Lease Purchase vs. Lease Option - A Potential Solution for Your Buyer or Seller
Lease Option or Lease Purchase Agreements, commonly referred to as “Lease-to-Own” Agreements are mistakenly used interchangeably, although they are vastly different. These agreements allow a potential buyer to occupy the seller’s property for a period of time before completing the sale. This arrangement can assist either or both parties in meeting their goals and needs with respect to the transaction and their specific circumstances. In some instances, these agreements may even allow a buyer the opportunity to build a bit of equity in the home as well.
It is important to understand the distinction between a Lease Option Agreement (“Lease Option”) and a Lease Purchase Agreement (“Lease Purchase”).
A Lease Purchase consists of two separate contracts:
- The residential lease which provides for the tenant-buyer’s lease of the property for a specified term; and
- The contract for sale which obligates each party to the typical terms of a residential purchase agreement upon the expiration of the specified lease term.
Typically this kind of agreement provides what are referred to as cross-default provisions to ensure that a breach of one of the agreements will result in an automatic breach of the other. As the tenant-buyer has contracted to purchase the property in the context of a Lease Purchase, oftentimes the lease will provide that the tenant-buyer is responsible for maintenance and repairs which are typically the duty of the landlord.
A Lease Option operates very similarly to a Lease Purchase in that it consists of two agreements and theoretically allows for the tenant to ultimately purchase the property. However, the tenant does not sign a contract for sale but instead enters into an option agreement (“Option Agreement”).
An Option Agreement provides the tenant-option holder the right to purchase the property at an agreed price during the lease term or other specified term, also called the “Option Period”, in exchange for a fee paid to the seller called the “Option Fee.”
This looks very similar to a deposit on a contract for sale which is why the Lease Option and Lease Purchase are so often confused. A Lease Option also provides for the cross-default provisions, and the Option Fee referenced above is typically non-refundable. Upon a tenant-option holder’s election to exercise their option to purchase the property, the Option Fee is usually credited to the purchase price, however, there may be an additional deposit required upon the parties’ execution of the contract for sale.
A key distinguishing factor of the Lease Option is that the agreement does not obligate the tenant to purchase the property, but does obligate the seller to sell the property if and when the tenant properly exercises the option to purchase.
Both the Lease Purchase and Lease Option create landlord-tenant relationships. Therefore, if the tenant defaults, the landlord-seller would evict the tenant-buyer or tenant-option holder like a normal tenant. An issue that may arise in the context of an eviction of a tenant to a Lease Purchase or Lease Option is an equitable interest claim. Although not typically successful, a tenant may assert an ownership interest in the subject property, which is grounded in the idea that a Lease Purchase or Lease Option is essentially the equivalent of a sale, similar to an installment land contract (or contract for deed), whereby the seller retains title to the property as security until the balance is paid by the buyer. If an equitable interest argument prevails, the landlord-seller will be required to remove the tenant by way of foreclosure action, as opposed to a more simple eviction.
What to consider before an agreement
To avoid a potential successful equitable interest claim, a seller should consider certain things when constructing the Lease Purchase or Lease Option:
- Structure of Lease Purchase or Lease Option should not resemble a contract for deed;
- Limit the lease term to one year or less;
- Provide for a security deposit (sellers don’t take security deposits, landlords do);
- Seller should continue to pay taxes and insurance on the property;
- Do not give large rent credits (this only creates more equity the tenant can claim);
- Refrain from using the words “credit”, “seller” and “buyer” in the lease agreement and/or option agreement portion of the Lease Option; and
- Will the tenant-buyer/option holder be making improvements, and what will the value be of such improvements?; and
- What is the difference between the tenant-buyer/option holder’s option price and the fair market value of the property? The closer these amounts, the more equity one could claim.
If you have questions regarding Lease Purchase, Lease Option or any real estate transaction, please contact us.
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