I have suggested strategies that you should initially start with, but there are more advanced strategies that can also be considered for lease options that will build your portfolio to greater depths. When I started out, I used only basic strategies; however, over the years there have been some things that I have learned from other students and national speakers that helped me take my deals to another level.
These strategies are not essential, but they can certainly sweeten your overall profit or afford you greater protection. You will need to evaluate each situation on its merits, and remember that all of your strategies must be negotiated before any paperwork is signed. Sometimes these techniques can scare some sellers away. They can be too complex or seem too difficult, therefore you will need to know your seller and understand them by building that relationship.
Extra Ways to Protect Yourself on a Lease Option
There are some things you can do in the area of lease options that will give you the extra protection of not being the title holder. Besides filing a memorandum of option described in Chapter 6, here are some additional strategies:
- Place a deed in escrow – The seller would actually sign the deed when they sign all of the lease option contracts; however, the deed does not get recorded on the title. It gets held by an attorney or title company, in most cases, with instructions on when the deed can be released and recorded. This does not protect the title against liens being filed against it, but it does in many cases allow for the investor to close on the home without the seller present.
When the title is held it will also include instructions on how and when it can be released – for example: When Wendy Patton pays $155,000 in certified funds to Joe Smith, this deed can be released to her. These funds must be paid by XX/XX/XXXX.
Although placing the deed in escrow does not keep the title protected, it does give most sellers the feeling that they have ‘deeded’ or sold their property. I think sellers are much less likely to try to back out later on a lease option deal when they have signed a deed and placed it in escrow.
- Performance Mortgage – A performance mortgage is used for several reasons that will protect you. A performance mortgage is like any mortgage except that it is for the performance of the seller to sell their home to you. It is a mortgage on their home that they grant to you. I think they are a very good concept; however, I have found that many sellers find signing them objectionable, therefore, you will need to utilize this one only when appropriate and where it can be accomplished with the seller. These are fairly complex and I don’t use them—I just want you to know they exist.
- Limited Power of Attorney
There are many states where the transfer fees (the costs to record a deed) are extremely high and doing a simultaneous closing (discussed in detail in Chapter 13) becomes expensive. Some states’ fees are up to 3% of the sales price of the home. On a home priced at $400,000 this would take an extra $12,000 in profit right off the top of each deal for investors in those states. There are two ways around this:
Option 1: You can have the seller sign a new purchase agreement with your tenant buyer for the new amount and you pay the difference in fees for what you paid the seller vs. what you sold it to for your buyer – e.g., you paid $350,000 to the seller and you sold it for $400,000 – you would have the seller sign a new contact with your tenant buyer for the $400,000 and you pay the extra costs on the additional $50,000 raised price.
This is fine if you don’t mind and the seller doesn’t mind the entire deal being laid out in front of them. Sometimes this is no big deal, other times it causes bad feelings. The sellers always know you are making a profit, but to put it in front of their faces can rob their job of the deal that once was a win/win for them. You will have to decide if this will work for your seller. Only you know your seller and how they will feel about the deal if you did it this way at the end.
To appease the seller, you also can offer to give them a little ‘bonus’ with this. For instance, let’s say they were going to receive $95,000 in cash at closing, if they sign this document, now you will give them $96,000 at closing. It now becomes more of a win/win. They get more money and so do you. You only pay $1,000 for the first $250,000 in closing cost and then your state’s regular rates on the additional $50,000 on the raised price.
Option 2: You decide you don’t want the seller to see the details or they are out of state anyway. You can have the seller fill out a limited power of attorney. This would allow you to sign documents on their behalf for this home at closing. You can then change the price to the new price, and sign on their behalf. It is completely legal and legitimate as long as they get the amount they were supposed to receive at closing. They will have to have a payoff letter prior to closing for the title company or attorney. It might have to have dollar figure of payoff vs. the sales price. It might say something like this:
To Whom It May Concern:
I am to receive $XXXX in my closing with Wendy Patton (and you subtract the closing costs and figure out what they should receive and type the letter for them so it is ready and sent to you or the attorney/title company). Please mail my check to __________. Call me for any questions at (111)222-3333. I will not be at closing, but Wendy will be signing the documents on my behalf, for which I have signed a limited power of attorney.
Sincerely,
Joe Smith
Here is what a limited power of attorney may look like.
LIMITED POWER OF ATTORNEY
This limited Power of Attorney is given to Wendy Patton , for the purpose of Closing, Closing Documents, Contract Changes that don’t affect owner’s bottom line, Insurance, Mortgage Payments, etc., or any other matters that pertain to the property located at:
This limited Power of Attorney shall become valid as of the date signed below and be in force until the final closing of the property. Photocopies of this document shall herby be treated as original counterparts.
POWER OF ATTORNEY GIVEN TO: Wendy Patton – or your name
Agreed to by:
____________________________________ ______________________________
Seller’s Name Seller’s Name
____________________________________ ______________________________
Date Date
NOTARY
STATE OF COUNTY OF __________________
Before me personally appeared ___________________ ___________________________
To me well known and known to me to be the person described in and who executed the foregoing instrument, and acknowledged to and before me that he executed said instrument for the purposes therein expressed. WITNESS my hand and official seal in the State and County aforesaid, this ______________ day of ________________ 20XX.
______________________
Notary Public Signed
______________________ ______________________
My County of Residence My Commission Expires
- Partner with the Seller for High-End or Hot Markets – There are some states and locations where property values are very high and might be cost prohibitive or risky.
