An option on real estate is an extremely versatile investment tool that comes in a variety of forms that can be used for a variety of purposes. The primary use of the option is that it gives the optionee (the party holding the option) control over property (in the sense of the right to buy it) for very little cash. It gives the most leverage and conserves cash, both very desirable for investors. An option gives the holder the right to buy a specific parcel of real estate at a specified price, on specified terms within a specified period.
An option can be compared to (1) a contract of sale with a liquidated damage clause, (2) a sale with a nonrecourse purchase money mortgage, and (3) a lease containing an option to purchase.
Contract of Sale
Instead of an option, an investor could enter into a formal contract of sale containing a liquidated damage clause. This is a contract that the investor may walk away from, subject only to the loss of the down payment as liquidated damages to the seller. The advantage of an option is that it is less complicated (and so may involve less negotiation and legal fees) than a contract of sale although it is undoubtedly a better idea to attach a contract of sale to the option agreement so negotiating problems do not arise later if the option is exercised. On the other hand, a seller may not be willing to give an option, preferring a contract under which the seller retains the choice of either accepting the down payment as liquidated damages or seeking actual damages in a larger amount from the buyer.
The prospective buyer does suffer some limitation of rights as an optionee because the holder of an option lacks a legal or equitable interest in the property (whereas a contract vendee has rights as set forth in the contract).
As an alternative to taking an option on property, an investor may purchase the land, acquiring legal title from the seller who takes back a standing (no amortization) purchase money mortgage equal to 100 percent of the sales price, with interest to be paid annually. The mortgage is nonrecourse (the buyer having no personal liability), so the seller’s sole remedy in the event of a default in payment of the interest is to repossess the land. If the purchase is of undeveloped land and the mortgage contains a provision for the release of individual parcels, the mortgage functions in the same manner as a rolling option.
Amounts received by the seller as interest each year are taxed as ordinary income, while the purchaser may be entitled to a deduction for interest paid, subject to the tax rules regarding deductibility of interest. By comparison, annual payments under a long-term option would not be income to the seller if properly structured and would not be deductible by the buyer.
Lease With Option to Purchase
Another alternative to the use of a straight option is a lease containing an option to purchase. In this arrangement, the investor can obtain immediate possession of the property as a tenant, paying rent rather than an option fee. This approach makes sense for income-producing property. The investor is in a position to earn a return over and above the rent paid to the landlord while at the same time retaining the right to acquire ownership of the property at a future date. Rent income is taxable to the landlord as received, and is deductible by the tenant assuming other requirements for rent deductions are met.