract sales of RE? I hope it isn’t true, I would hate to have to Foreclose on T/B’s rather than just evict them.
Any input would be appreciated.
BOGUS LEASE OPTIONS
A Purchase by Any Name
By Stephen Stralka
A home buyer with insufficient funds for a ten percent down payment responds to a broker’s ad under “Home for Sale”; the ad indicates that the credit worthy can move into a pricey single family residence with a small down payment. The buyer inspects the property, and decides that he would like to buy it. The seller is asking for five-percent down, and is willing to carry the balance. The five-percent down payment is called “option money,” and is to be applied to the purchase price should the option be exercised. Correspondingly, the monthly payment is called “rent,” and a portion of the rent is to apply to the purchase price - upon exercise of the option. Thus, except for the absence of a note, trust deed and grant deed, the terms of this so-called “lease option” have all the economic characteristics of a carry-back sale. There is an agreed-to-price, a down payment, monthly payments toward principal and interest, and a three-year due date.
After closing, the buyer incurs financial difficulties and is unable to keep up with his payments. The seller attempts to evict the buyer for non payment of rents. The seller claims that the lease is terminated by a Three Day Notice to Pay or Quit and the buyer forfeits the right to the possession of the property and the amounts to be credited toward the purchase price. Can the seller terminate the agreement as a lease with an option and keep the buyer’s money?
No! When a buyer in possession under an agreement receives credit toward the purchase of a portion or all of his payments to the seller, he has established and built up an “equity” in the property, and “ownership interest” which must be terminated by foreclosure.
A lease option agreement structured on terms economically consistent with a credit sale is neither a lease between a tenant and a landlord, nor an option to buy. This bogus “lease option” agreement is a disguised purchase agreement between a buyer and carry-back seller [Oesterreich v. Commissioner (1955) 226S2d 798]. Thus, the seller can only terminate the buyer’s ownership interest in the real estate through judicial foreclosure - no trustee foreclosure provisions are written into lease options, since such agreements are purportedly not sales at all.
THE BOGUS LEASE OPTION
A seller has a number of possible ways to structure carry-back financing for the sale of his property. He may, after a down payment:
· Convey title and carry back a trust deed (first or second) for the balance of his equity in the property;
· Convey title and wrap an existing first TD with all-inclusive trust deed (AITD);
· Enter into an unexecuted deposit receipt retaining title until escrow is opened and closed, and give the buyer occupancy under an interim occupancy agreement; or
· Use a land sale contract, also called a “Contract for Deed,” retaining a deed to secure payments of the balance due on the price.
THE CREDIT-TO-PRINCIPAL FEATURE
Incongruously, the bogus “lease option” has the buyer/tenant receiving credit on the price for both the down payment/option money and a principle portion of the payment called rent.
Seller financing, no matter how drafted, delays payment of all but a small fraction of the purchase price. Thus, buyers are able to own and occupy a home with little or no down payment. Sellers are able to move their real estate in a slow market. The lease option becomes viewed as a form of seller financing, and is, in effect, a financing aberration which gains popularity in times of recession and tightening of credit. Trust deeds and land sale contracts are fairly secure in their legal treatment - there exists a substantial body of case law and statutes relating to each, in spite of the extremely different foreclosure procedures. The legal situation of lease option financing is considerably less certain. Sellers - and unfortunately, brokers - view the bogus lease option as a purchase lease/option, a financing hybrid. A seller under a bogus lease option seeks to avoid all ownership responsibility and risk of loss by drafting the terms of the lease option to conform with those of a completed sale - that is, until the buyer defaults and the seller attempts to revert to the role of landlord and evicts the buyer as a non-paying tenant.
Specifically, inappropriate weight is placed upon the question of who holds the deed - which becomes a mortgage-in-fact. What the seller has created is a land-sale contract, but with the wrong name on it. The seller can’t have it both ways. A transaction is either a sale, or a lease with an option to purchase, but it can not be both. The hybrid purchase/lease/option arrangement does not exist. [Smith v. Morton (1973) 29 CA3d 616]
THE REAL OPTION TO BUY
Under a lease, a tenant pays rent, no part of which is credited toward the purchase of the property occupied. Non-refundable option money can be paid for an option to purchase which runs with the lease. However, the signing of the lease itself is nearly always the consideration for giving an option to purchase. Even if option money is paid, it is not credited toward the purchase price - option money is simply the consideration paid to keep the option open. The option is the landlord’s irrevocable offer to sell the real estate to the tenant within a certain period of time - should the tenant decide to buy. The tenant is given the absolute right to buy or not to buy the property, at his discretion. When a tenant with a genuine option to buy exercises the option, it become an enforceable bilateral purchase agreement. Until then, the agreement between the two parties is a lease for all purposes, and the roles of the parties are narrowly defined in terms of a landlord/tenant relationship.
NOT AN OPTION AT ALL
If the tenant receives credit toward the price of the property, the lease option will be re-characterized as a land sale contract - a carry-back sale without trust deed provisions to avoid the seller’s need to judicially foreclose and exhaust his security; thereupon wiping out the equity the buyer has paid-for and built up in the property. In each case, the seller (or the purported landlord) keeps the deed, while the buyer (or purported tenant) is in possession of the property, having paid money to the seller, which money is applied toward a purchase price to be fully paid in the future. Other signs for establishing a purported tenant as an actual buyer in possession include:
· Shift of the burden of care and maintenance, and risk of loss to the tenant;
· Payment of property taxes and insurance premiums by the tenant in addition to the regular monthly payment, and impound agreement;
· Good faith improvements made by the tenant - i.e., improvements made in the good faith belief that he is the owner of the property [CA. Code of Civ. Proc. §871.1];
· Monthly payments which substantially exceed the property’s fair market rental value - since it costs much more per month to own a higher end property than to rent it; and
· A fixed dollar purchase price.
A genuine option to buy within three or more years typically does not have a set price. Uncertainty as to what the property’s inflated and appreciated value will be in a number of years is a risk of ownership, a risk (or benefit) the fixed dollar price shifts to the purported tenant/optionee. If the price is set as a dollar figure, the setting is one indication that the property has been sold. Courts look to the economic substance of a transaction over the legal form in which it is drafted - especially when calling an agreement by the wrong name misrepresents the party’s rights and obligations actually existing under the agreement. [City of L.A., CA v. Tilem (1983) 142 CA3d 694] If the buyer in possession is building an equity, the lease option is a land sale contract in everything but name. Any option money paid in is really a payment on the price, with the rents to be considered as interest and principal under a disguised mortgage. [Oesterreich, SUPRA]
Editor’s Note - There is no legislation providing for the re-characterization of a bogus lease option as a masked land sale contract. However, statutes relating to similar lease-back arrangements involving equity purchasers have codified.
For example, an investor acting as an equity purchaser buys a property and leases it back to the seller with an option to buy. The transaction is not a genuine lease option: it is a real estate loan. The lender, who characterizes himself as an investor/buyer, in this case holds the grant deed to the property as security for repayment of principal and interest, rather than using a trust deed to document the transaction. [CC§1695.12]
When a lease option is a masked land sale contract, the tenant with a purchase option becomes a buyer with equitable ownership of the property - equitable because he is in possession of the property and makes the payments, which applies in part against the purchase price, but has not yet received the deed. [Mc Clellan v Lewis (1917) 35 CA64]
The landlord in fact becomes the carry-back seller in law - a secured with different rights than an owner - even though me may retain the title. [LA Invest. Co. v Wilson (1919) 181 C 616]
THE BUYER DEFAULTS
When a land sale contract is masked in the form of a lease option, most of the resulting problems occur when the tenant/buyer defaults in payments and refuses to vacate and sign a release (deed in lieu of foreclosure). Evicting a non-paying tenant is relatively quick and inexpensive compared to a foreclosure. The distinction becomes a most prominent reality when a purported landlord finds himself reclassified as a carry-back seller, and has no tenant to evict. His tenant is, in law, the equitable owner of the property.
The landlord/seller will incur great expense in time and money in order to rid himself of a defaulting lease option tenant who claims to be a buyer with equitable ownership rights. The cumbersome process of a judicial foreclosure will be required to eliminate the tenant/buyer, since there is no trust deed power of sale clause. If the seller refuses to allow a redemption payoff, the buyer in possession is entitled to a specific performance action against the seller. This is true of real leases with purchase options as well, since the tenant need only exercise the option to create and enforceable purchase agreement.
At the very least, the lease option buyer is entitled to a refund of ALL AMOUNTS HE HAS ADVANCED TOWARD THE PURCHASE PRICE. The seller may not keep the buyer’s money on default, since foreclosure of an equitable ownership is not permitted. [Peterson, Supra] Forfeiture is not an issue when a genuine purchase option is attached to a lease. Any payment the tenant makes is not part of the price. It is either rent, or it is non-refundable option money: consideration paid the seller for keeping the property off the market and the option to purchase open. Only when credit is given toward the price to be paid upon the exercise of the option does the purported tenant obtain an interest in the property.
