Rent-to-Own

by Mr. Cheap

Rent-to-own (also known as lease-option) is a popular real estate strategy in the US and has been making its way into Canada in “get-rich-quick through real estate” circles.

This agreement, between a landlord and tenant, involves the landlord selling the tenant the OPTION to buy the property at a fixed price at some point in the future (much like a call option for stocks).  Often there will be an initial payment as well as a portion of the monthly rent payments being credited to the tenant.  This might be useful for a tenant who has trouble getting a down payment together (but can afford to put away a little bit each month) or a buyer with credit issues that they’re working out (who expects to be in a position to buy within the option period).

As an example, pretend I’m renting you my condo (which has been assessed at $156K) for $1350 / month.  We agree that I will give you the OPTION (not the obligation) to purchase it for $160K at any time for the next 3 years, with an initial payment of $5K with $150 from each rent payment being credited towards the down payment.  At the end of 3 years say the condo is now worth $165K and you have accumulated a $10,400 down payment (5000+150*12*3).  You arrange for a 5% down mortgage, using the credit you’ve accumulated over the 3 years (which is worth 6.5% of the $160K ) with me using the other 1.5% to cover your closing costs (so you pay nothing more out of pocket and are now the owner of the property).

Say, instead, the real estate market tanks and you decide you don’t want to pay $160K for a condo now worth $130K, you don’t execute the option and at the end of the 3 years there are no further obligations (although the $10,400 is forfeit, the tenant does NOT get it back).

From the sellers perspective, they get to either sell at a price acceptable to them or earn a premium over market rental rates if the sale doesn’t go through.  Additionally, the tenants will take better care of the property (since they expect to own it) and will be very motivated to pay rent on time and honour their lease (since they could jeopardize the purchase if they don’t).

From one perspective, between financially sophisticated individuals, this is a reasonable way to allow the seller to earn a premium by acting like an insurance company, taking on more risk in exchange for payment.  Sadly, rent-to-own is often instead used to take advantage of unsophisticated renters who want to become buyers but don’t have the means.

Often the tenant who isn’t in a position to buy at the beginning of the lease term STILL won’t be at the end of it (and will be $10K poorer for having gone through the exercise).  Unsurprisingly tenants will be annoyed when this money is gone, and will often become destructive or difficult tenants if they aren’t able to close on the deal (and the seller refuses to return their option payments).

From the sellers position it’s a pretty good deal, as they can set the sale price higher than they expect it will be worth within the option period, and they get paid a premium over what they’d usually earn in rent.  The law is often on their side if the market takes off and they decide to not honour the deal and fight the sale.  That being said, judges will NOT be impressed by these sorts of shenanigans and will be looking for any excuse to rule in the tenant’s favour.

I saw a classified ad from a woman who wanted to do a rent-to-own deal (with her as the tenant) in Toronto so I contacted her.  Turns out her expectation was that she’d pay market rent, but her ENTIRE rent would be credited towards the eventual purchase of the property.  Why she would expect any landlord to agree to this is beyond me, but she did.

I talked to a lawyer friend who talked to a lawyer friends of her’s who specializes in real estate and they were of the opinion that lease-options were too untested legally in Canada to get into unless you were doing them in a big way (in which case they felt it might be worth the expense to research all the legal ramifications and develop the right contracts to make it a business).  Their advice was to do a vendor-take-back mortgage if I wanted to provide seller financing.  In the US, where these deals are far more common, there are also legal and ethical pitfalls.  John T. Reed outlines some of them in an article about lease options (and offers a report for sale with more info).

More information about lease options is available here (general overview), here (with a bunch of links to more articles at the bottom) and here (details lease options in BC with a couple of quotes from Mr. Reed).

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{ 6 comments… read them below or add one }

1 Shank

I also wonder from the landlord perspective how you would handle the tax implications which would only add to your costs as now you probably need an accountant in addition to legal counsel. And if the additional tax issues would be worth it.

For instance, in your example, $1800/year goes to a potential down payment. Normally, all rental income is taxed as that – income. But is this $1800 income? Deferred income? Or does it form part of a capital gain? You won’t know until three years out thus creating complications of how you file for three years, and do you refile if the option is exercised etc.

Essentially, if you are a small (only a few rental properties) rent-to-own landloard the handling of your taxes could just be an unneeded frustration.

2 Ray

I have been interested in Rent-to-Own option for a while but there really isnt a medium to find such units or advertise it.

Shank: that is actually a good question, i have never thought about it from a tax perspective.

3 Mr. Cheap

Shank: Yes, the taxation does get complicated.

Ray: If you wanted to advertise a rent-to-own property, I’d just advertise it in normal rental channels, and ad as part of the rental description that you’re open to offering a rent-to-own. In terms of finding such units, that’d be more of a challenge (my understanding is they’re fairly rare). It’d be a rare landlord / property seller who would be open to a lease-option if they didn’t offer the option from the start.

4 qmanrei

There are lots of different benefits and drawbacks to both parties. I’m not writing the article however.

You are taxed at your regular tax rate and not capital gains when you are doing a Lease to Own. Unless you incorporate.

Here’s our RTO web site http://appleridgehomesRTO.ca

5 Mr. Cheap

qmanrei: Thanks for a link to a real, Canadian rent-to-own real estate company.

6 Mark Loeffler

Great example of Rent-to-Own. The biggest thing in the rent-to-own business is managing expectations. If you can manage your tenants and investors expectations you will find that win-win scenario everybody is looking for.

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