"Rent-to-Own" – How Does It Work?
“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 payment is 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).
Let’s 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 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.
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.
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 high 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 option (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 option 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 a married couple) and the house was used for a personal residence for two of the five years preceding the sale. In our example, if the owner had lived alone in the property for one year preceding the rent-to-own period, he would have qualified for half of the $250,000 capital gain exemption. 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 by the tenant 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.”