| | Real Life Q & A: What’s the Difference Between a Lease/Option and a Land Contract?
Q: I really don't understand the difference between a lease/option and a land contract. Why would I want to offer a seller one as opposed to the other? -A.S, Atlanta
A: I can understand your confusion: on the surface, a lease with option to buy and a land contract (or contract for deed, agreement for deed, bond for deed, or land installment contract, as they are called in various parts of the country) look very similar. There's an up-front payment, a monthly payment, and an agreed-upon price that is often due in one large, future payment. Furthermore, are commonly used to circumvent the due-on-sale clause and to control properties for the purpose of "sandwiching". However, lease/options and land contracts have very different legal, tax, and control ramifications.
A lease with option to buy is an agreement between a seller and a tenant. The only rights that the seller conveys are the rights to occupy the property (a right which can be assigned to another person through a sublease, unless the contract forbids it), the right to enjoy the property unharrassed, and the right to buy at some set price in the future. These rights continue until the end of the lease term or as long as the rent payments are being made. If the tenant defaults, the seller can regain possession of the property through the relatively quick and simple eviction process. In a well written lease/option agreement, an eviction also terminates the tenant's right to buy the property.
A land contract, on the other hand, is an installment contract between a seller and a buyer. Once the contract is executed, the buyer gets an entire bundle of rights called equitable title, and takes on all of the legal responsibility to maintain the property, pay the real estate taxes, and so on. (Yes, the tenant in a lease/option can be made to agree to maintain their home as part of the option agreement, but, since they are really in a tenant-landlord relationship, cannot be held responsible under the law if they don't). If a buyer (“vendee”) in a land contract defaults, the seller's only remedy in most states is to foreclose, a lengthy, complicated, and expensive process. In short, a vendee in a land contract had much more legal and practical control over a property than a tenant in a lease/option.
The IRS also views these strategies differently. The seller in a lease/option treats the income as rent, reporting it on a Schedule "E". He can depreciate the property and can usually take advantage of a 1031 exchange at the time of the sale. The BUYER in a lease/option, like any tenant, receives no tax advantages, although a buyer who subleases to another buyer can deduct the rent and expenses he pays against the income he receives. A seller in a land contract treats the income as interest and installment sale income, cannot depreciate the property, and cannot engage in a 1031 exchange at the final sale. The vendee in a land contract can deduct the interest and tax portion of his payments from his income if he itemizes, and in the case of an investor who uses the property for business, can deduct any expenses related to the property, and can depreciate the property and any improvements he adds.
Knowing these things, how do you decide which to offer a seller? That depends on three things: your needs, the seller's needs, and what the property calls for. My own general preference is to buy on a land contract whenever possible. Here's why:
Land contracts give me more control and safety. A seller in a lease option can make a wide variety of mistakes that can destroy any chance I have of actually buying the property. From getting sued to declaring bankruptcy to getting a line of credit against the property and not being able to pay it off from my purchase price, he can do any number of things to mess up my deal. There are ways to aviod many of these problems, but they involve exotic mortgages and obscure paperwork that many sellers get nervous about signing. With a land contract, my legal interests are better protected, which is not to say that nothing can go wrong. But the better protected I am, the better I like it. And if the deal calls for a lot of monetary investment, either in up-front money or repairs, lease/ options simply don't give me the level of safety I need to put my cash into a deal.
I like the tax advantages of buying on land contract, and I also like the fact that, when I pay the seller off, the lender treats it like a refinance, which is easier and cheaper than a purchase money mortgage.
Land contracts give me more exit strategies. You can only pass on the interest that you have in a property, so lease/options limit you to renting the property or re-lease/optioning it to another person. With a land contract, you can also LAND CONTRACT it to another buyer.
This is not to say that there are no circumstances under which I would offer a seller a lease/option. If the deal involved a lot of cash flow and not much repair and I was less worried about eventually buying it than controlling the income now, I would certainly consider it. If the seller was in a situation where he didn't want to do a land contract because of the capital gains implications, but the deal was a good one, I would offer a lease/option. Understanding the pros and cons of BOTH of these great strategies is important; they can make you tons on money during your real estate career.
Reprinted from the Real Deal, a monthly newsletter for Real Life Real Estate Investors with permission of Vena Jones-Cox. Get a free 3-month trial subscription by logging onto regoddess.com