Lease Option Default
By
When Your Lease Option Buyer Defaults On The Rent, What Can You Do
Some published authors on real estate investing recommend lease option arrangements as a good way for investors to market their residential properties to buyers who are temporarily unable to qualify for a conventional loan, but whom otherwise are satisfactory purchasers. And such arrangements can be fine exit strategies for investors. Under such an approach the investor collects at least enough in the option payment from the buyer to cover the real estate excise tax (yes, an option to purchase a property is a “sale” for purposes of the REET) and sets up the lease payments to at least cover the investor’s mortgage payments during the period of the lease. The investor expects that when the buyer has repaired his or her credit by making lease payments during the option period, the investor will be cashed out by a conventional loan after the option is exercised.
Since the investor in this situation is both a landlord and a seller, the investor will naturally screen the buyers to make as certain as possible that they will be good tenants and have a reasonable chance to qualify for a loan at the end of the option period. But what happens if, after all the investor’s due diligence, the tenant-buyer unexpectedly defaults on the rent? Can the investor declare the option terminated, retain the option payment, evict the tenant-buyer and go on to market the property again? A recent court case says it all depends on how the paperwork is written up.
In this case, the tenant-buyer of a commercial property under a lease with option to buy had a dispute with the landlord-seller over repairs and refused to pay rent until the repairs were made. The landlord started an eviction case and won a decision from the court evicting the tenant-buyer. The tenant-buyer then sent the seller a written notice of exercise of the option to buy, including the option payment as earnest money. The seller refused to accept the notice and began a lawsuit to declare the option to buy to have been terminated. The tenant-buyer argued that the lease and the option were separate documents and that there was no provision in the option that required the tenant-buyer to be in compliance with the lease in order to be eligible to exercise the option to buy. The landlord-seller claimed that the lease and option were so intertwined that a breach of the lease terminated the option. The trial court agreed with the landlord but the Court of Appeals reversed, saying that there were inconsistencies between the lease and the option that indicated that the parties intended them to operate separately. The Court of Appeals said that the tenant-buyer still had the right to buy the property at the option price, even though it was in default under the lease and had been evicted.
It is common in the residential setting to write leases and options with an eye toward defending against arguments that tenant-buyers sometimes make in eviction cases that the lease and option are part of the same transaction which is in the nature of an equitable mortgage. Such concerns mean emphasizing the separateness of the documents. This case shows that there are also risks to which a landlord-seller is exposed when the lease and option are considered separate documents. Proper wording of the paperwork can help to protect against such risks in both situations.
The foregoing is for instruction only and is not to be considered as legal advice.
About the author…
Doug Owens practices real estate law and general business law from his office in Seattle. He offers a 10% discount for REAPS members and he can be reached at (206)985-6679 or dnowens1@clear.net.
“REAPS is the oldest – and largest – Professional Association for the real estate investor this side of the Mississippi. We provide education and networking resources for real estate investors, those who want to be investors and anyone who provides value to our members. Our goals are to motivate and support our members and guests through education, discussion, legislative action and networking. We host over 40 live events a year around Puget Sound and they are all open to the public. If you’ve never attended one of our meetings, just email our office at info@reapsweb.com and be our guest for free!”
