By James A. Gage
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 in 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 a residence.
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 this article.