TAX ASPECTS
Tax-wise, lease options are often re-characterized as disguised carry-back financing or land sale contracts. Strong income tax incentives exist for sellers to conceal property sales behind bogus lease options. Under a true option agreement, any option money received by the seller is not reportable as profit or income until, respectively, the option is exercised or expires, or the property is sold subject to the option. Thus, if the seller can convince the IRS that the principal and the interest payments he receives are really option money, he will pay no taxes on the “option money” until the buyer exercises the purchase option, or allows the option to expire. The seller, disguised as a landlord, will also deduct as an owner’s tax benefits the property’s annual depreciation - until re-characterized by the IRS.
However, tax courts look to a number of factors, including the buyer’s equity, who bears the risk of loss, who pays property taxes, the relationship of rent to market value, and the price paid upon exercise compared to the property’s value at the time of exercise, to determine whether a purported lease option is really a sale. If the lease option is found to be a sale in fact, the transaction will have been improperly reported. The seller will have to report the option credits toward price as payments on the principal ( allocated to profit and basis) and the balance of the rents as interest, and pay interest penalties or worse. Similarly, and for consistent reporting, the buyer may not deduct the payments as rent. [MW Gear Co. v. Commissioner (1971) 446 F2d 841]
CONCLUSION
Sellers often seek to combine the advantages of leases with sale transactions by structuring their sales as lease options. However, the purchase/lease/option hybrid financing does not exist. A transaction is either a lease or a sale: not both.
In a genuine lease with an option to purchase, neither any portion of the rent nor any option money paid applies toward the purchase price upon exercise of the option. If money paid by the tenant for rents or option consideration is applied toward the price, the transaction is not a genuine lease with a purchase, but is a disguised carry-back sale - a land sale contract.
The courts can easily re-characterize purported lease options as disguised sales, exposing sellers to all the consequences of mortgage law. If the lease option is found to be a disguised sale, the tenant is re-characterized as a buyer who builds an equity and has an ownership interest in the property. The seller may not simply evict a defaulting buyer as he could a tenant. The buyer’s interest can only be terminated by judicial foreclosure, since the lease option seller has no trust deed power of sale provision.
Also, if a lease option is re-characterized as a sale, the transaction will have been improperly reported for federal and state income tax purposes, and the property will be reassessed based upon a change of ownership.
Regardless of what the form of a transaction may be; if its economic substance indicates it is a sale, it will be treated as such for all purposes.
Don’t forget: all lease options, irrespective of their form or duration, do trigger due-on-sale clauses.
CEA News 8/91
Chicken little - Posted by William Bronchick
Posted by William Bronchick on July 09, 2003 at 09:21:14:
"The landlord/seller will incur great expense in time and money in order to rid himself of a defaulting lease option tenant who claims to be a buyer with equitable ownership rights. "
Sure, it’s possible if the transaction LOOKS LIKE A SALE, the buyer has a lot of equity in the deal and it is patenly unfair to allow the landlord/seller a windfall, but it’s rarely the case! Most tenant/buyers put a few grand down, pay rent for a year, then default. And, the landlord is almost always successful in evicting the tenant/buyer, since the buyer has no equity. If the buyer DOES HAVE $50k in equity, would you be in a court battle? Maybe, but is it worth paying your attorney $10k in legal fees to have the right to KEEP $50k in equity? Duh!
Well, this guy cites a lot of court cases, except the RELEVANT ones. There hasn’t been a reported case EVER of a short term (
Re: Lease Options… - Posted by Eric C
Posted by Eric C on July 08, 2003 at 23:05:23:
Hi Kevin -
There are some pretty good responses here already and JohnBoy has done his usual thorough job of explaning his position on the matter. But since options are a particular favorite of mine, I guess I’ll throw in my .02 worth.
I realize that you’re a newbie and that, for the time being, your primary focus is the single family market. That’s understandable. But you need to come to grips with the fact that options are very real. They are powerful tools that can be (and are) used in many forms of business (besides just RE) everyday. And like any other tool, options can be misused and/or improperly applied. After all, you don’t use a hammer when a saw is called for, right?
But that doesn’t mean options are bogus (regardless of what your author might say) – far from it. You’ve just been blissfully ignorant of their importance until now.
At the risk of straining your brain, I’m including a reference to a post over on the commercial board:
http://www.creonline.com/commercial-real-estate/wwwboard5/messages/3699.html
Take care,
Eric C
PS - You’re welcome to search the archives on this board, the mobile home board, and the commercial board. I think you’ll find enough about options (of all types) to keep you reading (and learning)for quite a while. Enjoy.
Re: Lease Options - Bogus? - Posted by Kevin
Posted by Kevin on July 08, 2003 at 21:24:56:
Being new and trying to learn as much as possible about L/O’s as well as other vehicles used for RE investment I was a bit concerned when I read this article the other night. I posted it here (after trying to see if there had already been a discussion about it in the past) for all of you experienced investors to tell me it aint so - That the article is BS.
You have.
Thank you very much for your input and for setting the record straight. And thank you for putting my fears to rest.
Bogus??? NOT!!! The FACTS! - Posted by JohnBoy
Posted by JohnBoy on July 08, 2003 at 21:08:55:
You read one man’s opinion that was taken completely out of context and twisted around in an attempt to scare people from doing L/O’s.
You can read my response to this at this link I made over a year ago:
http://www.creonline.com/wwwboard/messages/arc_2002/arc_72/72379.html
Here is my response"
BOGUS LEASE OPTIONS REVISITED!
The following is a closer look at an article that has been posted about bogus lease options. In taking a closer look at this article, I’ve added my NON-lawyer opinions of how I read this based on the author’s exaggerated interpretations. By taking a closer look I think this could become beneficial to those that are just starting out and being able to see what you shouldn’t do when doing lease options and what you should do when lease optioning a property to a tenant.
For anyone that may have gotten any second thoughts about doing lease options after reading this over exaggerated and misleading article, I hope this helps to clear things up regarding any concerns this may have given you.
BOGUS LEASE OPTIONS
A Purchase by Any Name
By Stephen Stralka
NOTE: The title of this article says, “Bogus Lease Options”, yet the first thing the author starts out with pertains to what may be construed as a sale and would have nothing to do with a lease option.
The author says"
“”“A home buyer with insufficient funds for a ten percent down payment responds to a broker’s ad under “Home for Sale”; the ad indicates that the credit worthy can move into a pricey single family residence with a small down payment.”“”
The fact that the author indicates an ad to refer to a buyer being able to move into a home with a “small down payment” would indicate a sale is to take place. In a “sale” a “down payment” is usually required by a “buyer”.
In a “lease option” there is no “down payment”. In a “lease option” the “landlord” will typically collect “option consideration” for giving a “tenant” the “right” to purchase the “landlord’s” property at a predetermined future date. The “option consideration” is in no way, shape or form, a “down payment” and should never be construed as being a “down payment”. It is exactly what it is called, “option consideration”, period!
Next the author says:
“”“The buyer inspects the property, and decides that he would like to buy it. The seller is asking for five-percent down, and is willing to carry the balance.”“”
Here the author claims the “buyer” decides he would like to “buy” it. Whether this is a “buyer” or a “potential buyer” that becomes a “tenant” under a lease option agreement is irrelevant as to what they would “like” to do. If the “potential buyer” enters into a “lease option” agreement then the “potential buyer” is in fact, a “tenant” and not a “buyer”. The “tenant” does not become a “buyer” until the “option” is exercised, IF, the “option” is ever exercised. If the “option” is never exercised, then the “tenant” is never a “buyer” since in order to be a “buyer”, one must actually “buy” something.
Next the author states the “seller” is asking for “five-percent down” and is willing to “carry the balance”. Well if the “seller” is asking “five-percent down”, then this would indicate a “sale” is to take place with “seller financing”. In a “lease option” there is no “down payment” and there is no “seller financing” since the “potential buyer” will be a “tenant” under a “lease” agreement with an “option” to buy. Any money paid up front to the “landlord” under a “lease option” agreement is not received as a “down payment”. Any money paid up front by the “tenant” is paid as “option consideration”, period! It has nothing to do with a “down payment” since the “tenant” is merely “leasing” the property with an “option” to buy at a future date. There is no “carrying of a balance” in a “lease option”. There is only “rent” to be paid under a “lease”, not a “balance carried”. A “balance” is carried under a “sale agreement”, not a “lease option” agreement!
Next the author states"
“”“The five-percent down payment is called “option money,” and is to be applied to the purchase price should the option be exercised. Correspondingly, the monthly payment is called “rent,” and a portion of the rent is to apply to the purchase price - upon exercise of the option.
