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Article of the Month for July 2005 Printer friendly version

The Lease Option Bugaboo

by Ward Hanigan

It's an almost 100% certainty that if a seller gets their attorney involved in a sale where you're putting very little down and proposing the use of a title holding trust to sidestep a due-on-sale contingency, the attorney will propose the use of a short-term lease with an option to buy instead.

Why? Because attorneys commonly think that lenders don't consider a short-term lease a significant enough shift in the control of property to justify calling their loans due. However, the longer a lease runs the more such an arrangement takes on the aspect of a sale.

The test of short-term versus long-term is actually set out in the federal Garn-St. Germain Depository Institutions Act of 1982. A lease term longer than three years is thought to be so prolonged as to be tantamount to an outright sale, especially if the lease is coupled with an option to purchase. In such a case a lender would be within their rights to call in their loan.

Another reason attorneys favor the lease option is that they feel it would be easier and faster to evict a defaulting lessee rather than going through both a foreclosure and subsequent eviction.

But a lease option is a poor substitute for the transfer of ownership via a title holding trust because:

  • With no immediate change of ownership under a lease option you end up bogged down with a prolonged sales transaction that can run for two or three years.

  • Most leases aren't recordable, so the lessee runs the risk of supervening liens taking precedence over his or her unrecorded interest in the property, until the title is ultimately deeded to them.

  • Until title actually changes hands the lessor won't earn any interest on their unpaid equity in the property.

  • The complication of a holding escrow is necessary to ensure the smooth exercise of the option and the transfer of title to the lessee two to three years in the future.

  • No resale or refinancing by the lessee can take place until they have title. And most leases prohibit the lessee from subletting the property without the lessor's prior permission.

  • A lessee is subject to needless constraints on his/her privacy and less control over the property since the lessor can insist on periodic property inspections and may require his or her approval if the lessee wants to have a pet, paint or make even minor improvements.

  • A lease situation doesn't relieve the lessor from the costs for ongoing repairs or replacement of major items not damaged by the lessee - such as cracked slabs, leaking roofs, fire damage, etc.

  • Usually a lessee doesn't qualify to take all the tax deductions inherent in property ownership.

  • A lessor's interest in a lease isn't salable whereas a note that's secured by a junior trust deed (that was carried back by a seller to facilitate the sale of his property) can be quickly sold or hypothecated via a classified ad in the local newspaper.

  • In a lease situation it's difficult to regularly verify if the monthly payments on the underlying loans are being made - regardless of which party (the lessee or lessor) is responsible for sending them to the lenders.

However, if in spite of all the above negatives, you elect to participate in a lease option as a lessee then I'd suggest trying to use as short an agreement as possible. It seems that the longer such an agreement is the more controlling and intrusive it ends up being for the lessee.

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