Re: Bogas Lease Option Deals - Posted by Scott
Posted by Scott on January 01, 2002 at 19:33:28:
I found this on another website. Does anyone have any response to this article. It makes me scared about doing LOs.
Scott
BOGUS LEASE OPTIONS
A Purchase by Any Name
By Stephen Stralka
A home buyer with insufficient funds for a ten percent down payment responds to a broker’s ad under “Home for Sale”; the ad indicates that the credit worthy can move into a pricey single family residence with a small down payment.
The buyer inspects the property, and decides that he would like to buy it. The seller is asking for five-percent down, and is willing to carry the balance.
The five-percent down payment is called “option money,” and is to be applied to the purchase price should the option be exercised. Correspondingly, the monthly payment is called “rent,” and a portion of the rent is to apply to the purchase price - upon exercise of the option.
Thus, except for the absence of a note, trust deed and grant deed, the terms of this so-called “lease option” have all the economic characteristics of a carry-back sale. There is an agreed-to-price, a down payment, monthly payments toward principal and interest, and a three-year due date.
After closing, the buyer incurs financial difficulties and is unable to keep up with his payments. The seller attempts to evict the buyer for non payment of rents. The seller claims that the lease is terminated by a Three Day Notice to Pay or Quit and the buyer forfeits the right to the possession of the property and the amounts to be credited toward the purchase price.
Can the seller terminate the agreement as a lease with an option and keep the buyer’s money?
No! When a buyer in possession under an agreement receives credit toward the purchase of a portion or all of his payments to the seller, he has established and built up an “equity” in the property, and “ownership interest” which must be terminated by foreclosure.
A lease option agreement structured on terms economically consistent with a credit sale is neither a lease between a tenant and a landlord, nor an option to buy. This bogus “lease option” agreement is a disguised purchase agreement between a buyer and carry-back seller [Oesterreich v. Commissioner (1955) 226S2d 798].
Thus, the seller can only terminate the buyer’s ownership interest in the real estate through judicial foreclosure - no trustee foreclosure provisions are written into lease options, since such agreements are purportedly not sales at all.
THE BOGUS LEASE OPTION
A seller has a number of possible ways to structure carry-back financing for the sale of his property. He may, after a down payment:
· Convey title and carry back a trust deed (first or second) for the balance of his equity in the property;
· Convey title and wrap an existing first TD with all-inclusive trust deed (AITD);
· Enter into an unexecuted deposit receipt retaining title until escrow is opened and closed, and give the buyer occupancy under an interim occupancy agreement; or
· Use a land sale contract, also called a “Contract for Deed,” retaining a deed to secure payments of the balance due on the price.
THE CREDIT-TO-PRINCIPAL FEATURE
Incongruously, the bogus “lease option” has the buyer/tenant receiving credit on the price for both the down payment/option money and a principle portion of the payment called rent.
Seller financing, no matter how drafted, delays payment of all but a small fraction of the purchase price. Thus, buyers are able to own and occupy a home with little or no down payment. Sellers are able to move their real estate in a slow market.
The lease option becomes viewed as a form of seller financing, and is, in effect, a financing aberration which gains popularity in times of recession and tightening of credit.
Trust deeds and land sale contracts are fairly secure in their legal treatment - there exists a substantial body of case law and statutes relating to each, in spite of the extremely different foreclosure procedures. The legal situation of lease option financing is considerably less certain.
Sellers - and unfortunately, brokers - view the bogus lease option as a purchase lease/option, a financing hybrid.
A seller under a bogus lease option seeks to avoid all ownership responsibility and risk of loss by drafting the terms of the lease option to conform with those of a completed sale - that is, until the buyer defaults and the seller attempts to revert to the role of landlord and evicts the buyer as a non-paying tenant.
Specifically, inappropriate weight is placed upon the question of who holds the deed - which becomes a mortgage-in-fact.
What the seller has created is a land-sale contract, but with the wrong name on it.
