Tuesday, March 5, 2013

Lease Option - The Perfect Tool?

CAVEAT #1 - This post does not provide legal advice.  Readers must consult with an attorney in order to determine how the law applies to their particular forms, contracts, transaction, and circumstances.
CAVEAT #2 - This is information intended to generally inform for educational purposes, and minor changes in the facts can create major changes in the outcomes - SEE CAVEAT #1.

The lease option - is it the perfect tool?  Maker of millionaires, key to financial independence, or so many real estate "gurus" would have one believe.  I have several points to make in the following discussion relating to lease/options and the related dangers.  However, please do not understand this to mean that I am categorically opposed to leases and/or options.  I have used these tools with my clients as well as personally on countless occasions.

I have no objection to using either a lease contract, an option contract, or both in the appropriate circumstances.  Problems arise with the substance of transactions in which they are sometimes used.

Point #1 - You are not going to get rich quick.  As I have written previously, I receive many calls from students of real estate "gurus."  One of the techniques taught in seminars is the lease/option.  Often a form book, CD, or link is sold to the student as part of a package (for a mere $500, $1,500, $5,000 or more) which is represented to contain all necessary forms which have been tested by the finest lawyers in all 50 states.  This is nonsense.  A "form" is just a piece of paper with words on it.  A "contract" is an agreement in which there is a meeting of the minds.  Form is not synonymous with contract.  In fact, the law commonly recognizes a doctrine called "substance over form."  This means that the law will analyze the actual details of the transaction over what the papers call the transaction. 

Point #2 - There is nothing inherently wrong with using a lease, with using an option, or with using both a lease and an option in a coordinated fashion.  To the contrary, these documents are widely used, often in completely appropriate, legal, and binding ways.

Point #3 -  Be careful.  I say this not only because I am an attorney but also because it is good advice - go see a knowledgeable real estate attorney.  Small changes in the facts can result in large changes in the outcome of lease/option transactions.  Some of the dangers include (and this is NOT a comprehensive list):
  • the transaction could be construed as a land contract in which case
    • Wisconsin law requires (with certain exceptions) the party offering seller financing to have a mortgage originator's license and
    • the failure to have a license could subject the seller/financer to sanctions including administrative action, $25,000 forfeiture as well as the possible ability of the buyer to rescind the transaction and receive return of all of their payments.
    • the Seller would have to foreclose the buyer out of the property (rather than simply evicting the tenant).  This can be much more costly and time-consuming and is an equitable remedy which can permit the Court to address the "fairness" and totality of the transaction.
    • the IRS would likely be owed interest and penalties in the event that the transaction were to be construed as an installment sale.
  •  the transaction may trigger the "due on sale" clause.
  • Under the terms of a standard mortgage, if any interest in the mortgaged property (or beneficial interest in the property) is transferred without the lender/mortgagee's prior written consent, the lender/mortgagee may, at its option, require immediate payment in full of the principal balance due on the note. This is indicated under the provision known as the "due on sale clause." 
    12 USC 1701j-3(d)(8) provides that the "due on sale clause" is triggered by any lease for longer than 3 years and any lease that includes an option to purchase. 
    While triggering the "due on sale clause" is not unlawful provided that one is prepared to accept the consequences, one must be careful not to commit a fraud on the lender/mortgagee in an effort to conceal the transfer. 
    I have been told that there is "no way that the lender could know" about the transfer of a beneficial interest or grant of a lease/option.  This is an evidentiary question.  Is there a change in insurance?  The lender receives notice of that directly.  Is there a change in the utility payor or real estate tax payor?  Could a third-party vendor perform this relatively simple investigative service?  There are services currently that perform this investigation for foreclosures (in order to determine whether the property is occupied and, if so, owner occupied).
    Granted, very few notes are called as a result of the due on sale clause ... currently. However, we have historically low interest rates. Lenders might become more diligent in reviewing files once interest rates rise substantially.  
  • the transaction includes all of the risks associated with being a landlord.  Landlord/tenant law is notoriously pro-tenant and full of traps for the unwary.  A lease and option deal creates a landlord/tenant relationship with all of the associated liability.  Further, the deal typically involves a tenant/buyer with poor credit.  If they could arrange for traditional financing, there usually would be no need for the lease/option.  Is that person who is a poor credit risk a fair tenant risk?  One shouldn't give the keys to a bad tenant just because the tenant might buy the property later. I always recommend that the tenant be qualified as though there were no option agreement.  
So, is the lease/option the perfect tool(s).  Consider the wood chisel.  Is it the perfect tool for carpentry? No, there really is not such a thing as the perfect tool.  Further, whether it is even an appropriate tool depends entirely upon what one is trying to accomplish and under what circumstances.    A lease contract used in coordination with an option contract can be a good set of tools.  However, it depends upon circumstances.

Attorney James N. Graham is a real estate and business lawyer with Accession Law LLC. 

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