Thus, except for the absence of a note, trust deed and grant deed, the terms of this so-called “lease option” have all the economic characteristics of a carry-back sale. There is an agreed-to-price, a down payment, monthly payments toward principal and interest, and a three-year due date.”“”
WRONG! If this is a “sale” taking place with seller “financing”, then a “down payment” is collected. If it’s a “lease option”, then only “option consideration” is paid. It can’t be both! Either one or the other. It’s either a “sale” or it’s a “lease option”, but it can’t be both. If your contracts were to state a “down payment” as being paid, then that could be construed as a “sale” is taking place. If the money paid is stated as being “option consideration” being paid, then that is no indication of a “down payment” having been paid and is merely what it’s called, “option consideration”, plain and simple!
The author states the monthly payment is called rent. Under a “lease option” the money paid each month IS “rent”. Under a “sale” agreement the money paid each month is called “monthly payments”.
The author states there is an agreed-to-price, a down payment, monthly payments toward principle and interest, and a three year due date.
In a “sale” agreement this would be correct. In a “lease option” agreement this is not correct. A “sale” agreement would state an agreed-to-price, a down payment, monthly payments toward principle and interest, and a due date.
A “lease option” would NOT include a down payment, monthly payments, principle or interest being paid, or a due date.
A “lease option” would include “option consideration” being paid, “rent” to be paid, and a agreed upon “option price”.
You can’t have both. Either it’s a “sale” or it’s a “lease option”. How you word and structure the contracts can determine whether a “sale” is taking place or whether it’s a “lease option”. You either pay “monthly payments” that apply to principle and interest when a sale, or you pay “rent” which does NOT apply to principle and interest when a lease option. You either pay a “down payment” towards buying the property, or you pay “option consideration” towards getting the “option” to buy. Whether you “buy” under a contract “sale” or pay “option consideration” to get an “option” to buy, a purchase price is set and agreed upon between both parties. In some cases in a lease option, the purchase price could be determined based on having an appraisal done on the property at the time the option is exercised. But whether you set an option price up front or to be determined by an appraisal at the time of exercising the option, neither way affects the validity of whether or not it’s a lease option or a sale. It’s still a lease option regardless of when you determine what the purchase price will be.
The author further states:
“”“After closing, the buyer incurs financial difficulties and is unable to keep up with his payments. The seller attempts to evict the buyer for non payment of rents. The seller claims that the lease is terminated by a Three Day Notice to Pay or Quit and the buyer forfeits the right to the possession of the property and the amounts to be credited toward the purchase price.”“”
Here the author has terms that would be described in both, a “sale” agreement and a “lease option” agreement. You can’t have both, it’s either one or the other depending on which method the property is being offered. It’s either a “sale” taking place or it’s a “lease option”, but not both!
In a “sale” agreement there may be a closing at the time of entering into a “sale” agreement or the closing may take place later at the time the “buyer” pays off the balance owed on their contract, depending on the type of method being sold under. In the event of a default by the “buyer” in a “sale” agreement the “seller” may be able to “evict” or the “seller” may need to foreclose. That will depend on how the “seller” “sold” the property, the terms of the contract, the wording used in the contract,the type of contract used and what the laws are pertaining to the type of method the “seller” sold the property. In some States a “seller” may be able to “evict” the buyer vs. having to go through a judicial foreclosure to get the property back. Each State has different laws pertaining to contract “sales” and anyone “selling” on a contract should seek proper legal advice on how they are handled in their own State.
Under a “lease option” agreement, when the “tenant” defaults under the “lease”, the “landlord” can “evict” the “tenant”. A foreclosure is not necessary because there is NO “sale” involved under a “lease option” until the “tenant” exercises their “option”.
The author also states the “seller” claims the lease is terminated by a Three Day Notice to Pay or Quit and the buyer forfeits the right to possession of the property and the amounts to be credited towards the purchase price.
In a “lease option” the “landlord” may “evict” after serving proper notice. In a “lease option” there is no amounts forfeited that were credited towards the purchase price. Under a “lease option” anything offered as a credit to be credited against the purchase price is NOT credited until the time the “tenant” exercises their “option”. NO credits are given before that! The “option” agreement states any “option consideration” and any “rent credits”, if any, shall be credited towards the purchase price, IF, and ONLY IF, the “optionee” exercises the “option”.
So before any “credits” are actually given, the “tenant” must FIRST EXERCISE THE OPTION! If the “option” is not exercised, NO credits have ever been actually given to the “tenant”. The “tenant” MUST exercise the “option” before any credit towards the purchase price can be realized. The author claims this is all forfeited by the “buyer”, which is not a “buyer”, but merely a “tenant” until the “tenant” becomes a “buyer” later, only IF, the “tenant” exercises the “option”. So how does a “tenant” forfeit something they have never received to begin with??? In order to have something forfeited, one must have already received it! Any “rent credits” or “option consideration credit” is NOT received until AFTER THE FACT! The “tenant” must FIRST exercised the “option” BEFORE ANY CREDITS OFFERED CAN BE RECEIVED! So their is nothing forfeited in a “lease option” as far as “option consideration” and “rent credits” are concerned because the “tenant” never exercised the “option” in order to realize and receive the “credits” to begin with!
Next the author states:
“”“Can the seller terminate the agreement as a lease with an option and keep the buyer’s money?”“”
See how the author has worded this question and can easily confuse someone? Let’s rephrase the question the way it should be asked pertaining to a “lease option”.
Can the “landlord” terminate the “lease” and “option” and keep the “tenant’s” “rent” and “option consideration” paid???
If the “tenant” has defaulted and breached the contract, then ABSOLUTELY!!!
The author goes on to say"
“”“No! When a buyer in possession under an agreement receives credit toward the purchase of a portion or all of his payments to the seller, he has established and built up an “equity” in the property, and “ownership interest” which must be terminated by foreclosure.”“”
HUH??? WHAT CREDIT??? First of all, it’s the “tenant”, not the “buyer”. Second, the “tenant” has NOT received any credit towards the purchase price or any portion of the “rent” (not payments) towards the purchase price. There has been NO established built up “equity” in the property because the “tenant” does not “own” the property, nor is the “tenant” under any kind of a contract to “buy” the property. NO credits have been received by the “tenant” because the “tenant” has not exercised the “option” in order to receive and realize any “credits” that may have been offered, “IF”, and “ONLY IF”, the “tenant” exercises the “option”, the option must first be exercised. Again, you CAN NOT claim an equity interest because of something you NEVER HAD to begin with! The ONLY way the “tenant” can get any credits is by FIRST exercising the “option”. If they exercised the “option” then none of this would have ever been an issue since the “tenant” would have purchased the property!
Next the author states:
“”“A lease option agreement structured on terms economically consistent with a credit sale is neither a lease between a tenant and a landlord, nor an option to buy. This bogus “lease option” agreement is a disguised purchase agreement between a buyer and carry-back seller [Oesterreich v. Commissioner (1955) 226S2d 798].”“”
Here the author would be correct based on what he’s saying. IF the lease option is structured on terms economically consistent with a CREDIT SALE, then the lease option could be claimed as being bogus and disguised as a purchase agreement. This is WHY it’s very important to use properly worded and structured contracts. If it looks like a duck, walks like a duck and quacks like a duck…it’s a duck!
What the author doesn’t tell you about the case he mentions above is, that this case involved the IRS that reclassified the lease option as a sale because it involved a 30+ year lease.
Here is a quote from Attorney, Bill Bronchick pertaining to this case:
"The article refers to the ONE IRS CASE (Oesterreich v. Commissioner (1955)) that reclassified a lease/option on real estate as a sale. That case involved a 30 + year lease/option. That case is also 45 years old.
In TC Memo 1999-11 (decided 2 years go), the tax court clearly stated that a 3 year lease w/option was NOT a sale. You can read the case by following this link:
http://www.legalwiz.com/articles/tcmemo.pdf"
The author goes on to state:
“”“Thus, the seller can only terminate the buyer’s ownership interest in the real estate through judicial foreclosure - no trustee foreclosure provisions are written into lease options, since such agreements are purportedly not sales at all.”“”
Again, more garbage being blown completely out of context attempting to use terminology found in a “sales” agreement and mixing into a “lease option” agreement.
In a “sales agreement” there is a “seller”, a “buyer” considered to have “ownership interest” that may or may not require the “seller” to go through a judicial foreclosure.
In a “lease option” there is NO “sales agreement”, but merely a “lease” with an “option” to buy. The reason there are no trustee foreclosure provisions written in a “lease option” is because a “lease option” is NOT a “sale”. A “lease option” is just what it says it is…a “lease” with an “option” to buy. There is no foreclosure involved with a “lease option”. In the event the “tenant” defaults and breaches the “lease” or “option” agreement, the “landlord” files for eviction just as any “landlord” would have to do under any other “lease” agreement. A “lease option” is not, “purportedly not a sale at all”. IT’S NOT A SALE AT ALL, PERIOD!
THE BOGUS LEASE OPTION
The title used here is funny because what the author states under this title has nothing to do with a “lease option” what-so-ever!
