What the experts say:
Donald J. Valachi, CCIM, a well-respected real estate authority. Here is his summary:
“Although the lease option is a valuable strategy in many situations, it should be used with great care. There is always a threat that the IRS may view the lease-option transaction as a sale and the lease as merely a financing device. Rents that are significantly above fair market rents, when combined with a “bargain” option price, indicate that the transaction is likely to be characterized as a sale and that the rental payments are, in fact, installment payments on the purchase price. Thus, both the rental payments and the option price should be set by the parties with reference to going market values and rents for similar properties. And the parties should be prepared to justify their estimates of rent and purchase price if the transaction is later challenged by the IRS. Rental value and property value are best established through independent appraisal by experts.” Here is the link to the full article:
John Cash Locke: ""A Lease/Option can be considered that the Tenant Buyer has “Equitable Title” in the property and a judicial foreclosure is required to remove the T/B, I have seen it happen so I know this for a fact. Even if you separate the lease from the option once the T/B says he has an option the judge can rule “Equitable Title.”
John T. Reed: John T. Reed, (whom I do not like but who many believe) says: “The gurus are not interested in finding out what the law really is on lease-options. I have long urged them to obtain an IRS private letter ruling on the income-tax legality of their lease-option agreements. The cost of such letter rulings was drastically lowered years ago. But not a single lease-option guru has ever requested such a ruling, in spite of the fact that it would help his clients and help him market his material.”
Scott Moyes (Realtor, Investor, Author):
"As a result of the Lease Option and the ensuing claims of “Equity” (i.e., the tenant held an “equitable interest” in the property as a result of having paid an option fee and being given rent credits) a simple eviction was not in the cards. I would now be relegated to the time and expense of a foreclosure process instead (you can’t evict an owner with “equitable interest”, which foreclosure no doubt had to be followed by an ejectment action in order to retain possession and entry, and then a quiet-title action to remove the legal claims and clouds to the deed in order to allow it to be sold (sigh). After months of no rent for me and free payments for the tenant, the lender finally began foreclosure proceedings. After another 10 months, the property was sold on the courthouse steps.
The tenant buyers sued me for their $10,000 option fee, and all the rent credits I had given them. To add insult to injury, the optionor (owner) didn’t like me anymore and sued me for making him lose his house to foreclosure. I decided right then and there that I was finished with lease options."
Rod (Moderator): There is risk involved in any activity and it does not matter if we are talking about Real Estate investing or not. The key is to simply select activities that will minimize that risk. Personally I have seen the DOSC kicked in on a Lease Option situation. I don’t do lease options just for that reason. As we all know they are cracking down on Lease Options across America and there is a reason for this. What is that reason? The United States Government does not like the fact that you are giving someone a specific time frame to purchase the home and or lose your deposit on that property and personally I do not blame them for that. Is there a creative yet simple way around that? Yes and someday when it is not 1 am I will share that with you if you would like.
Here is the bottom line on this situation If you are doing Lease Options chances are you are also doing Subject 2 I have also seen the DOSC kicked in there as well. So it gets back to the key point here which was select activities that will minimize that risk.
Judge Pierce (former Sen. and author of AZ’s Tenant/Landlord law: Different states have different laws so these are just guidelines and one or more may not be applicable in your own state:
Collection of more than 1.5 times the monthly rent as Option Deposit is illegal in Arizona by statute, and seen by the court as a “possible down payment”. Check your state’s laws.
Collection of an Option Deposit or Rent Credit to be credited to a Purchase, or to discount the Purchase as in a Down Payment.
Predetermining a Purchase Price, as in delaying or disguising a sale. Think about it. If you agree upon a sale price at the beginning and you agree how that price will be paid, you have a sales contract, no matter how you disguise it.
The Lessee also holding an option on the same property they are leasing regardless if it is one document or two separate documents. (This means no sandwich leases and is becoming more prevalent in this anti-small investor market).
The Lessee being responsible for maintaining the property.