The seller can’t have it both ways. A transaction is either a sale, or a lease with an option to purchase, but it can not be both. The hybrid purchase/lease/option arrangement does not exist. [Smith v. Morton (1973) 29 CA3d 616]
THE REAL OPTION TO BUY
Under a lease, a tenant pays rent, no part of which is credited toward the purchase of the property occupied. Non-refundable option money can be paid for an option to purchase which runs with the lease.
However, the signing of the lease itself is nearly always the consideration for giving an option to purchase. Even if option money is paid, it is not credited toward the purchase price - option money is simply the consideration paid to keep the option open.
The option is the landlord’s irrevocable offer to sell the real estate to the tenant within a certain period of time - should the tenant decide to buy. The tenant is given the absolute right to buy or not to buy the property, at his discretion.
When a tenant with a genuine option to buy exercises the option, it become an enforceable bilateral purchase agreement. Until then, the agreement between the two parties is a lease for all purposes, and the roles of the parties are narrowly defined in terms of a landlord/tenant relationship.
NOT AN OPTION AT ALL
If the tenant receives credit toward the price of the property, the lease option will be re-characterized as a land sale contract - a carry-back sale without trust deed provisions to avoid the seller’s need to judicially foreclose and exhaust his security; thereupon wiping out the equity the buyer has paid-for and built up in the property.
In each case, the seller (or the purported landlord) keeps the deed, while the buyer (or purported tenant) is in possession of the property, having paid money to the seller, which money is applied toward a purchase price to be fully paid in the future.
Other signs for establishing a purported tenant as an actual buyer in possession include:
· Shift of the burden of care and maintenance, and risk of loss to the tenant;
· Payment of property taxes and insurance premiums by the tenant in addition to the regular monthly payment, and impound agreement;
· Good faith improvements made by the tenant - i.e., improvements made in the good faith belief that he is the owner of the property [CA. Code of Civ. Proc. §871.1];
· Monthly payments which substantially exceed the property’s fair market rental value - since it costs much more per month to own a higher end property than to rent it; and
· A fixed dollar purchase price.
A genuine option to buy within three or more years typically does not have a set price. Uncertainty as to what the property’s inflated and appreciated value will be in a number of years is a risk of ownership, a risk (or benefit) the fixed dollar price shifts to the purported tenant/optionee. If the price is set as a dollar figure, the setting is one indication that the property has been sold.
Courts look to the economic substance of a transaction over the legal form in which it is drafted - especially when calling an agreement by the wrong name misrepresents the party’s rights and obligations actually existing under the agreement. [City of L.A., CA v. Tilem (1983) 142 CA3d 694]
If the buyer in possession is building an equity, the lease option is a land sale contract in everything but name. Any option money paid in is really a payment on the price, with the rents to be considered as interest and principal under a disguised mortgage. [Oesterreich, SUPRA]
Editor’s Note - There is no legislation providing for the re-characterization of a bogus lease option as a masked land sale contract. However, statutes relating to similar lease-back arrangements involving equity purchasers have codified.
For example, an investor acting as an equity purchaser buys a property and leases it back to the seller with an option to buy. The transaction is not a genuine lease option: it is a real estate loan. The lender, who characterizes himself as an investor/buyer, in this case holds the grant deed to the property as security for repayment of principal and interest, rather than using a trust deed to document the transaction. [CC§1695.12]
When a lease option is a masked land sale contract, the tenant with a purchase option becomes a buyer with equitable ownership of the property - equitable because he is in possession of the property and makes the payments, which applies in part against the purchase price, but has not yet received the deed. [Mc Clellan
v Lewis (1917) 35 CA64]
The landlord in fact becomes the carry-back seller in law - a secured with different rights than an owner - even though me may retain the title. [LA Invest. Co. v Wilson (1919) 181 C 616]
THE BUYER DEFAULTS
When a land sale contract is masked in the form of a lease option, most of the resulting problems occur when the tenant/buyer defaults in payments and refuses to vacate and sign a release (deed in lieu of foreclosure).
