Avoid the Pitfalls of Lease Options With the Equity Holding Trust

February 24th, 2009 categories: Land Trusts, Seller Financing

Lots of people are exploring whatever it takes to get their properties sold in today’s market, even considering low down payments, or a small option payment. Lease options/rent-to-owns are popular in part because the property owner/seller can get more up front and each month than if they just did a straight lease.

So, even if the buyers don’t exercise their option (and I suppose some sellers hope they don’t), the owner has maximized his cash flow all along. Lease options have been around a long time, and even though they’re considered fairly standard, there are some compelling reasons to take a good look at other ways of achieving the results you’re after.

But first, the basics. By definition, a lease option (L/O) is a unilateral agreement to sell with bargain terms at a future date:

Buyer pays the seller option money for the right to later purchase the property. The lease option money may be small or substantial.
Buyer and seller may agree to a purchase price up front, or the buyer may agree to pay market value at the time the option is exercised. It’s negotiable; however, most buyers want to lock in the future purchase price upon inception.
During the term of the lease option, the buyer agrees to lease the property from the seller for a predetermined rental amount.
The term of the lease option agreement is commonly one year to three years.
Option money does not usually apply toward the down payment.
A portion of the lease payment typically gets applied toward the purchase price.
Option money is rarely refundable.
No one can buy the property out from under the option holder
If the buyer does not exercise the lease option at the end of the term, the option expires.
The buyer has the right, but not the obligation to buy the property.

So what’s the down side?

Lease options are explicitly named in numerous laws and legal documents. The fact that most real estate brokers won’t let their agents be involved in putting together a lease option for their clients is evidence of the liability involved.

The lease option violates a lender’s due-on-sale clause, and the lender has the right to ‘call’ or accelerate the loan.
In California, they can trigger a reassessment of property taxes.
L/O’s can lead to an inability to evict a defaulting tenant. A tenant in default can claim having “Equity” in the property, and in so doing, force a judicial foreclosure process versus an eviction. This can really eat up your return on investment as the defaulting party sits around peeling grapes on your dime.

And then there’s the doctrine of substance over form, which says that what you call something does not necessarily determine what the law will regard it to be. If it looks like a duck, walks like a duck, and talks like a duck, the official IRS position is this, and I quote:

“It’s a duck.”

If, from an economic standpoint, you’ve created the equivalent of an installment sale (seller carry back), you could potentially be in for all sorts of unpleasant surprises. You could have a 1031 exchange invalidated, or have the IRS coming after you for overdue taxes and penalties.

So how can you get the rewards of the lease option without the associated risks? I’m glad you asked, because this is where the Equity (or Title) Holding Trust rides in like a white steed.

More than a simple land trust, this is a whole trust transfer system with the following advantages:

Prevent the lender from exercising its “due on sale” clause
Be able to evict a defaulting “resident beneficiary” instead of having to foreclose on them
Get privacy, safety and legal protection
It’s quick and easy (you can often close in 21 days)
Defer capital gains
Superior income tax treatment
Preserve tax basis (property is not reassessed)
Protection from litigation, creditor judgments, tax liens and probate issues
Reduces the risk of taking a relatively small down payment
Freezes the seller’s equity until some point in the future when housing has begun to appreciate again. This insulates the seller somewhat from further price depreciation in the current market.
Sell without short sale or foreclosure, even if you’re a little bit upside down (if you have a decent loan and you’re not too far behind on payments)

The Title-Holding Land Trust (often referred to as the “Illinois Land Trust”) is accepted throughout the United States. This may arguably be the best possible means of real property asset protection and/or transferring real estate. I like to call it ‘Seller Financing on Steroids.’

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