The author says:
“”"A seller has a number of possible ways to structure carry-back financing for the sale of his property. He may, after a down payment:
· Convey title and carry back a trust deed (first or second) for the balance of his equity in the property;
· Convey title and wrap an existing first TD with all-inclusive trust deed (AITD);
· Enter into an unexecuted deposit receipt retaining title until escrow is opened and closed, and give the buyer occupancy under an interim occupancy agreement; or
· Use a land sale contract, also called a “Contract for Deed,” retaining a deed to secure payments of the balance due on the price.“”"
Conveying title and carrying back a trust deed for the balance of the seller’s equity is a “sale” and has nothing at all anything to do with a “lease option”.
Conveying title and wrapping an existing first TD with all-inclusive trust deed (AITD) is a “sale” and has nothing at all anything to do with a “lease option”.
Entering into some, unexecuted “deposit receipt” of some kind, retaining title until escrow is opened and closed, giving the “buyer” occupancy under an interim occupancy agreement has nothing to do with a “lease option”.
Using a land sale contract, also called a “Contract for Deed”, where the “seller” retains the deed until all payments have been made and the balance paid in full, is a “sale” and has nothing at all anything to do with a “lease option”.
Perhaps what the author should have included here was something stating to the effect…
“Anything including provisions listed below that are included in a lease option agreement would be considered a bogus lease option in an attempt to disguise a sale taking place and not a lease option.”
At least that would have added some merit to the title he used. Otherwise the title itself has no merit since everything he mentions pertains to a sale taking place and has nothing to do with a lease option!
The following section the author states:
THE CREDIT-TO-PRINCIPAL FEATURE
“”“Incongruously, the bogus “lease option” has the buyer/tenant receiving credit on the price for both the down payment/option money and a principle portion of the payment called rent.”“”
If in fact, the lease option agreement has the tenant/buyer receiving credit on the price for a “down payment” and a “principle” portion of the “payments”, calling it rent, then the lease option may be construed as being a sale and not a lease option. But under a “lease option” there is NO “down payment”, there is NO principle being paid, only “RENT” is paid and “rent” is called “rent”, plain and simple!
Again, ANY credits offered in a “lease option” are only applied AFTER the “tenant” goes to exercise the “option”. Until that happens, there is NO credits issued to the “tenant”, period! The “lease option” does not automatically apply any credits during the term of the “lease” or during the term of the “option”. NO credits are given or applied until AFTER the “tenant” exercises the “option”. The “option” must be FIRST exercised before ANY credits are to be applied! Otherwise, NO credits are given or applied, nor have any ever been given or applied! The “lease option” clearly states that, “IF”, and “ONLY IF” the “optionee” exercises the “option”, shall ANY credits be applied towards the purchase price!
The key words here are, “IF” and “ONLY IF” the “optionee” exercises the “option”, which clearly means there are NO credits given nor applied until AFTER THE TENANT EXERCISES THE OPTION!!!
The author goes on to say"
“”“Seller financing, no matter how drafted, delays payment of all but a small fraction of the purchase price. Thus, buyers are able to own and occupy a home with little or no down payment. Sellers are able to move their real estate in a slow market.”“”
And??? This refers to “seller financing” and delays payment of all but a small fraction of the purchase price. Umm…can we say…that’s because on ANY loan installment almost all of the payments being made are applied to the interest and only a small amount applies to the principle owed, due to the loan being amortized over 20 - 30 years!!! None of this has a thing to do with a “lease option”.
“”“The lease option becomes viewed as a form of seller financing, and is, in effect, a financing aberration which gains popularity in times of recession and tightening of credit.”“”
BS! Absolutely NOT true! A “lease option” has nothing to do with being a form of “seller financing”. If “seller financing” is involved, then it’s a “sale” taking place, period! “Seller financing” includes principle and interest payments. A “lease option” does not. A “lease option” pertains to a lease that collects “rent” and an “option” to buy at a future date. There is NO principle or interest payment involved with a “lease option”.
“”“Trust deeds and land sale contracts are fairly secure in their legal treatment - there exists a substantial body of case law and statutes relating to each, in spite of the extremely different foreclosure procedures. The legal situation of lease option financing is considerably less certain.”“”
Trust deeds and land sale contracts have nothing to do with “lease options”. “Lease options” does NOT involve any “financing”. The potential legal situation of a “lease option” can depend on how the contracts are structured, worded, length of time involved, whether principle and/or interest payments are involved or not, whether the “tenant” is required to pay property taxes and/or insurance or not, whether you use terms like “down payment” vs. “option consideration” or not, etc…
Again, this WHY it’s important to use properly structured contracts that include proper wording in order to prevent the “lease option” being ruled as a “sale” instead of a “lease option”. If you don’t, then the potential legal situation of a “lease option” is less certain.
Next the author says:
“”“Sellers - and unfortunately, brokers - view the bogus lease option as a purchase lease/option, a financing hybrid.”“”
Well I can’t speak for what some “sellers” and “brokers” may view a “lease option” as. Everyone has their own opinion as to how they may “view” something. But regardless of how one may “view” a “lease option”, “viewing” it has nothing to do with what it really is! Which IF properly structured and worded, it’s a “lease option” no matter what I or anyone else may “choose” to “view” it as!
Next the author states:
“”“A seller under a bogus lease option seeks to avoid all ownership responsibility and risk of loss by drafting the terms of the lease option to conform with those of a completed sale - that is, until the buyer defaults and the seller attempts to revert to the role of landlord and evicts the buyer as a non-paying tenant.”“”
If in fact, the “lease option” was set up as a “bogus lease option” in an attempt to cover up a “sale” where the “lease option” included wording that would constitute a “sale” has taken place, then perhaps. But under a “lease option” that is properly structured and worded, the “tenant” is responsible for taking care of repairs and maintenance as per the “lease agreement” which could easily be construed as being part of additional consideration for getting an “option” to buy, and does not avoid all ownership responsibility and risk of loss by the “landlord”. The “landlord” IS the owner and/or optionor of the property until the “tenant” actually exercises the “option” and “buys” the property! Regardless of who the “lease” makes responsible for taking care of any repairs and maintenance, the “landlord” bares ALL the responsibility and RISK involved, because the “tenant” could simply vacate the property and leave town at any time. The “landlord” is stuck with having to take care of any repairs and risks all the cost and losses involved by having to go in and take care of everything to protect the “landlord’s” investment!
Under a properly structured and worded “lease option”, if the “tenant” defaults the “landlord” evicts, period! That IS the way “lease options” are handled, plain and simple!
Next the author states:
“”“Specifically, inappropriate weight is placed upon the question of who holds the deed - which becomes a mortgage-in-fact.”“”
Specifically, the author is full of BS! There is no inappropriate weight placed upon the question of who holds the deed! There is NO QUESTION as to holds the deed. The “landlord” holds the deed because the “landlord” OWNS the property! The “tenant” is under a “lease” with an “option” to buy, period! The “tenant” has NO ownership interest in the property what-so-ever! The “tenant” is just that…the TENANT!
“”“What the seller has created is a land-sale contract, but with the wrong name on it.”“”
BALONEY! In order to be considered a land contract the “lease option” would have to be written under a long term agreement and include things within the contract to appear like a sale has taken place. That could include principle and interest, an amortization schedule, property taxes and insurance to be paid by the tenant, etc. Without any wording in the “lease option” to appear as if a “sale” has in fact, taken place, then a “lease option” is NOT a “land contract”.
Next the author says:
“”“The seller can’t have it both ways. A transaction is either a sale, or a lease with an option to purchase, but it can not be both. The hybrid purchase/lease/option arrangement does not exist. [Smith v. Morton (1973) 29 CA3d 616]”“”
Really??? Isn’t that what I’ve been saying all along, that you can’t have it both ways? It’s either a “sale” or it’s not! A “lease option” is NOT a sale if properly structured and worded!
Here is a quote taken from a post made by Attorney Bill Bronchick pertaining to the case cited above:
"As for state courts reclassifying a lease/option as a sale, it almost NEVER happens unless the lease/option really looks like a sale, e.g.:
*Large option deposit
*Long term lease
*Declining purchase price, as in a loan paydown
The article cites some very old CA cases which are not at all on point. The article cites Smith v. Morton, 29 Cal.App.3d 616, for example, which involved a 5 year contract written just like a sale. It used words like “interest,” “balance of the purchase price paid” and “monthly payments on account of the purchase price.” "
Next the author goes on to say:
THE REAL OPTION TO BUY
“”“Under a lease, a tenant pays rent, no part of which is credited toward the purchase of the property occupied. Non-refundable option money can be paid for an option to purchase which runs with the lease.”“”
Under a “lease” the “tenant” does pay “rent”! That’s what I’ve been saying all along! Under the actual “lease”, no part is credited towards the purchase price. But under a separate “option” agreement, a portion of the rent may or may not be offered to be credited towards the purchase price, “IF” and “ONLY IF”, the “tenant” exercises the “option”. Whether a credit is given when the “tenant” exercises the “option” is entirely negotiable between the “landlord” and the “tenant”, and it has NO bearing what-so-ever as to whether giving a credit against the purchase price at the time of exercising the option is construed as a sale or not! Anyone can agree to reduce the purchase price on their property if they so choose to do so. There is no law that I’m aware of that states you can’t! Whether the credit comes in the form of just lowering the price, giving allowances for any repairs, or giving a rent credit or crediting the option consideration paid makes no difference! Until the purchase actually takes place, then there is NO credits or price reductions given or realized! In order to receive any credits, you must FIRST BUY THE PROPERTY! This isn’t just freely given automatically to where you would be entitled to it if you didn’t buy the property! You have to first buy the property before the actual credit can be realized or actually given to you! That has nothing to do with the “lease” agreement. It all pertains to the separate “option” agreement!
