For whatever it may be worth, here's what I do, and what I recommend that other Investors do. Although some may not be interested in acquiring "holders (property to be owned for a longer period of time)." I see holding as an opportunity to earn potentially larger profits in the future, versus picking up the quick-flip money now; though this is not by any means, to discourage the latter when doing so is possible.

First of all, agree to have the current owner place the property in a title-holding trust in his/her own names for a few years. The trust will continue then until you can either -- 1) sell the property and pay off the loan, or until 2) you can refinance it in your own name and hang onto the property.

This way, the seller needn't "trust you," or take chances on passing title to you. Neither do they have to take any chances with your personal problems that could result in getting liens, suits, judgements, BKS (or your OWN martial dispute actions) against the property. Essentially the seller gives you, say, a 90%:10% ownership (beneficiary interest in the trust), and agree that when you dispose of the property in 2-3 years, that they will relinquish their ten percent at that time. This agreement to forfeit is made as consideration for your prompt payment record and strict adherence to all contract provisions throughout the term of the agreement. The 10% interest helps in protecting against a due-on-sale violation (the DOS may not be a big deal to most Investors; but it makes a seller much more comfortable. And so long as some beneficiary interest in held, and no more than 50% of the voting rights within the trust are relinquished, neither will there be property tax increases, or compromises of federal or state income tax regulations.

The Beneficiary Agreement between you and the seller specifies that upon your disposition or refinance of the property, the seller will be paid all of their beginning equity. This way the seller saves a bundle in RE commission, sells the house for full price, and they earn a lot more than they ever could otherwise

Now... after you've gotten the seller's agreement to proceed, if you'd like to have someone else cover all the costs and expenses, consider this:

Get an agreement to be able to assign a portion of your beneficiary interest to another, then run an ad in the newspaper that says something like:

 

NO DOWN, NO BANK QUALIFYING. AS LITTLE AS 2-3 PMTS AND CLOS. COSTS CAN MOVE YOU IN. CALL ABOUT INCRED. TRUST PROPERTY OPPOR."

Then when the prospects call (and they will... in large numbers), you say this (exactly this):

"Yes, I have this house that is currently in a land trust: and what I'm looking for is someone who can afford the payments and the closing costs, to basically… just 'give it to. [Pause] The only thing I want out of it personally, is your agreement to either sell it, or refinance in your own name in a couple years. And, of course, if there's been any appreciation over that period of time, I'd like to just split it with you."

Now... think about it... if you've done all of this… haven't you, in effect purchased a property with NO (or minimal) Down, NO lender qualifying; and NO payments, NO maintenance, NO repair, NO upkeep and NO landlording headaches, NO constructive notice of the transfer, and NO Due on Sale violation? In fact, haven't you just acquired clear, unobstructed profit potential while someone else pays all the bills?

Note especially in this scenario, that whatever you may give up in "Future Appreciation" to a Resident Co-Beneficiary over the next couple years, will more than likely be more than made-up-for by your having avoided all Negative Cash-Flow, Maintenance Costs, Management Expense, Vacancies, and those myriad other landlord annoyances. And perhaps even more importantly (to some of us), there are no restrictions in how many properties we can own or manage this way. Do you supposed if you owned a hundred income properties this way--with no expenses, management costs or mortgages in your name (or negative cash flows)--that you'd have any trouble getting a loan?

I personally have acquired dozens of properties this way (including my own residence), and have yet to have paid on closing costs or monthly expenses. This doesn't, of course, include the payments on my own home: a $375K house in a nice gated and guarded community, that I acquired recently with No Down, No Bank Loan, and closing costs of less than $2,000, with $75,000 equity...and which now is on the market for $530,000..

In any of my own "income properties," should the resident co-beneficiary default, I need simply remove them (very easy under a co-tenant land trust arrangement), and replace them with somebody else, charging anther few thousand dollars in the process. We have some clients who've had as many as three defaults in the same trust property, and they've each made 5-10K additional bucks, each time they do a "Beneficiary Substitution."

Good Luck.

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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

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Re. A purported Lease Option Arbitration
By Bill Gatten

In a nutshell, what reportedly happened in this case was that the option period was by-passed by nearly 3 months; but the Optionor was none-the-less forced to sell at the original option price, even though the property had gone up over $54,000 during the period of the [forgone] Option. At this writing the Optionor says she is also being directed by the court to refund all moneys having been taken from the Optionee for insurance and property tax over the option term, and to pay reasonable attorneys fees to the plaintiffs on top of it all.

Here's the deal as told to me (all hearsay, from my point of view at this point in time):

12/1/97 - Party A accepted a PACTrust™ Purchase Offer from Party B which was to commence on, or about 12/18/97, and which was to include payments for PITI+HOA and Trustee Fee. Property worth $195,000 Mutually Accepted Value was $181,000. Broker informed seller that Party B had filed a BK in the past and that a home they had owned had been deeded to a relative and was not a part of the BK. Party A was OK with all of that.

