Submitted by Jessica Jensen
A common question I am asked about rental property is how to handle a situation where a tenant wants to buy the property but can’t get a loan or doesn’t have a large enough down payment to be able to purchase the property outright. There are three options.
First is a straight purchase with owner financing. In this situation, there is a purchase and sale agreement with a modest deposit and a closing within a reasonable timeframe at a price and on terms that the parties agree. The seller will typically want as much cash down as the buyer can afford. This is also in the buyer’s interest too because the more the buyer puts down, the less interest the buyer will pay. The buyer and seller also need to agree on the interest rate for the owner financing and how many years the buyer has to pay. Owner financing is typically at a higher interest rate than a bank and usually includes a “balloon payment” where the loan must be paid in full after a period of years (typically 2 to 10). This allows the owner to get his cash sooner and the buyer to build his credit and/or build enough equity to be able to refinance the balance owed. At closing, the seller will provide a warranty deed and the buyer will pay the cash the parties have agreed on and sign a promissory note for the balance owed. The note will be secured by a deed of trust (commonly referred to as a mortgage), which creates a lien on the property securing repayment in case the buyer defaults and doesn’t pay the loan.
Second is a lease-purchase. In this scenario, the buyer continues to rent the property with the right to purchase within a specified period of years. There are many ways to structure a lease-purchase. The purchase provision can be specified to occur by a certain date or an option at the buyer’s election or merely a right of first refusal if the seller decides to sell. The purchase price can be fixed in the lease-purchase agreement or left for future negotiations. The buyer can put money down toward the purchase up front or at closing or make monthly payments toward a down payment along with rent.
The parties will sign a lease-purchase agreement and may also sign a purchase and sale agreement either at the same time or shortly before the buyer is ready to purchase. The buyer will want to record the lease-purchase agreement with the county auditor’s office to protect the buyer’s right to purchase. Payments made toward the purchase price need to be reported as income to the seller for federal tax purposes and are subject to state excise taxes, so a seller will want to consult with an accountant before entering into a lease-purchase. The seller provides a warranty deed at the agreed closing date.
Third is a real estate contract. This option was very popular in years past and is becoming more common again. In this case, the seller and buyer enter a real estate contract that establishes a purchase price and provides for the buyer to be in possession of the property and pay the seller’s mortgage, taxes, insurance and be fully responsible for maintenance and repairs. The seller provides a warranty deed at signing of the real estate contract which is held in escrow until the buyer pays off the seller’s mortgage and pays the seller the balance owed on the purchase price or otherwise comes up with the cash to pay the balance owed on the contract price. Like a lease-purchase, the real estate contract should be recorded. Sometimes there is a balloon payment due before the seller’s mortgage is paid off, but usually the sale is completed when the buyer finishes paying off the seller’s mortgage and the warranty deed is released from escrow and recorded at that time.
In any of these cases, the seller typically pays for a title policy for the buyer and for the legal fees to document the transaction but the parties can also agree that these costs are paid by the buyer or split between the parties.
Jessica Jensen is the senior attorney with Jessica Jensen Law of Olympia. Her holistic, general practice firm focuses on business, real estate and land use, wills, trusts and estates, family law and alternative dispute resolution. She may be contacted at 360-705-1335 or www.jessicajensenlaw.com.