Next the author states:
“”“However, the signing of the lease itself is nearly always the consideration for giving an option to purchase. Even if option money is paid, it is not credited toward the purchase price - option money is simply the consideration paid to keep the option open.”“”
Says who??? Sure, the signing of the lease itself “could” be accepted as the consideration for giving an option to purchase, but that is entirely up to the “landlord” to accept, not the “tenant”! Otherwise, ANY “tenant” just leasing a property could claim they paid consideration by signing a lease and that they are automatically entitled to an option to purchase! Get real!
Even if option money is paid, it is not credited toward the purchase price? Well, I guess I could agree with that since any option money paid that is credited towards the purchase price is only credited and applied, “IF” and “ONLY IF” the “tenant” exercises the “option”! I think I already covered this several times here! 
Even though the option money is simply the consideration paid to keep the option open…that doesn’t mean the “landlord” can’t agree to give the “tenant” that amount as a credit towards the purchase price, “IF” and “ONLY IF”, the “tenant” exercises the option. That’s entirely negotiable between the “landlord” and the “tenant”, and has no affect as to whether a “lease option” is a sale or not!
Here is a quote taken from a post made by Bill Bronchick pertaining to the option money and rent credits given in a “lease option” pertaining to this article:
"The article states that if ANY option money or monthly credit is given to the tenant, the lease/option is really a sale. Really? According to what legal authority?
Let’s look at the law:
In re Merten, 164 B.R. 641 (Bankr. S.D. Cal. 1994), a federal case applying CA law, ruled that an unexercised option to purchase real estate is PERSONAL property, not a real estate interest (hence no “equitable interest” in the real estate).
A recent GSA board of appeals tribunal (In the Matter of SAMUEL G. BAKER, GSBCA 15408-RELO, Jan 2001) ruled that a $15,600 option deposit on a lease with option did NOT create an interest in the property. You can read the facts of this case here:
http://www.gsbca.gsa.gov/relo/r1540810.txt
Again, the article is a GROSS exaggeration of the truth. A typical one to three year lease/option, even with option money down and small monthly rent credits will NOT be construed as a sale requiring foreclosure."
Next the author says:
“”“The option is the landlord’s irrevocable offer to sell the real estate to the tenant within a certain period of time - should the tenant decide to buy. The tenant is given the absolute right to buy or not to buy the property, at his discretion.”“”
Whoa!!! I don’t believe it! The author actually has a sentence in this article that he’s correct on without distorting the facts! It’s about time he got “something” completely right without exaggerating the truth!
Next the author says:
“”“When a tenant with a genuine option to buy exercises the option, it become an enforceable bilateral purchase agreement. Until then, the agreement between the two parties is a lease for all purposes, and the roles of the parties are narrowly defined in terms of a landlord/tenant relationship.”“”
Whoa! This guy is on a roll here! That’s two in a row he’s gotten right! Of course, this contradicts everything he’s been claiming all along in this article!
Here’s what the author says about an option not being an option at all:
NOT AN OPTION AT ALL
“”“If the tenant receives credit toward the price of the property, the lease option will be re-characterized as a land sale contract - a carry-back sale without trust deed provisions to avoid the seller’s need to judicially foreclose and exhaust his security; thereupon wiping out the equity the buyer has paid-for and built up in the property.”“”
Says who??? WRONG!
Again, here’s the quote made by Attorney Bill Bronchick pertaining to this:
"The article states that if ANY option money or monthly credit is given to the tenant, the lease/option is really a sale. Really? According to what legal authority?
Let’s look at the law:
In re Merten, 164 B.R. 641 (Bankr. S.D. Cal. 1994), a federal case applying CA law, ruled that an unexercised option to purchase real estate is PERSONAL property, not a real estate interest (hence no “equitable interest” in the real estate).
A recent GSA board of appeals tribunal (In the Matter of SAMUEL G. BAKER, GSBCA 15408-RELO, Jan 2001) ruled that a $15,600 option deposit on a lease with option did NOT create an interest in the property. You can read the facts of this case here:
http://www.gsbca.gsa.gov/relo/r1540810.txt
Again, the article is a GROSS exaggeration of the truth. A typical one to three year lease/option, even with option money down and small monthly rent credits will NOT be construed as a sale requiring foreclosure."
Next the author says:
“”“In each case, the seller (or the purported landlord) keeps the deed, while the buyer (or purported tenant) is in possession of the property, having paid money to the seller, which money is applied toward a purchase price to be fully paid in the future.”“”
There is no “seller”, “buyer” relationship until the “tenant” exercises the “option”. Until then, there is only a “landlord/tenant” relationship because the “landlord” is merely “leasing” the property with an “option” to buy. I have never heard of a case involving a “landlord” giving up the “deed” to their “tenant” in a “landlord/tenant” relationship!
There is NO money that has been paid as “rent” that has been applied toward any purchase price during the term of the “lease option”. The “lease option” is just that…a “lease” with an “option”. ANY monies offered by the “landlord/optionor” is only agreed to be applied as a credit towards the purchase price, “IF” and “ONLY IF”, the “tenant” exercises the “option”. Until the “option” is actually exercised, NO credits have been given what-so-ever, period!
Next the author claims:
“”"Other signs for establishing a purported tenant as an actual buyer in possession include:
· Shift of the burden of care and maintenance, and risk of loss to the tenant;
· Payment of property taxes and insurance premiums by the tenant in addition to the regular monthly payment, and impound agreement;
· Good faith improvements made by the tenant - i.e., improvements made in the good faith belief that he is the owner of the property [CA. Code of Civ. Proc. §871.1];
· Monthly payments which substantially exceed the property’s fair market rental value - since it costs much more per month to own a higher end property than to rent it; and
· A fixed dollar purchase price.“”"
WRONG!
A lot of leases that don’t contain an option to buy shifts the burden of care, maintenance and risk of loss to the tenant! That has nothing to do with a “lease option”. I use a straight lease that consists of 6 pages on legal size paper that shifts all the burden of care, maintenance and risk of loss (loss caused by the tenant’s negligence) to the tenant. This lease has been to court evicting a tenant that had no option involved and the Judge never blinked an eye about the lease! Just because someone was to give a “tenant” an “option” to buy the property they leased doesn’t have any validity as to what the “lease” says about repairs, maintenance and loss caused by the “tenant”, being the “tenant’s” responsibility!
A “lease option” does not state anything about the “tenant” being responsible for paying property taxes and insurance. In a “lease option” the “tenant” pays only “RENT”, period!
Good faith improvements made by the “tenant” - ie., improvements made on the good faith belief that he is the owner of the property??? What exactly does that mean? If a “tenant” elects to make improvements and claims to have done so in good faith with the belief that he is the owner, that makes it so? Does that mean if I in good faith went around giving toys to some children in good faith with the belief I was Santa Clause mean I am Santa Claus??? Baloney! Believing you’re the “owner” and actually “being the owner” is two separate issues! Under a “lease” agreement you are NOT the owner, regardless of what you do or believe! Under most lease agreements, ANY improvements made by the “tenant” on the property MUST be approved in writing by the “landlord” prior to making any. Failure to comply would be a breach of lease and the “tenant” could be evicted from the premises. Getting written permission from the “landlord” does not constitute any good faith and belief on the tenant’s behalf of being the owner. The “lease” should clearly state any improvements made by the tenant must be approved in writing by the landlord and any improvements approved in writing by the landlord shall become the property of the landlord’s. That would give notice to the tenant informing them that any improvements made by them will not belong to them, taking away any doubts as to who the owner of the property is!
As far as “monthly payments” which exceed the property’s fair market rent value…WHAT “monthly payments”??? There are no monthly payments in a lease option. Only “monthly RENT” is paid. As the “landlord” of any property you own, it’s the landlord’s right to charge whatever amount they so choose to charge as “RENT” for their property, period! (with the exception of being in a rent control district that may only allow a landlord to charge so much for rent). If the landlord succeeds in getting a much higher rent then that is what the market bares and would be considered fair market rent value. If the “tenant” thinks the rent is to high, they don’t have to sign a “lease” and agree to pay that much!
