Sunday, August 01, 2004

The 2 kinds of lease options

8/1/04 9:40 AM

While I’ve got some down time this weekend, I thought I might explain the two kinds of lease options you might hear about. Unless you know there are two types, it can be confusing.

If you go buy a book on real estate and it talks about lease options or lease purchases, what they are generally referring to is this: you find a person selling a house. You work out a deal with them whereby you agree to buy the house in X years and in the meantime you rent it from them. The seller continues to own the house and but you make the mortgage payments. In turn, you lease the house out to someone else, charging them more in rent than the mortgage and you pocket the difference. You may or may not have a contract with the tenant to buy the house. If you do, they pay you a non-refundable option fee that gives them the right to buy the house for a specified price in the future. So the seller doesn’t sell the house right away, but he does get to stop making the mortgage payments and yet still receives the tax write-off for mortgage interest. This is not what I did.

The lease option method I used was to actually buy the house, then lease it to someone and they pay to have the option to buy the house for a specific price in the future. In my case, the lease was for 2 years at $1,100 a month and an option to buy the house anytime within those two years for $125,000. That option cost a non-refundable $3,000. I chose not to credit any portion of their rent towards the down payment for purchase. Some people may credit $50 - $100 of each month’s rent, but I didn’t offer that and the tenant didn’t ask. A benefit of this approach is that, since the tenant is theoretically going to buy the house, you can put it in the contract that he is responsible for all repairs – expect for major things, such as a roof caving in or something. And it works. For two years, I never had a single call to fix anything in the house. (Of course, after seeing the dishwasher when they moved out, I wish they would have called me, but oh well.) A drawback is that the house may appreciate more in value than you thought and you’ll have to sell for less than the fair market value. Had my tenant opted to buy the house, he would have had an instant $17,000 in equity – his contract was to buy the house for $125K, yet I ended up selling it to someone else for $142K.

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