|Is there a big difference between a lease option and
a contract for deed?
The lease option and the contract for deed are both popular methods of creative financing.
However, that's where the similarities stop.
First, let's start with the lease option. A lease option is not a sale it is a standard
rental agreement with an added perk (the opportunity to purchase). A lease option actually consists
of two separate and very different agreements - the lease and the purchase option. The lease is the
written agreement under which the property owner allows a tenant to use the property for a specified
period of time in exchange for the payment of rent. In the option contract, the seller gives the buyer
the exclusive right (or option) to purchase this leased property. Typically the price is set at the
time the lease is written, and usually the "option" period is the same as the length of the
lease - but this can change especially if you are an investor.
Keep n mind, a lease, just like a sales contract is a "two-sided" agreement. Both
the landlord and the-tenant are legally bound to the contract. An option contract, on the other hand,
is "one- sided". The seller gives the "option", but the buyer is not legally
bound to take it.
For tax purposes, a lease option is treated the same as any other lease until the option is
exercised, then it would be considered a sale.
A contract for deed is a sale. The seller holds legal title to the property as security for
payment, while the buyer has "equitable" title. This equitable title gives the buyer the
right to live in the property, improve it, rent it and otherwise enjoy all of the benefits of
ownership. However, since the buyer does not have legal title, he typically cannot use it as
collateral for a home equity loan. When the buyer pays the full amount due under the contract, the
seller delivers legal title to the buyer. For tax purposes, the IRS generally treats a contract for
deed as a sale, which means the buyer has the tax benefits of ownership. The payments of interest that
are made by the buyer in possession are deductible as "mortgage interest," even though the
buyer does not have legal title to the property. A contract for deed seller must report the
transaction as an installment sale on IRS Form 6252. Once sold, the seller cannot claim depreciation
or any other tax benefits of the property. If the buyer defaults on the contract and the seller
exercises his legal option to reclaim the property, the tax code treats the transaction as a
foreclosure- not where you want to be as an investor.
Which one works best?
To determine which way to go you will need to consider many factors, such as the buyer's
situation, the market, and what you need at that time.
Contract for deed has a major downside, you may have to foreclose, which could take a lot
more time (and money) than a simple eviction. Also, the entire balance paid on the contract will
be due as a capital gain, which could mean a big tax hit if you have a low basis in the property.
With a lease option, you, (as the landlord/seller), maintain legal control of the property
with the ability to claim depreciation and to defer gains by 1031 exchange. But, along with all
these benefits of ownership, you still have all the burdens of upkeep and landlord duties. You want
to structure your agreement to ensure that if the tenant fails to purchase the property, you get to
keep the non-refundable option money payment and any additional rent that was paid for the option.
Most renters would like to buy, but lack of cash or credit is holding them back. The typical
tenant wants to plant flowers and wallpaper, but only to their own home.
Investors like upfront cash and steady monthly income with minimal hassle, but don't want to
take a chance on just any credit problem off the street. Therefore, I believe that Lease Purchase AKA
Rent To Own is by far a superior way to control real estate, whether a investor or someone looking for
The aim of this article was to give the reader a basic understanding of the contract for
deed Vs lease option approach to real estate; hopefully I have accomplished that in the context of
James A. Gage. is a best-selling author and internationally-known expert in Lease Purchase, AKA
Rent To Own Real Estate Investing and Negotiating. He Mentors One-On-One throughout the U.S. and
across the world. James is also director of the Gage Consulting Group, LCC , 800 Main Street,
Suite 104 Holden, MA 01520 . http://www.jgage.com
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