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Understanding A Lease With Option To Purchase

Written by on Thursday, 06 June 2002 7:00 pm
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Q. We have a house and are in no real hurry to sell. However, we plan to retire shortly to the Maryland Eastern Shore. Recently, a very nice young couple expressed interest in leasing our house for a period of up to two years, with an option to purchase at the end of that period of time. Exactly what is a "lease option" and what should we be looking out for?

A. A lease with an option means simply that your young couple will enter into a two year lease with you, and will have the option – the right – to purchase your house within a two year period. In order to accomplish this, there are two important things to consider. F

First, the tax consequences of such a transaction. You have advised me that your house has appreciated considerably in value. The tax law will allow you to exclude up to $500,000 of the profit you have made on the house, if you have lived in the property two out of the past five years ending on the date of sale. (Note: if you are not married, and filing your tax returns jointly, you can only deduct up to $250,000 of profit.)

Thus, in order to avoid having to pay capital gains tax on this $500,000 worth of profit, you must make sure that you will be able to sell your house within the time parameters spelled out above. If, for example, you have been living in your house for a long time, and enter into a lease option in July of 2002, you must sell your house by July, 2005, in order to take advantage of this great exclusion. Why 2005? Because after that, you will not have lived in the house two out of the previous five years ending on the date of sale.

Houses are selling at a fairly rapid pace now. But what will happen should this couple decide – in 2004 at the end of their lease – that they do not want to buy? You will have only one year in which to sell to take advantage of the tax exclusion, and in the meantime, you may be stuck with a vacant house. This means that you will have to pay taxes, insurance and mortgage payments, while not receiving any income. More significantly, you will have a vacant house, which is not a good idea.

The second issue goes to the terms of the lease option. You must have a written document, spelling out all of the terms and conditions before the couple moves into the house.

Here are some of the issues which you should consider – and put into the lease:

  • Down payment: many jurisdictions prohibit a landlord from taking more than one month’s security deposit. However, you will be entering into two separate legal situations – a lease and a contract to purchase. Thus, you may want to consider asking your potential purchasers to place in escrow with your attorney a separate earnest money deposit, as good faith for the purchase and sales agreement.

  • Sales price: normally, when you enter into a lease with an option, the purchase price is set at the time you negotiate the deal. Thus, you are probably going to sell the property two years from now, but at today’s prices. Clearly, this can cut two ways. If property values continue to escalate, this will be a good deal for your tenant, and you will be losing money. On the other hand, if property values should decline – which is always a possibility – your tenant will probably decide not to pay you the contract price, and you may end up on the losing end of this transaction.

    Thus, I would recommend a different course of action – namely a lease with a "right of first refusal." This means that at the end of the lease term, your tenants will be given the absolute right to purchase your house, but at a price to be determined by you – two years from now. This may still put you on the losing end of the transaction should property values decline, but since your tenants will probably not purchase anyway if they had an option – rather than a right of first refusal – this at least will give you some benefits should the property value increase.

  • Credit for rent payments: this is one of the thorniest issues involved with a lease option or a lease with a right of first refusal. For two years, your tenants have been paying you rent. Should any portion of this rent be credited toward the sales price? Obviously, from your point of view, they should not. After all, your tenants would have had to pay rent anywhere they go, and why should you take a loss if they opt to purchase?

    On the other hand, many tenants want to receive some credit for the rent they have been paying.

    This must be negotiated in advance of the commencement of the lease, and reduced to writing. This is clearly a negotiable issue, and not a legal issue. However, there is a compromise position between no credit and full credit – namely a partial credit. I have seen some leases where the tenant is given a credit for some percentage of the rent if they purchase in the first year, and a different credit if they purchase during the second lease year.

    Once again, this is something which only you can decide. If, for example, you want to sell the house quickly, the first year percentage can be higher. If you would rather sell at the end of the second year, then that second year credit can be higher.

    You should also keep in mind that until this couple actually go to closing on your house, they will still be your tenants. Thus, you have to have a carefully drafted lease, spelling out all of the rights and responsibilities of both the landlord and the tenant. You should also confirm that you have complied with all local, state and federal requirements – such as lead paint, any license or certificate of occupancy required, or registration as exempt from rent control in the District of Columbia if you own four or less rental properties in the District.

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      About the author, Benny L. Kass

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