Uncovering Contracts for Deed vs. Lease Options
Before investing your hard earned dollars in property, it's important to clearly understand the difference between contracts for deed and lease options.
You may be familiar with these concepts, which are also known as "installment" and "contract", but there is still some confusion between the two. So it is worth taking the time to make sure you are clear about the implications of both, from an investment, taxation and legal point of view.
Contract for deed is an agreement whereby the buyer makes installment payments on an arrangement similar to car financing. That is, the seller holds the title to the property while the buyer has the equitable title.
Under an equitable title, the buyer has the right to live in the property and enjoy all the benefits of ownership, but cannot use it as collateral for a home equity loan until they have the legal title. When the buyer pays the off the amount on the contract, the seller hands over the legal title to the buyer.
One of the advantages of using contracts for deeds is that you can seek a higher down payment from the buyer, as the agreement feels more like a sale, and you can also collect interest payments, which can be higher than normal rent.
The attraction of contracts for deeds for the buyer is that the IRS generally regards it as a sale, which means interest payments are deductible as mortgage interest, even though the buyer doesn't have legal title to the property.
In this situation, the seller is responsible for reporting the transaction as an installment sale on IRS Form 6252, but the seller can't claim depreciation or any other tax benefits from the property once it is sold.
The seller needs to be aware though that when the balance of the contract is paid it will be treated as a capital gain, which can lead to a big tax liability if you have low equity in the property. The other disadvantage for sellers is that it can be hard to evict a defaulting buyer from the property, particularly if court action is pending.
One issue that is often overlooked and can lead to disputes is who is responsible for maintenance and repairs until the sale is completed. The documents need to clearly spell out who is responsible for what. To avoid disputes, the buyer should have an inspection carried out on the property prior to signing and both parties should be given a copy of the report, so there are no misunderstandings.
There are a number of options covering maintenance, such as making the buyer responsible for all repairs in a certain price range, the seller accepting responsibility for a certain period of time, and the owner purchasing a home warranty.
Don't assume the buyer will take on responsibility for all repairs and maintenance. After all, if they are paying a hefty monthly payment and don't possess the title, things could turn ugly if they suddenly have to pay out a large amount in repairs, even if insurance does cover major damage.
A fairly common practice is for the buyer to assume 50 per cent of the cost of any repairs outside insurance, usually for a set period of time – 30 to 60 days.
If the deal falls apart, the buyer defaults and the seller then exercises their legal option to reclaim the property, the tax code treats the transaction as a foreclosure, but the legal process can be quite a bit more involved.
The legal process for repossession of the property is not always clear as some state statutes (IL & PA) for example, clearly spell out the process, but in most states the process is not clearly defined, so the courts deal with it on a case-by-case basis.
Lease options consist of two elements, the first of which is the lease. This is a contract for use and possession of the property, thus creating a lessor/lessee relationship.
The second element provides a purchase option, which is a unilateral agreement where the seller agrees to give the buyer the exclusive right to the leased property.
Be aware that an option is not the same as a regular contract. A regular contract is a bilateral agreement which legally binds both parties to an agreement, while an option only binds the seller. Lease Options are not an arrangement to sell like contracts for deeds are. They are strictly a lessor/lessee agreement, meaning that if the tenant decides not to use their option to purchase, the owner will benefit from any market appreciation.
Occasionally, a court may re classify the transaction as a sale if it appears to be one, but the IRS does not recognize a lease option as a sale until the option is exercised.
Deciding which option to take will depend on your financial situation and ultimate goals. As an investor, a lease option is not a sale, so you will benefit from any market appreciation if the lessee decides not to exercise the purchase option.
On the other hand, it means less money down, lower incoming payment and ongoing landlord responsibility.
A contract for deed sale will allow you to ask for a higher down payment, higher monthly income, and no landlord hassles, but can lead to a hefty tax hit and transfer tax payable when the sale occurs.
When deciding which process is best for you as an investor, consider the work involved, tax implications and, of course, cash flow.
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