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A “lease-option” is actually two transactions occurring at or near the same time between the same parties. The first is the execution of a standard residential lease. The second is the granting to the tenant of a special option to purchase the property in the future. The landlord does not want to link the lease and option, thereby giving a court a reason to treat the lease-option as one transaction. So, the guidelines and suggestions that follow largely address the mistake of linking, in any way, the lease to the option. The more the lease and the option are linked, the greater the chance that a court will view the documents as evidencing one transaction, namely a land contract.
The landlord should require an initial option fee for the option, which is in addition to any security deposit or first month’s rent. The monthly rent should be equal to the fair market rent; however, the landlord should charge an additional option fee, payable in one lump sum or monthly. The option fee, if paid monthly, should be paid by separate check than the rent check.
The total of the additional option fees should be about the same as the discount given from the future fair market value of the property at closing, or some other amount calculated to compensate the landlord for removing the property from the market during the option period. This will leave the landlord in financially the same position as if the property were sold at the end of the lease to a third party at fair market value, but provides an incentive to the tenant not to default under the lease and to keep the property in good repair.
In the past, the landlord might give the tenant a rent credit equal to a portion of the monthly option fees. I now longer advocate that approach. Why? Because it creates another link between the lease and the option. In any case, if the tenant does not purchase the property then all option fees are forfeited.
Use Separate Documents
A common mistake is to merge the lease, the option, and the purchase agreement into the same “short” form. This can be extremely dangerous for the landlord, because it allows the tenant (or worse, a court) to interpret the lease as a land contract or purchase agreement, and thus delay or prevent eviction by demanding foreclosure. These problems often arise in the tenant’s bankruptcy.
The option should either include the terms of the purchase or incorporate by reference a separate attached purchase agreement. My preference for landlords is that the option agreement be short and that a purchase agreement be attached. Do not refer to the option or the purchase itself in the lease. The purchase agreement would not be signed, however, until the option is exercised by the tenant. The purchase agreement should be fully negotiated with all its provisions completed. Only the lease and option agreement should be fully executed (signed) at the initial document closing. The attached purchase agreement is not signed, because the tenant has not exercised the option and has not agreed to purchase the property. Later, when the option is exercised, the purchase agreement is signed and serves to replace the option agreement.
If the landlord is also going to be financing the tenant’s purchase of the property, then attach unsigned forms of the warranty deed, note and mortgage to the purchase agreement. You should also consider using lead-based paint forms and disclosures when the lease is signed. However, the state-required Seller’s Residential Real Estate Sales Disclosure forms should not be completed or signed at the time the lease and option are signed. Why? Because that is evidence that the entire transaction is really a sale disguised as a lease-option. When the option is exercised and the purchase agreement is actually signed, then the real estate disclosure form can be signed and dated the same date as is the purchase agreement.
Other Timing Considerations
I used to advocate signing the lease and the option agreement at the same time. This area of the law is changing, and so too must sound business practices change to track the changes in the law. Now, I prefer to sign and date the option agreement months after the lease is signed. I now tell tenants that I will negotiate with them the terms of an option agreement, under certain conditions: 1) the tenant must pay all rent on time, 2) the tenant must show efforts to remove any bad credit marks on the tenant’s credit report, 3) the tenant must actively work with a mortgage broker in an effort to obtain financing or pre-approval, and 4) the tenant cannot otherwise breach the lease. Then, if all these conditions are being met over a period of four to six months, subject to my sole approval, then I will negotiate the terms of a fair option agreement. Using this procedure, there are four to six months separating my lease and my option agreement. Additionally, I know that I have a serious potential buyer who really wants to clean up her credit, obtain financing, take good care of my property, and will likely get financing to close on the purchase of my building. I have improved my legal position, in the event I have to evict the tenant, and I have improved the chances that my tenant will close on the purchase.
Language Is Important
Use good legal forms. Do not simply use the forms you purchased from a non-lawyer, national speaker, or from the office supply store. Use professionally-written legal forms. In other words, NEVER use a legal form, unless your legal adviser wrote it, fixed it or approved it.
My first lease-option lawsuit for a client was a bankruptcy case, in which the landlord-client had his tenants sign a one-page “Rent to Own” form. The facts were not in my favor, and we settled the case. There was very little that was done well in that “Rent to Own” form. The problems started with the title of the agreement: “Rent to Own.” This was really a lease and purchase agreement and option all rolled into one document. The form used the term “down payment,” rather than “option fee.” The landlord was called the “seller.” The tenant was called the “buyer.” The entire document was littered with language suggesting that the tenant was purchasing the property. And, that language suggested a land contract, rather than a lease with a separate option agreement. There’s an expression in my profession: “Bad facts make bad law.” In other words, relative to lease-options, if you use bad legal forms, you might get a bad result in court. Don’t be cheap- buy good legal forms from a knowledgeable attorney who understands lease-options.
Since my first lease-option lawsuit, I have handled dozens upon dozens of similar disputes. Unfortunately, the legal forms sold by regional and national speakers are still being used, and those forms still contain bad draftsmanship and poorly chosen language. In the end, poorly drafted legal forms can cause bad results and significant financial losses for the real estate investor. If you do not have lease-option forms, call your real estate attorney and get his forms. If you already have forms, have your real estate attorney review and correct them. And remember that not every attorney fully understands lease-options and the recent developments in this area of the law. Pick the right attorney, or be prepared to educate your attorney about lease-options. However you do it, make sure that your legal forms are in good order and contain the appropriate language.
The landlord should collect multiple checks, each check representing a different obligation under a different agreement. In other words, the tenant will pay the first month’s rent, a security deposit (sometimes called last month’s rent), an option fee or monthly option fees, and, once the option is exercised, a separate down payment or escrow payment. Each of these payments is made at different times, under the different agreements: the lease, the option agreement, and the purchase agreement, respectively. The memo portion of each check should describe the nature of the payment: “security deposit” or “down payment” or “option fee.”
By collecting different checks at different times, the landlord is making it clear that there are separate agreements, not a single transaction that looks like a land contract.
The Option Fee Amount
Many investors are getting bad advice about the amount of option fees to charge a tenant. The option fee is supposed to compensate the landlord for keeping the property off the market during the option term. An option agreement is not a license to cheat and steal from tenants who are hoping to buy a home. Yet, more and more investors are taking ever-bigger option fees from tenants. These huge option fees more than compensate the landlord for keeping the property off the market during the option term. These big option fees look like down payments to the courts. Frankly, these big option fees look like down payments to me, and I am a pro-landlord attorney.
The reason some judges are treating lease-options as land contracts is because the tenant-buyer is believed to have substantial equity in the property. Judges tend to be fair and try to right wrongs.
These judges perceive that the tenant is being cheated out of substantial equity. So, structure your lease-options in a way that makes it difficult for a judge to find that the tenant will lose meaningful equity in an eviction. There is a simple way to accomplish this task. Increase the purchase price or the rent, dollar for dollar, by the amount that you lower the option fee.
How big is an option fee that has become too big? That depends on several factors. What is the property worth today? What will the property be worth at the end of the option period? What is the appreciation rate in the area? How good or bad is the tenant’s credit? What are the other risks to the landlord? How long is the option period? By answering these questions and keeping in mind that option fees are intended to compensate the landlord for keeping the property off the market during the option term, the well-advised investor can determine a fair option fee that does not look like a down payment.
As a final thought, remember that pre-payment of the last month’s rent or any amount greater than the first month’s rent will be considered a security deposit under Indiana’s 45-Day Letter Rule. Make sure to treat security deposits as security deposits, even if you call them something else.