Whether a property’s mortgage is higher than what rents in the area are going for or not has nothing to do with anything! If anything, by being able to get a higher rent because of giving a tenant an option would only be considered additional consideration for getting the “option” to buy. It has nothing to do with whether a “lease option” is a “lease option” or a “sale”! The way the “lease” is structured and wording dictates whether it’s a “lease agreement” or a “sale agreement”!
Next the author says:
“”“A genuine option to buy within three or more years typically does not have a set price. Uncertainty as to what the property’s inflated and appreciated value will be in a number of years is a risk of ownership, a risk (or benefit) the fixed dollar price shifts to the purported tenant/optionee. If the price is set as a dollar figure, the setting is one indication that the property has been sold.”“”
Any “lease option” that exceeds a 3 year term is asking for problems. Any LONG term “lease option” runs the risk of being classified as a sale. You should keep any “lease option” agreement for less than 3 years. I prefer to keep them down to 1 - 2 years max! Then if need be, I can always agree to renew the “lease option” by giving the “tenant” a new contract that starts over or find another “tenant” to “lease option” the property to!
Next the author says:
“”“Courts look to the economic substance of a transaction over the legal form in which it is drafted - especially when calling an agreement by the wrong name misrepresents the party’s rights and obligations actually existing under the agreement. [City of L.A., CA v. Tilem (1983) 142 CA3d 694]”“”
If it looks like a duck, walks like a duck and quacks like a duck…it’s a duck!
A properly structured and worded “lease option” would not create a problem here!
Next the author says:
“”“If the buyer in possession is building an equity, the lease option is a land sale contract in everything but name. Any option money paid in is really a payment on the price, with the rents to be considered as interest and principal under a disguised mortgage. [Oesterreich, SUPRA]”“”
In a “lease option” the “tenant” does not build any equity, with the exception of any property appreciation during the term of the “lease option”. In order for the “tenant” to realize any equity by appreciation, the “tenant” must first exercise the “option” to gain any of the equity! Any option money paid is NOT really a payment on the price. It’s merely consideration for getting the “option” to buy the property. The author is contradicting himself here by saying this.
Above the author stated: “option money is simply the consideration paid to keep the option open.”
Now he back pedals by saying any option money paid in is really a payment on the price. Sheesh! I wish he would make up his mind already! LOL
Where does he get this “with rents to be considered as interest and principle under a disguised mortgage” crap from? My guess is this is coming from someone that had structured a “lease option” improperly that had something to do with a long term lease option and the purchase price being reduced drastically over a number of many years!
Any properly structured and worded “lease option” agreement for a 1 - 3 year term, that allows for a small rent credit to be applied towards the purchase price, “IF” and “ONLY IF”, the option is exercised would not constitute a disguised “sale” nor would it be considered as interest and principle being paid under a disguised mortgage!
Now look at the editor’s note:
“”“Editor’s Note - There is no legislation providing for the re-characterization of a bogus lease option as a masked land sale contract. However, statutes relating to similar lease-back arrangements involving equity purchasers have codified.”“”
Isn’t this a hoot! NO legislation providing for the re-characterization of a bogus lease option as a marked land sale contract! Yet, all the author has done in this article is toot his own horn on how lease options are bogus! What a joke!
Next he adds in, “However, statutes relating to simular lease-back arrangements involving equity purchasers have codified.”
HUH? How is a lease-back to seller in distress anything simular to doing lease options in general??? This relates to investors bailing out sellers in distress by paying off the loan, or bringing the loan current and getting the seller to deed over the property, then the investor letting the distressed seller remain in the property by giving them a lease option allowing them to have an option of buying the property back at a future date for a much higher price. Some courts have ruled this practice to be nothing more but a glorified high interest loan made by the investor. This has nothing to do with lease options in general.
The author goes on to say:
“”“For example, an investor acting as an equity purchaser buys a property and leases it back to the seller with an option to buy. The transaction is not a genuine lease option: it is a real estate loan. The lender, who characterizes himself as an investor/buyer, in this case holds the grant deed to the property as security for repayment of principal and interest, rather than using a trust deed to document the transaction. [CC§1695.12]”“”
See my response above.
Next the author says:
“”“When a lease option is a masked land sale contract, the tenant with a purchase option becomes a buyer with equitable ownership of the property - equitable because he is in possession of the property and makes the payments, which applies in part against the purchase price, but has not yet received the deed. [Mc Clellan v Lewis (1917) 35 CA64]”“”
IF, the lease option is ruled as being a masked land sale contract! what the author doesn’t tell you is, IF! Instead he says, “When”, which would imply it “will” happen if it went to court. Not true! It all depends on how the lease option is structured and worded as to whether a court would rule the lease option as a masked land sale contract or not. The author doesn’t tell you that though! Instead he cites a case without telling about any of the details as to WHY the lease option in this case was masked as a land sale contract. I’ll wager that this case involved an improperly structured and worded contract with all the makings of a sale as to WHY it was ruled as a masked land sale contract!
Next the author says:
“”“The landlord in fact becomes the carry-back seller in law - a secured with different rights than an owner - even though me may retain the title. [LA Invest. Co. v Wilson (1919) 181 C 616]”“”
Again, more than likely a case involving a lease option agreement that was structured and worded wrong and included wording that is found in a sale agreement and not a properly structured and worded lease option agreement!
THE BUYER DEFAULTS
“”“When a land sale contract is masked in the form of a lease option, most of the resulting problems occur when the tenant/buyer defaults in payments and refuses to vacate and sign a release (deed in lieu of foreclosure).”"
Sure, “IF” it’s in fact a land sale contract that is masked in the form to look like a lease option! If it’s a properly structured and worded lease option agreement then there is nothing to worry about with having the lease option ruled as a masked land sale contract!
The author claims:
“”“Evicting a non-paying tenant is relatively quick and inexpensive compared to a foreclosure. The distinction becomes a most prominent reality when a purported landlord finds himself reclassified as a carry-back seller, and has no tenant to evict. His tenant is, in law, the equitable owner of the property.”“”
Again, IF you structure your contract to look like a duck, walk like a duck, and quack like a duck…your going to have a duck!
“”“The landlord/seller will incur great expense in time and money in order to rid himself of a defaulting lease option tenant who claims to be a buyer with equitable ownership rights. The cumbersome process of a judicial foreclosure will be required to eliminate the tenant/buyer, since there is no trust deed power of sale clause.”“”
Depends! If the lease option agreement has been properly structured and worded, then a simple eviction process is all that will be required, regardless of what the “tenant” may claim! Even if the lease option was improperly structured and worded, it doesn’t automatically mean a foreclosure will be required. It will depend on the laws in your state pertaining to land contract agreements. In some States an eviction still may be all that is required. To avoid this all together, use properly structured and worded lease option agreements!
“”“If the seller refuses to allow a redemption payoff, the buyer in possession is entitled to a specific performance action against the seller. This is true of real leases with purchase options as well, since the tenant need only exercise the option to create and enforceable purchase agreement.”“”
Here the author first talks about “sellers” and buyers". In a lease option agreement we have “landlords” and “tenants”.
The author states, “This is true of real leases with purchase options as well, since the tenant need only exercise the option to create and enforceable purchase agreement.”
Sure, the tenant need only exercise the option to create an enforceable purchase agreement, but SO??? If the tenant can exercise the option and buy the property, then GREAT! PAY ME!!! Only one question though? IF the tenant has defaulted because of non-payment of rents…HOW ARE THEY GOING TO EXERCISE THEIR OPTION WHEN THEY HAVE NO MONEY AND BEHIND ON THE RENT??? But if they can, great! Just pay me off and we’ll all walk away happy!!!
“”“At the very least, the lease option buyer is entitled to a refund of ALL AMOUNTS HE HAS ADVANCED TOWARD THE PURCHASE PRICE. The seller may not keep the buyer’s money on default, since foreclosure of an equitable ownership is not permitted. [Peterson, Supra]”“”
In a “lease option” the “tenant” has NOT advanced anything towards the purchase price, unless the there were specifically additional payments made by the “tenant” in addition to the “rent” being paid that was specifically to be paid towards the purchase price! ALL the “rents” paid were paid “rent”, period! The “tenant” is NOT entitled to a refund of any “rents” paid! Any rent credits would NOT be refundable since the credits were not yet given or applied before exercising the option! The “landlord” would NOT be keeping any of the “tenant’s” money on default, since any “rent” that was paid is the “landlord’s” money, and NOT the “tenant’s” money! Any “option consideration” paid is NOT the “tenant’s” money, it’s the “landlord’s” money for SELLING the “tenant” an “option” to buy the property. Option money is NON-REFUNDABLE!!!
