"Rent-to-own" is a way of acquiring an asset - most often a principal residence. Usually, a rent-to-own agreement is a lease with an attached option. The landlord sells the tenant an option to buy the property at a fixed price at some point in the future. There may be a small down payment of some "option money." A portion of the monthly rent payments are credited to the tenant as part payment of the purchase price. This can 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).
Lets assume I rent you my house for $1200 a month. I give you an option to buy the house for $130,000 at any time over the next four years. $200 of every month's rent payment is credited to the purchase. At the end of the four year period, you will have paid $9,600 ($200 x 12 months x 4 years) toward the purchase price which acts as your down payment. You can exercise the option to buy, apply for a mortgage, and buy the house at any time during the 4-year period. If you wait until the end, your down payment will be $9,600. If you don't exercise the option - because you decide you don't want to own the house or because you can't get a mortgage, then the deal is over. You do not get any part of your payments back.
Looking at this from the seller's point of view, the Seller has made a deal at a price that is acceptable and either he will sell the property at that price or they will get a premium rent for the 4 year period if the sale doesn't get made. The Seller hopes the tenant will take better care of the property because the tenant hopes to be the owner. The Seller also hopes the tenant will make sure to make rent payments on time so as not to breach the agreement and lose the right to purchase and lose the accumulated "down payment."
The Landlord/Seller's responsibilities do not change under a "rent-to-own" arrangement. The insurance and taxes are paid by the Landlord/Seller. The Landlord/Seller is responsible for major repairs. There is no transfer of title until the tenant/buyer exercises the option and completes the sale.
Unfortunately, rent-to-own is often used to take advantage of unsophisticated renters who want to become buyers but don't have the means. Many times, the tenant who isn't in a position to buy at the beginning of the lease term still won't be able to when the option expires. Tenants who can't buy become very angry when their "down payment" is not returned to them.
If the seller is really willing to provide financing, it would be better for the house to be sold and for the seller to "take back" a mortgage.
Rent-to-own deals have garnered a very bad reputation. People in the business of selling properties on a rent-to-own basis report a 50% or higher, as much as 95%, failure to close rate. That means that the majority of the prospective buyers fail to buy and lose the extra money they were paying the landlord as their "down payment." The set-up has been criticized as taking advantage of poorer, less sophisticated tenants, giving the property owner a premium rent..
In general option money is not taxable to the optionor (the landlord/seller) until the option is exercised. The landlord/seller would not report the part of the monthly payment that is the option price until the tenant buys, at which time it is part of the purchase price and may or may not be capital gain to the landlord/seller depending on his/her situation. If the option expires or is abandoned, the option price is taxable to the optionor (landlord/seller) as ordinary income at the time it expires or is abandoned.
A personal residence sold using rent-to-own may qualify for capital gains exemption. Gains from the sale of a personal residence are exempt so long as the gain is less than $250,000 ($500,000 for married couple). If the lease was "incidental" to the sale, court decisions have held that the property would still qualify as a personal residence and not a rental.
The lease and option payments made by the tenant are not tax deductible if the property is used as a residence. If the tenant purchases the property, his option payments (including monthly rent credits) become part of his tax basis in the property. The tenant's option payments may be deductible as a capital loss if the buyer is an investor.
The rent-to-own agreement is important. There is no standard form. Despite the document being titled "rent-to-own" or "lease option" courts and the IRS may find that the actual agreement is really an installment sale. That receives very different tax treatment, and may change the rights and responsibilities of the tenant/buyer with regard to for the return of the "down payment."