12/18/98 - A new agreement, a Lease Option, was drawn up in lieu of the PACTrust™ because Party B was short of cash. That offer was initially rejected by Seller; however, it was constructively accepted by Party A when she let Party move into the property and begin payments on the Agreement. Party A indicated (reportedly) that the Lease Option would become effective only if there was a full Escrow, and only upon the opening of such Escrow… which Escrow was never opened. As well, it was clearly understood by all parties that a balloon payment on the property was coming due in full on 08/01/99.

Jan 1998 - The first payment and option fee several weeks late. Insurance not paid and HOA not paid for 2 more months.

Feb 1998 - Option Agreement (from 12/18/97 to 12/18/98) finally executed by Optionor, but never by Optionees.

The year goes by…

12-18-98 - Option Agreement terminates.

Feb 1999 - Property, having gone up from $181,000 to approximately $235,000 (good upswing in Ca. Market) is offered for sale. Note here that according to Party A, over the term of the Option Agreement, payments from Party B were invariably 1 to 2 months late (to the detriment of Optionor's credit record) and paid only after "begging" by the Optionor. Likewise, HOA Due were always 2-3 months late, and the hazard insurance carrier threatened cancellation for non-payment on one occasion. On various occasions, Party A paid the HOA dues to avert a lien being placed on the property by the HOA…an act which would bite them later.

Party B was notified of the planned sale of the property by Party A, who offered to return their option fee (about $3,500). Party B then, realizing the value of the house, sought out an attorney (a partner in the law firm of Tyler and Dorsa - Temecula, CA) who I'm told, successfully sued for Party B's right to exercise the Lease Purchase Option, even though the option date had passed. Shortly thereafter Party B reportedly thought they had obtained a financing commitment at 85% LTV (just prior to, or just after approaching the law firm); but were subsequently turned-down by the lender when it was discovered that a house they had formerly owned had been foreclosed upon. The lender also discovered at that time that Party B was in the midst of an "eviction" and UDT Action re. the property (the lender presuming they were still living there).

Next, Party B made a Purchase Offer to Party A for a sum, which would have given Party A about $10,000 cash. That offer was rejected but followed with a counter offer for an amount that was $10,000 under Fair Market Value. Party B rejected the counter and proceeded with the law suit..

The suit was based upon: "The detrimental reliance of Party B upon an oral modification of the original Lease Option (purportedly an oral Agreement to Extend…which Party A insists was never proffered, but which the Realtor for Party B insisted at the hearing had been made)." Interestingly, the Lease Option contract contained an estopple strictly forbidding any such reliance upon ANY oral modifications to the Agreement.

Now, Party A, in order to avoid the minimum of a one year delay that a court hearing would no doubt entail, agreed after the failure of their UDT, to Arbitration. The arbitration hearing was overseen by a Judge Kenneth Ziebarth Ret. (retired, but still sitting on the bench in San Juan Capistrano) and concluded by "J.A.M.A. Endispute" at the rate of $240 per hour (including the Judge's research).

5/4/99 Judgement rendered in favor of Party B. The judge's statement was that "Even in view of the caveat prohibiting reliance upon oral modifications, there must have been acceptance: else why on Earth else would Party B not have exercised an Option that would clearly give them $54,000 in real estate equity in a property on which they had been diligently making payments for over a year?"

The order was for Party A to sell to Party B at the price of $181,000 (the original Option Price); and to give Party B 60 days in which to arrange for financing. And since the Option itself did not contain a provision for HOA dues and insurance, Party A says she is now also to refund all such sums paid by Party B. She is also, she says, directed to pay court costs and all of plaintiff's reasonable attorney's fees.

It appears that a Hard Money lender has now agreed to loan 75% LTV on the property, without any consideration for credit, credit history or the former BK and eviction record. It seems apparent to all concerned, however (we are told), that once the sale does take place, Party B will be forced to default and lose the property to the hard money lender. They are believed to be without enough money even for Closing Costs, and have never, it is said, had enough money to regularly cover their lease obligations on a timely basis, much less the new considerably higher mortgage payments.

Closing Costs? Party B has (again… "reportedly") indicated that they plan to cover their Closing Costs with the settlement money from Party A. And Party A has a taped recorded message from Party B indicating that if Party B's payment record is revealed to the new prospective lender, that they (Party B) will tie up the property beyond the call date of the existing loan, and notify the lender that the house is not owner-occupied (a provision of reinstatement of the 5 year call date).

Note: Party A in this story has indicated that she would gladly authorize our releasing her name. We have chosen not to do so, however, until and unless a serious minded request would come about from someone wishing to contact her directly.