Consider partnering on those homes with the seller — that is, inviting the seller to become a partner in the profit of the sale. If a home is worth $700,000 and the rental rate is $3,000.00 per month, you may have reservations about taking on this type of property; however, this home may also net $150,000 or more in profit.
A seller of this home may also feel uncomfortable giving away all the profit for this type of property. This might become an objection for a seller in this price range or in a hot market that is appreciating rapidly. It is often wise to offer to partner with this type of seller.
Partnerships don’t always mean 50/50; it’s up to you to determine what’s fair in each situation. If you are doing all the work, they should cover all the risks. For instance, if the home is vacant, the seller should continue to cover the monthly mortgage payment, or if the tenant buyer doesn’t pay their rent, then the seller should cover the payment. If they want part of the reward, they need to cover the risk.
- Land development –I love land development. Land development is extremely profitable in areas of the country where land is valuable. For instance, in my area of Michigan, even a very small lot used to sell for $40,000, but not as much now that the market has gone down. If I can buy just a house valued at $150,000 that might have a bigger lot then normal, I can then split that lot and add $40,000 to the value. It will not affect the value of the home much if the surrounding homes sit on the same size of property, but it makes that house and lot combination worth more for me, the investor.
This can be even more profitably when the home needs renovation or can be lease optioned out to a new buyer for more than the original $150,000. You can do something mid-size like an eight-acre parcel and do five one-acre home sites, depending on your zoning requirements.
Ethics and Capital Gains
One area of Ethics to be aware of – Capital Gains for Sellers on Lease Options
There are ethical issues you will need to deal with in the real estate investing business. Many times we will know about certain IRS or other regulations or laws relating to real estate that the seller may not understand or even consider when making a deal with us. It is important to deal with everyone fairly. The rules with the IRS are constantly changing and you can’t give tax advice unless you are a CPA – so have the seller check with their CPA or tax advisor – but you should be aware of the capital gains rules and how they can affect your sellers.
The Capital Gains Rule
(check with a tax advisor as this can change at any time)
If you have lived in the property as your primary residence for more than two years and you sell it, you don’t have to pay capital gains. The IRS has changed the capital gains on our personal residences to a rule that in simplified terms goes like this: Every two years you can sell your primary residence (yes, the one you LIVE in — not your investment deals!) and you can keep the profits of up to $250,000 if you are single and $500,000 if you are married tax free. Anything above that is taxable, and any time period different than that becomes more complex. Basically, if the seller lives in it for 2 out of 5 years, it qualifies for this tax free gain. This allows the seller to rent this home for 3 years, but not one day longer.
However, if I know the seller has little to no equity in the home, I am far less concerned about their capital gains and may do a 5-year option.
What to do when your option has come to an end…
Time is out on your contract – now what? Let’s assume you had three years with the seller to purchase their home. That time is fast approaching and you have no buyer that can purchase yet. First make sure you don’t end a contract with a potential buyer on the same day as your contract ends with the seller. I recommended leaving three to six months at the back end of a deal. For instance, if you have three years with the seller, you give your buyer 18 months. If they don’t exercise, then give the next tenant buyer only 12 months, therefore, leaving yourself six months at the end of your contact with the seller for other plans. Let’s say buyer number two doesn’t want to exercise either. What are your choices? Surprisingly, there are many. You can do any of the following and in any order you choose, but I recommend to always try number one first:
- Ask the seller for an extension (if you want one) — Most sellers will give you an extension if you ask. Many times the sellers will just give it to you with no costs. Sometimes the extension might cost you more money — a little more now, in the future on the sales price, or on monthly payments. If you work it out for a win/win then do it. Make sure the extension is in writing. Don’t take their word for it. All real estate deals MUST be in writing or they are not enforceable.
- Buy it yourself —You can get a mortgage with a lender and purchase the home. You would definitely want to consider this if you can afford to do it and there is enough profit in the deal. Don’t give the home back to the seller unless it is not worth the amount you agreed upon or there is something wrong with the market or the home (that you didn’t create with yourself or your tenant). With 12 months of cancelled checks on a lease option, you can usually get a mortgage that is treated like a refinance vs. a purchase. This type of program is also available to your buyers after 12 months of payments. If your mortgage broker doesn’t have this program, find another mortgage broker (however the mortgage industry is always a moving target also). You don’t always need good credit yourself if there is enough equity. Look around and talk to some lenders, but don’t wait until thirty days before the end, talk to them months in advance. Sometimes these types of loans can take months. I found this out the hard way.
- Sell the home directly to another buyer —You will have to sell the home to another buyer directly. It will just not be a tenant buyer. It will be someone from a RealtorÒ or someone you found in the newspaper. You can sell it to anyone you would like.
- Partner with someone if you can’t do the mortgage yourself — If the home has some equity and you can’t refinance it, you can’t sell it, and the seller won’t extend, then bring in a money partner who can get the mortgage. Give them a part of the equity or a fixed amount for doing the financing. This will give you more time to resell it on the market or to lease option it again. You can find money partners all day long in your local real estate investing group.
- Don’t exercise your option —Tell the seller you don’t want to purchase and then you can walk away from the deal. Remember that an option with the seller only gives you the right, not the obligation, to purchase. You must return the home in equal or better condition, less any normal wear and tear. You can’t return the home with damage.
- Assign the deal to another investor — You can wholesale this lease option to another investor for a fee, then they can do one of the above five choices.