“”“Forfeiture is not an issue when a genuine purchase option is attached to a lease. Any payment the tenant makes is not part of the price. It is either rent, or it is non-refundable option money: consideration paid the seller for keeping the property off the market and the option to purchase open. Only when credit is given toward the price to be paid upon the exercise of the option does the purported tenant obtain an interest in the property.”“”
WRONG! First of all, any credits offered are NOT given until the option is exercised, period! Now if credits were given and realized before the option is exercised, then perhaps. But NO credits are given or realized until the tenant first exercises the option! Remember, credits are offered to be given, not just given during the lease or option period, but merely OFFERED to be given, “IF” and “ONLY IF” the option is exercised! In order to be given the credit the option must first be exercised!
TAX ASPECTS
“”“Tax-wise, lease options are often re-characterized as disguised carry-back financing or land sale contracts.”“”
Often??? Out of the THOUSANDS of lease options being done every year, how many have been re-characterized as disguised carry back financing or land sale contracts? Any of the ones that have been related to long term contracts and/or drastic principle reductions against the purchase price that occur over the term of the contract, perhaps! This is NOT the case in any lease option agreement that is over a 1 - 3 year period!
“”“Strong income tax incentives exist for sellers to conceal property sales behind bogus lease options. Under a true option agreement, any option money received by the seller is not reportable as profit or income until, respectively, the option is exercised or expires, or the property is sold subject to the option.”“”
The fact that any option consideration doesn’t have to be reported until the option is exercised or expires has NOTHING to do with a lease option being a concealed sale!
“”“Thus, if the seller can convince the IRS that the principal and the interest payments he receives are really option money, he will pay no taxes on the “option money” until the buyer exercises the purchase option, or allows the option to expire.”“”
There are NO principle and interest payments in a lease option agreement, period! Option consideration is NOT a principle and interest payment. Option consideration is exactly what it’s called…OPTION CONSIDERATION!
“”“The seller, disguised as a landlord, will also deduct as an owner’s tax benefits the property’s annual depreciation - until re-characterized by the IRS.”“”
The “landlord/owner” of the property is entitled to deduct as an owner, tax benefits against the property! The author tries to make someone reading this to assume that if they do lease options, they WILL be recharactorized by the IRS as being a seller under a disguised sale agreement. Not true! A properly constructed and worded lease option agreement is NOT a disguised sale!
“”“However, tax courts look to a number of factors, including the buyer’s equity, who bears the risk of loss, who pays property taxes, the relationship of rent to market value, and the price paid upon exercise compared to the property’s value at the time of exercise, to determine whether a purported lease option is really a sale.”“”
When using a properly structured and worded lease option, there is NO buyer’s equity, the landlord always bears the risk of loss, the landlord pays the property taxes, the price in relation to the property’s value is usually within 10% of market value, and the lease option IS a lease option and not a sale!
“”“If the lease option is found to be a sale in fact, the transaction will have been improperly reported. The seller will have to report the option credits toward price as payments on the principal ( allocated to profit and basis) and the balance of the rents as interest, and pay interest penalties or worse.”“”
IF the lease option is found to be a sale! Again, use properly structured and worded contracts, keep them down to a term of 3 years or less, and the lease option won’t be found to be a disguised sale!
“”“Similarly, and for consistent reporting, the buyer may not deduct the payments as rent. [MW Gear Co. v. Commissioner (1971) 446 F2d 841]”“”
A “tenant” is not allowed to deduct “rent”. Never has been!
CONCLUSION
“”“Sellers often seek to combine the advantages of leases with sale transactions by structuring their sales as lease options. However, the purchase/lease/option hybrid financing does not exist. A transaction is either a lease or a sale: not both”“”
Solution! Don’t be a seller trying to disguise a sale as a lease option! Instead, if you do lease options, be a “landlord” that use’s properly structured and worded contracts and keep the term down to 3 years or less! .
A transaction is either a lease or a sale, not both. Gee…where have I heard that before???
“”“In a genuine lease with an option to purchase, neither any portion of the rent nor any option money paid applies toward the purchase price upon exercise of the option.”“”
WRONG! The fact that a lease option offers any rent credits or offers for the option consideration to be applied towards the purchase price, “IF” and “ONLY IF”, the option is exercised has NO bearing as to whether a lease option is genuine or not! This is plain BS!
When you offer rent credits and offer the option money to be applied towards the purchase price, “IF” and “ONLY IF” the option is exercised, and your “tenant” has exercised the option at which time the “tenant” receives the credit and after closing on the sale of the property, is that not a genuine lease option deal that successfully closed already??? Was there any recharactorizations of the lease option being called a sale by the IRS? Has any of these properly structured and worded lease option agreements that offered rents credits and offered the option money to be applied to the purchase price, ever been over turned by any court and reclassified as a sale??? I sure haven’t heard of any and with all the thousands of lease options being done year after year, where are these cases reclassifying them as sales???
“”“If money paid by the tenant for rents or option consideration is applied toward the price, the transaction is not a genuine lease with a purchase, but is a disguised carry-back sale - a land sale contract.”“”
WRONG AGAIN! There is NO rent money or option money applied to the purchase price during the term of the lease option. The credits do NOT apply until after the fact! Which means the credits are only an “offering” as an incentive for the “tenant” to exercise the option, at which time any credits shall be given and realized by the “tenant” at the time of closing on the sale of the property, which takes place AFTER exercising the option.
“”“The courts can easily re-characterize purported lease options as disguised sales, exposing sellers to all the consequences of mortgage law.”“”
If the Judge gets up on the wrong side of the bed he can rule any way he desires! Does that mean we should never do lease options? If that’s the case, don’t do anything and never leave the house! Otherwise you could just as easily find yourself in court before a Judge being sued or prosecuted for something, whether you are guilty or not and the Judge throws the book at you because he got up on the wrong side of the bed!!! Quick! Everyone go into hibernation for the rest of your lives!!! LOL
“”“If the lease option is found to be a disguised sale, the tenant is re-characterized as a buyer who builds an equity and has an ownership interest in the property.”“”
“IF”! IF, IF, IF! Again, use properly structured and worded contracts and this will eliminate most, if not all the IF’s!
“”“The seller may not simply evict a defaulting buyer as he could a tenant. The buyer’s interest can only be terminated by judicial foreclosure, since the lease option seller has no trust deed power of sale provision.”“”
What does a defaulting buyer have to do with a defaulting tenant under a lease option agreement? Nothing! Also, depending on the state you live in and how you sold the property as a seller financing the sale, you may or may not need to foreclose depending on the laws in your state and how your contract is structured and worded!
“”“Also, if a lease option is re-characterized as a sale, the transaction will have been improperly reported for federal and state income tax purposes, and the property will be reassessed based upon a change of ownership.”“”
There’s that “IF” word again! IF, IF, IF! Don’t structure a lease option as a sale agreement and there should never be a problem!
“”“Regardless of what the form of a transaction may be; if its economic substance indicates it is a sale, it will be treated as such for all purposes. Don’t forget: all lease options, irrespective of their form or duration, do trigger due-on-sale clauses.
CEA News 8/91"”"
Well, this makes a total of 3 lines in this entire article where the author hasn’t taken something out of context or grossly exaggerated the facts!
It’s also common knowledge for most, that any type of an “option” violates a due-on-sale clause.
There you have it! The above responses to the author’s grossly exaggerated article are based on my own non-lawyer opinion and are a direct response to the author’s misinterpretations of what he “thinks” are the facts!
That’s my story and I’m sticking to it!
PS.
Any of the attorney’s here reading this, feel free to chime in and correct me on anything I may have wrong in my opinions.
JohnBoy
Re: Lease Options - Bogus? - Posted by GL - ON
Posted by GL - ON on July 08, 2003 at 17:00:09:
Why not read the whole story? The author explains how to do a lease option that will stand up to legal scrutiny, as well as the kind that are considered an installment sale in disguise.
Have a question for Bill and others - Posted by ken in sc
Posted by ken in sc on July 09, 2003 at 09:52:18:
Saw your post here and thought I would take the opportunity to ask you this question. Here is the story.
I have a house for sale ls/option. My option agreement states that they give me $3600 option consideration and if for any reason they do not buy, $1000 is treated as damage deposit on the seperate lease form. The other $2600 is non-refundable. I tell them that this way they only have $2600 at risk and we can part friends if they get a job transfer and they just give me notice and leave the place clean.
Now, this couple looked at the house and wanted to buy it. We agreed on a slightly higher price if I would install new carpet. Fine by me. They came in last thursday and signed the option and wrote me a check for $2000, with the balance due at the lease signing after I installed the carpet. This was written in an addendum to the basic option form. On Monday he calls and wants out of the deal as he got the transfer he applied for months ago but did not think he would get. Of course he wants his $2000 back. I told him it would not be fair to give it back as I would not give it back to any other tenants. He says that since he has not moved in and I have not installed the carpet and it has only been a few days, what’s the big deal? I told him that I have to treat all people the same - what if I gave him his money back but did not for a minority a few months from now? I could be sued for discrimation. He was nice enough on the phone but did say “I guess we will have to go to court”. I told him I would think about it and get back to him.
