Solrak & JRyan,
Since this is your first lease option, there is much you should be aware of before committing yourself to this type of transaction. I don’t want to be a party pooper but you should have this information available. Lease options are great for the buyer. Anytime you are on the Seller’s end of the lease option, you are taking a big chance.
It is a myth that you can get much higher rents with lease options because the “buyer” really has no homeownership benefits other than an option to buy at a later date. He has no tax or interest writeoffs and no share of future appreciation.
Sellers often seek to combine the advantages of leases with sale transactions by structuring their sales as lease options (as you have done). 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 (EQUITABLE) 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.
In addition, some states have some squirrely rules to follow. Texas has banned lease options and Arizona is very strict. Here is a list of five things that may violate the law and cause the judge to classify the transaction as a “disguised sale”. This is not my list, but the list prepared by a Judge in Arizona who actually co-authored Arizona’s landlord/tenant laws (this is direct from the court transcript):
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Collection of more than 1.5 times the monthly rent as Option Deposit.
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Collection of an Option Deposit or Rent Credit to be credited to a Purchase, or to discount the Purchase as in a Down Payment.
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Predetermining a Purchase Price, as in delaying or disguising a sale.
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The Lessee also holding an option on the same property they are leasing regardless if it is one document or two separate documents. (Sandwich lease)
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The Lessee being responsible for maintaining the property.
If the lease is not recognized by the court as a lease, it doesn’t get the benefits that go along with a legally recognized lease. If the judge feels a sale has taken place instead of a lease, the rules governing foreclosures will apply. For this reason, possession of the property will be decided by a judge in position to decide matters of title and the process can be extremely expensive. Costs can run $10,000+, not including having to pay the back mortgage payments during the life of the suit.
Be very careful and good luck to you.
Da Wiz