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Copyright 1998, 1999, 2001, 2006 by John T. Reed
There are two major problems with lease options the way they are being taught in seminars:
Claude Diamond runs his lease-option business in a way that I object to, although it's pretty typical. He says about 50% of his lease-option tenants are unable to exercise their options. That means that about half the people who do business with him as lease-option tenants end up thousands of dollars poorer as a result when they walk away from their large front-end payments and year or two of above-market monthly rent payments. These are people who entered into the deal in the hope of becoming homeowners and leave less able to become homeowners than they were when they first met Diamond.
That reminds me of the trade schools whose students pay thousands of dollars tuition, then a high percentage of the "graduates" of the school cannot find a job in the field for which they were trained. When I voiced my objections about the high rate of his lease-option tenants being unable to exercise their options, Diamond asked, "Whose responsibility is that?"
In other words, if a lease-option tenant pays Diamond thousands of dollars for the lease option, then loses it all because they are unable to exercise the option before it expires, that's the tenant's problem, not Diamond's, even when it occurs half the time. I disagree with that attitude toward such a high failure rate. And I give the general advice that whenever you deal with anybody in any field of endeavor, you should make the working assumption that the person will treat you the same way he treats other people.
Other lease-option practitioners have failure rates as high as 95%. That's not right. The lease-option tenants are typically young couples who cannot afford their dream of home ownership and are convinced that a lease option is a back door to owning a home. In fact, the vast majority lose the thousands or tens of thousands of extra dollars they shell out, above and beyond what a lease would have cost. When the lease option is over, they are far less able to afford a home than when they started. I suspect many permanently lose their ability to buy a home because they fell for the false promise of the lease option.
There is no question a lot of real estate investors are making a lot of money from lease options. But most of it is dirty money earned by scamming young couples, not by finding a need and filling it, the age-old legitimate path to profits. Rather, this is the predators' way: a fool and his money are soon parted, so devote your life to finding fools and taking their money.
The tenants do not exercise the options for two reasons:
An option is “in the money” when the option price is less than the current market walue of the property. You would not exercise unless that were the case. In probably the vast majority of cases, the landlord sets the option prices in the lease option so high that the option price is never likely to be less than current market value. Furthermore, on the rare occasion when the option price turns out to be less than market value, the landlord just reneges. In the stock market, they have procedures to prevent that. No such procedures exist in real estate.
Lease options are targeted at people who want to own a home but who lack the cash down payment, credit, and/or income to qualify for the mortgage. In virtually all cases, there is little reason to believe that will change during the two or three years the option lasts.
So by making a lease option that is never likely to be in the money to a person or couple who is not likely to qualify for a mortgage so they can exercise the option, the lease-option scammer does a deal that he is pretty certain will result in his pocketing $10,000 to $20,000 of the tenant’s money and leave the tenant out in the street with nothingno benefit from having paid all that extra front money and rent.
Lease options are explicitly named in numerous laws and legal documents as triggering events. They trigger almost all mortgage due-on-sale clauses. They trigger reassessment for property-tax purposes in California, thereby wiping out the protection California homeowners normally get from Proposition 13.
Another problem is the legal doctrine of substance over form. It is possible to do a lease option that is clean. But the various gurus advocate doing lease options in a way that arguably triggers the federal income tax doctrine of substance over form.
That doctrine says that what you call something does not necessarily determine what the law will regard it to be. Calling a lease option a lease option does not mean the court will treat it as a lease option. In fact, I believe they will treat most guru-designed lease options as land-contract sales in substance. The legal implications of such a determination are amazing in their number and seriousness. You could have a tax-free exchange invalidated. You may find that you are unable to evict the tenant. IRS may say that all your lease options were installment sales and that you must pay overdue tax and penalties on them, tax that will be inflated by the typically inflated option prices.
The gurus are not interested in finding out what the law really is on lease-options. I have long urged them to obtain an IRS private letter ruling on the income-tax legality of their lease-option agreements. The cost of such letter rulings was drastically lowered years ago. But not a single lease-option guru has ever requested such a ruling, in spite of the fact that it would help his clients and help him market his material. The fact is they know what they advocate is probably illegal and they are afraid to get a ruling.
I cannot give you the whole picture here because I am in business to sell this information, not give it away. To get all the details on lease options, you should read my special report, which is only $29.95. Heck, given the astronomical prices they charge, the other lease-option gurus probably expect you to tip them more than that.