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A Lease-Purchase Contract is not unusual in residential transactions, particularly where the property or purchaser may not meet standard lender requirements. Though not as prevalent or popular in commercial real estate, a lease-purchase arrangement could be advantageous and desirable – for both buyers and sellers of commercial properties, and for reasons other than property condition or financing challenges. Indeed, this “hybrid” strategy, oft-dismissed as desperate or sketchy, could be a mutually brilliant strategy and solution . . . at the right time . . . for the right tenant, the right owner, and a “rightly-minded” real estate professional. Like you.

A Lease-Purchase Contract combines a traditional rental agreement with an exclusive option to purchase the property at a later date. And true, while it’s mostly employed to eventually (hopefully) hook up unconventional properties and buyers, its use or usefulness needn’t be that restrictive or reluctant. Offering a lease-purchase opportunity upfront at time of listing a commercial property deeply widens the pool (ocean) of potential property users, some of whom don’t presently qualify for a traditional loan (but might later on). BUT in broadcasting a “rent-to-own” opportunity, you’ll likely attract an even larger number of prospects who DO qualify for more “conventional” commercial financing, but may still be hesitant to commit long-term to a new, untried location, business venture or expansion. A 3 to 5-year lease might provide them enough “safety-valve” to take the plunge, gain traction, proven income and credit history, while minimizing losses and liability should the business falter and fail.

Indeed, if properly structured, a lease-purchase should help the landlord-seller get top rents, and contain current (and deferred) repair and maintenance costs (tenants take better care of their future property) – and still allow them to take depreciation and other tax write-offs.  And if properly structured, provide would-be sellers ample time to calculate potential capital gains (and solutions) down the road.

Properly structuring the Lease-Purchase Contract is most important, requiring your knowledge and guidance (in conjunction with your client’s legal and tax advisors, of course). 

In addition to standard commercial terms, the Lease-Purchase portion of the lease contract should include:

• Option fee – Paid upfront for the exclusive right to purchase the property – non-reimbursable should the tenant fail to exercise the option. Take enough option fee to show good faith, but not so much it virtually compels the tenant to proceed with the purchase, or suffer a disproportionate penalty. (See “tax” discussion that follows)

• Monthly Payment – The total amount tenant will be paying each month should be specified as rent. 

• Rent Credit – How much of the total monthly payment will be applied as down-payment should the option be exercised. Like the option fee, the credited amount should not far exceed prevailing rents, almost forcing the tenant to buy the property rather than forfeit both the option fee and accrued rent credits.

• Duration — Timeframe of the Lease-Purchase Agreement, including expiration date of the lease, and the time within which the option remains exercisable (usually 3-5 years). Hopefully, enough time for tenant to prove income and credit history, and secure outside financing to complete the purchase. While it may seem desirable to let tenant exercise the option at any time, an earlier than expected exercise may be disadvantageous tax-wise to the seller. Seek professional advice beforehand.

• Sale Price — Usually locked-in at time of execution (can be a problem if property prices are moving skyward, but also an attractive selling point). An alternative is to hire an appraiser to evaluate the property at the time the option is actually exercised. 

• Other Terms –Including payment of property taxes, insurance, maintenance services, repairs, and/or merchant or condo association fees. Lease should be very clear about tenant improvements to the property if option is not exercised.

Should the tenant/buyer be unable or unwilling to purchase the property, the parties could terminate the lease, extend the option period, or convert the Lease-Purchase Contract to a traditional rental agreement.   

Taxes on Real Estate Options

Generally, real estate owners don’t pay taxes on option fees until the option expires or is exercised. If the option is not exercised, the property owner pays ordinary income tax on the option money received. But if exercised, option fees become eligible for capital gains treatment (another tax plus).

CAUTION: The IRS could reclassify a long-term lease option as an “installment sale,” wherein gains must be recognized and accounted for at the time the “lease” is executed, not when the deed is actually transferred. To avoid reclassification, avoid contractual terms and conditions that invite IRS scrutiny:

• The amount of potential forfeiture of option fees and accrued rent credits plays a major role in determining whether a sale already occurred. If deemed inordinately high or onerous, IRS may claim an installment sale has already occurred.

• Further, a lessor invites scrutiny if it charges the buyer only a nominal (i.e. reduced) sale price when the option is finally exercised.

• Or when the monthly “rent” far exceeds comparable leasing rates.

Should the IRS re-characterize a lease option as an installment sale contract, the lease payments, including the option consideration, are reclassified from ordinary rental income to capital gain. This might seem beneficial to the lessor, but is usually outweighed by the loss (forfeiture) of any deductions previously taken for depreciation and operating expenses as well as possible back taxes and penalties.