Now, the $2000 while I would like to keep it is really not the main issue but the precedent does worry me. I would like to know that I follow written contracts to the word and do not discriminate.
Any thoughts or wise council?
Thanks, Ken
Re: Bogus??? NOT!!! The FACTS! - Posted by Bill Gatten
Posted by Bill Gatten on July 09, 2003 at 18:03:50:
JohnBoy,
Your very complete and well thought out article is certainly from the heart; however, I’d say maybe too ‘much’ from the heart, and not enough from cases, codes and cites.
The fact is that, as exaggerated as Stralka?s article may seem, I personally know of dozens of L/O’s that have failed precisely because of the things he talks about. The occurrences he refers to is precisely why Coldwell Banker (to name just one large company that has made that dictum) forbids its agents to do lease options (even though, in spite of the due-on-sale violation, most local Realtors Associations continue to publish Lease Option forms for the use of their Realtor members).
JB, I get these ?bad L/O? reports on regular basis from folks who are either attempting to side with the Equity Holding Trust Concept (to kiss up): though for each one intended to butter me up there is another that honestly attest to my contention that there is indeed a far better way of doing lease options). I know at least 6 or 7 have even been spoken of here on the website within the past year or so.
Understand that I am not Chicken Little (as I was once referred to on this board), and the sky is not falling. It’s just that there is a better way. And the post in question is proof of how many folks still remain unaware of the pitfalls of lease options (whether they can be accepted and absorbed, avoided or just ignored or not).
If you have a way of creating a straight lease and straight option that do no relate to each other, then these admonitions and warnings are not for you. But, believe it or not, there a a bunch of folks out there who are not as smart, adroit or experienced as you are when it comes to these things who are screwing up royally because of listening to LO proponents.
Can a Lease Option guarantee the following (if so, I am wrong about my assertions that there is a better way)?
-
Provide protection again a tenant?s forcing foreclosure and ejectment action versus a simple eviction
-
Avoidance of a claim of Equity by a tenant who asserts that his rent credit or option fee are in fact installments toward ownership
-
The ability to transfer income tax write-off of the tenant without a transfer of title or creation of a Cont of Sale
-
Avoidance of a direct violation of a lenders due-on-sale admonition
-
Avoidance of deadlocks between Optionee and Optionor in the event of dispute
-
Protection against an Optionor?s changing his/her mind and forcing judicial action on top of the cost of purchase and all monies paid for credits and the option fee
-
Avoidance of the possibility of the Optionee be carrying the option over for months after the option has expired, when the property has appreciated significantly and the Optionee had failed to exercise its option on time (we were involved in just such a case a year or so ago)
Suggestion, at least rethink you ?attitude,? even if everything you say may be absolutely true and correct. I have no bones to pick, my quest is only to scream about there being a better way for anyone willing to go to the trouble.
Bill
Re: Bogus??? NOT!!! The FACTS! - Posted by Tom-FL
Posted by Tom-FL on July 09, 2003 at 04:56:13:
Great diatribe there. One thing you missed though:
“A genuine option to buy within three or more years typically does not have a set price.”
Within three or more years? Is it within three years? Or is it more than three years? Seems to be covering all bases there.
I also did a quick add up of the LO ads I see in my local paper, applied some magical math and a fair amount of pixie dust to it, and guesstimated that there are perhaps 5000 lease/option contracts done per state per year, totaling 250,000. The earliest case sited in the article was 1917. So in 86 years and 21,500,000 contracts, this guy was only able to find 5 or 6 that went south. I’d say that’s pretty good odds.
Re: Lease Options - Bogus? - Posted by JohnBoy
Posted by JohnBoy on July 08, 2003 at 21:11:25:
His story is so twisted it mixes L/O’s with a sale in an attempt to make people think L/O’s are just a disguised sale. You can read my response to his article above in response to Kevin.
Re: Have a question for Bill and others - Posted by DavidV
Posted by DavidV on July 09, 2003 at 11:11:18:
I’m sure you’ll get both sides of the fence. As far as possibly going to court i take the “what the heck can i do to stay out of court” approach. Way to much headache. I look at it as the same as if someone gives me a deed and changes their mind the next day. I’ll give it back, and ask for any costs back (title search, etc.) Just not woth the hassle to me.
I use an “enforcement” clause ( i think its from Bronchick’s stuff) that says something like… i may or may not enforce something in the agreement now, but doesn’t preclude me from enforcing it if you do it again. Not sure that is what you’re looking for. Seems like you would just be making a settlement to break the lease, not a precedent in my humble non-lawyer opinion. Doesn’t mean you have to settle to break every lease.
What i would do is tell the guy i took my marketing off the property and turned away potential renters over the weekend. Settle for part of the 2K and find someone else. Just my humble opinion.
David
Re: Bogus??? NOT!!! The FACTS! - Posted by JohnBoy
Posted by JohnBoy on July 09, 2003 at 22:46:39:
Can a Lease Option guarantee the following (if so, I am wrong about my assertions that there is a better way)?
- Provide protection again a tenant?s forcing foreclosure and ejectment action versus a simple eviction
Absolutely! If you structure your contract to look like a sale, then no. But a properly structured L/O will not force a foreclosure suit. A simple eviction is all that will be required.
- Avoidance of a claim of Equity by a tenant who asserts that his rent credit or option fee are in fact installments toward ownership
Absolutely! Again, a properly structured L/O will not cause for any rent credits or option consideration to be construed as equitable interest. You don’t give rent credits during the L/O period. You only give rent credits AFTER the L/O period at the time of closing the sale. Rent credits do not apply and are not applied until AFTER the tenant exercises the option. If you don’t exercise the option, then there are NO rent credits.
- The ability to transfer income tax write-off of the tenant without a transfer of title or creation of a Cont of Sale
This is a non-issue. We don’t transfer tax write offs in a L/O. Even if I had the ability to do it, I would never allow it. It’s never been an issue and there is no reason to make it one. I don’t see the need to have it just to use as a selling point.
- Avoidance of a direct violation of a lenders due-on-sale admonition
ABSOLUTELY! Again, as long as the lease option is structured correctly. Federal Law states the DOSC is not violated by giving a leasehold interest for 3 years or less, and as long as the lease does not contain an option to buy. Key wording here: As long as the LEASE does not CONTAIN an option to buy. A straight option does not violate the DOSC. But a lease that contains an option does. So use separate contracts. A straight lease of 3 years or less and a separate straight option agreement. No DOSC violation. This pretty much goes along with your argument where Federal Law states: As long as the owner remains “A” beneficiary of the trust. Well, if the L/O is properly structured, where the LEASE itself, does not CONTAIN an option, and where the option is SEPARATE as in, using a straight option, then no DOSC violation.
- Avoidance of deadlocks between Optionee and Optionor in the event of dispute
Absolutely! This is why we have the deed in escrow with written instructions. This avoids any deadlocks!
- Protection against an Optionor?s changing his/her mind and forcing judicial action on top of the cost of purchase and all monies paid for credits and the option fee
Absolutely! As long as you use properly structured contracts this is a non-issue. Have all the proper docs held in escrow with written instructions. Of course, nothing in this world can guarantee you will never have to deal with a judicial proceeding. Anyone can sue anyone over anything, no matter how frivolous.
- Avoidance of the possibility of the Optionee be carrying the option over for months after the option has expired, when the property has appreciated significantly and the Optionee had failed to exercise its option on time (we were involved in just such a case a year or so ago)
Yes. A contract is a contract, period. If the contract expires, there is no longer a contract!
Bill, I understand the things the author was saying. But he mixes L/O’s along with all the makings of a contract sale. He even contradicts himself in the article. He wasn’t just pointing out the pitfalls of doing L/O’s incorrectly. He was making L/O’s out to sound like all L/O’s are nothing but disguised sales.
I don’t argue the fact that if you use terms like, down payment, interest and principal, taxes and insurance, in your contracts and naming them a lease option, that you could and will have problems with it being classified as sale. There are people that do these things and they are doing them incorrectly.
My response had nothing to do with coming from the heart. Not at all. My response was coming from my opinion based on the facts as I know them to be.
I’m not saying there are not better and safer ways of doing deals other than doing L/O’s. That was not the subject here and has nothing to do with the authors article. His article did not address other methods. It only bashed doing L/O’s making it sound like all L/O’s are bad and bogus that will be reclassified as disguised sales. This is simply not true and you know that. This isn’t about comparing other methods that may be safer to use. It is about doing lease options and nothing else.
Re: Lease Options - Bogus? - Posted by GL - ON
Posted by GL - ON on July 08, 2003 at 21:30:17:
I have some lease option courses that recommend doing lease options a certain way so they won’t be considered a disguised installment sale. Two of the things they mention are having a separate lease and option, and not giving a rent credit.