Evicting a non-paying tenant is relatively quick and inexpensive compared to a foreclosure. The distinction becomes a most prominent reality when a purported landlord finds himself reclassified as a carry-back seller, and has no tenant to evict. His tenant is, in law, the equitable owner of the property.
The landlord/seller will incur great expense in time and money in order to rid himself of a defaulting lease option tenant who claims to be a buyer with equitable ownership rights. The cumbersome process of a judicial foreclosure will be required to eliminate the tenant/buyer, since there is no trust deed power of sale clause.
If the seller refuses to allow a redemption payoff, the buyer in possession is entitled to a specific performance action against the seller. This is true of real leases with purchase options as well, since the tenant need only exercise the option to create and enforceable purchase agreement.
At the very least, the lease option buyer is entitled to a refund of ALL AMOUNTS HE HAS ADVANCED TOWARD THE PURCHASE PRICE. The seller may not keep the buyer’s money on default, since foreclosure of an equitable ownership is not permitted. [Peterson, Supra]
Forfeiture is not an issue when a genuine purchase option is attached to a lease. Any payment the tenant makes is not part of the price. It is either rent, or it is non-refundable option money: consideration paid the seller for keeping the property off the market and the option to purchase open. Only when credit is given toward the price to be paid upon the exercise of the option does the purported tenant obtain an interest in the property.
TAX ASPECTS
Tax-wise, lease options are often re-characterized as disguised carry-back financing or land sale contracts.
Strong income tax incentives exist for sellers to conceal property sales behind bogus lease options. Under a true option agreement, any option money received by the seller is not reportable as profit or income until, respectively, the option is exercised or expires, or the property is sold subject to the option.
Thus, if the seller can convince the IRS that the principal and the interest payments he receives are really option money, he will pay no taxes on the “option money” until the buyer exercises the purchase option, or allows the option to expire.
The seller, disguised as a landlord, will also deduct as an owner’s tax benefits the property’s annual depreciation - until re-characterized by the IRS.
However, tax courts look to a number of factors, including the buyer’s equity, who bears the risk of loss, who pays property taxes, the relationship of rent to market value, and the price paid upon exercise compared to the property’s value at the time of exercise, to determine whether a purported lease option is really a sale.
If the lease option is found to be a sale in fact, the transaction will have been improperly reported. The seller will have to report the option credits toward price as payments on the principal ( allocated to profit and basis) and the balance of the rents as interest, and pay interest penalties or worse.
Similarly, and for consistent reporting, the buyer may not deduct the payments as rent. [MW Gear Co. v. Commissioner (1971) 446 F2d 841]
CONCLUSION
Sellers often seek to combine the advantages of leases with sale transactions by structuring their sales as lease options. However, the purchase/lease/option hybrid financing does not exist. A transaction is either a lease or a sale: not both.
In a genuine lease with an option to purchase, neither any portion of the rent nor any option money paid applies toward the purchase price upon exercise of the option.
If money paid by the tenant for rents or option consideration is applied toward the price, the transaction is not a genuine lease with a purchase, but is a disguised carry-back sale - a land sale contract.
The courts can easily re-characterize purported lease options as disguised sales, exposing sellers to all the consequences of mortgage law.
If the lease option is found to be a disguised sale, the tenant is re-characterized as a buyer who builds an equity and has an ownership interest in the property.
The seller may not simply evict a defaulting buyer as he could a tenant. The buyer’s interest can only be terminated by judicial foreclosure, since the lease option seller has no trust deed power of sale provision.
Also, if a lease option is re-characterized as a sale, the transaction will have been improperly reported for federal and state income tax purposes, and the property will be reassessed based upon a change of ownership.
Regardless of what the form of a transaction may be; if its economic substance indicates it is a sale, it will be treated as such for all purposes.
Don’t forget: all lease options, irrespective of their form or duration, do trigger due-on-sale clauses.
CEA News 8/91