By Real estate options and leases with purchase options can enhance your real estate investment profits. Here’s a concise guide to help you navigate the potential pitfalls and maximize your returns.
Stand-Alone Purchase Option
A stand-alone purchase option can be highly profitable. Here’s how it works:
- Immediate cash. You receive cash up front from a buyer wanting the option to purchase your property at a set price within a specific period.
- Outcome benefits. If the buyer exercises the option, you sell the property at a premium. If the option lapses, you keep the property and the option payment.
Lease with Option to Buy
This approach offers several financial advantages:
- Higher rent. Charge a premium rent, possibly applying a portion toward the option price.
- Up-front cash. Require an up-front option payment, which becomes your immediate cash.
- Property maintenance. Tenants are more likely to maintain the property well, often handling repairs themselves.
- Long-term tenants. Tenants planning to buy tend to take better care of the property.
Legal and Tax Considerations
Understanding the tax implications is vital:
- Option proceeds. If the buyer exercises the option, the up-front payment is part of the sale proceeds. If the option lapses, it’s ordinary income.
- Example. If Mary pays $10,000 for an option to buy your property for $300,000 within 15 months, she adds the option cost to her property basis if she buys. If she doesn’t buy, the option lapses, resulting in a long-term capital loss for Mary and ordinary income for you.
Avoiding Pitfalls
Options and leases can sometimes be deemed sales contracts by the IRS, especially if
- the option forces the tenant to buy due to high rents, or
- the lease conveys significant ownership benefits to the tenant.
Eight Rules of Thumb
To ensure your lease-with-purchase-option is compliant and beneficial, be sure to follow this advice:
- No equity build-up. Don’t apply rent toward equity.
- No automatic title transfer. Avoid clauses that transfer ownership after a specific number of payments.
- Short-term rent proportion. When renting for a short period, ensure rents are not an inordinately large portion of the total price.
- Fair market rents. Ensure rents are reasonable and not excessively high.
- No interest equivalents. Avoid building interest equivalents into rents.
- Proper investment. Maintain at least a 20 percent investment in the property.
- Fair option prices. Set option exercise prices at or above fair market value.
- Restrict improvements. Prohibit tenant improvements.
If you want to discuss real estate options, please call me on my direct line at 408-778-9651.