Subject to/Lease option question

[Kevin Craig]

If I buy a house for 100,000 and sell it for 120,000 and charge a buyer 5,000 down to get into the house. How is that contract structured?

Does he begin a new contract for 120,000 after the time period comes where he can excercise the option or does he keep paying the normal rent?

If he enters into a new contract for 120,000 what happens to the old one and do I get 10,000 right then and there when he enters into the new one?

Thanks in advance for all answers..

All answers appreciated..

[Jon Holdman]

Here are some answers, but I would encourage you to do some reading here on these topics. You're trying to orchestrate a pretty complex deal. Both subject to and lease options have been discussed at length in many posts and there's lots more than I'll write here.

First, lets get straight on the two different types of deals you're talking about: subject to and lease option. Then lets look at how to combine these like I think you're trying to do.

Normally when a house is sold, the buyer gets a new loan. The money from the new loan goes to the seller, who typically uses most of it to pay off an existing loan. In a "subject to" deal, the buyer takes over the existing loan. That is, the buyer buys the house "subject to" the existing loan. The buyer begins making the payments on the old loan instead of getting a new one. The old loan stays in the seller's name. The lender usually has the right to "call" the loan based on the "due on sale" clause. That's a clause in almost all loans since the late 80's that says if you sell the house you have to pay off the loan. Calling the loan means the lender can demand full payment and if you don't make it they can foreclose.

A lease option is where there are two separate agreements between the seller and buyer. The first is a lease from the seller (acting as a landlord) to the buyer (acting as a tenant.) It gives the buyer possession of the property. That is, the buyer can occupy the property. The second agreement is the option. An option is an agreement that allows the buyer to buy the property at a later time for a specific price. There is typically an "option fee" or "option money" from the buyer to the seller. That's non-refundable. If the buyer doesn't "exercise the option" (that is, buy the property), they lose the option fee. Typically, if the buyer does exercise the option, the option fee is applied to the purchase price. Also typically in a lease/option, some of the rent is credited toward the purchase price.

Both of these are forms of "seller financing". The simplest form of seller financing is where the seller owns the house free and clear, and agrees to take payments from the buyer rather than getting the money all at once. That's how I bought my first house over 20 years ago. Subject to and lease/options are more complex forms of seller financing. Others you might want to learn about are wraps and land contracts.

I think you're saying you want to buy a house subject to, then sell it with a lease option. So, you would buy a house where the outstanding loan balance is $100K. You start making the payments instead of the seller. The seller walks away with nothing, but is rid of a property and a payment they don't want. You are now responsible for the payments. If you don't make them, the sellers credit gets screwed and they sue you. You're also responsible for maintenance, taxes, insurance and any other expenses for the house. There are lots of posts about this topic.

Now you have the property and a payment. On a loan amount of $100K your payment might be, say $800. That includes taxes and insurance. You turn around and do a lease option with someone else, your "tenant buyer". You charge them market rent, or maybe a little more. On decent rental deals, rent is usually quite a bit higher than your payments. On a house like this example, break even rent would be around $1300. So lets say market rent (which you DO NOT control, you must research and find out what this really is) is $1400 for a house like this. You find a lease option buyer who will give you $5000 for the option fee for the right to buy the house for $120K within two years. You agree to give $100 a month of the $1400 toward the purchase. You also get the buyer to agree to be responsible for all maintenance on the property. (This may not be legal in all areas. You're still a landlord, and most areas have minimum requirements on rentals properties. If the furnace fails in the middle of winter, and has to be replaced, you WILL be legally required to replace it at your expense in most areas regardless of what your lease or option agreement says.)

After two years, the tenant buyer exercises their option and buys the house from you for $120K. How does this work out for you.

Up front, you will pay about $2000 in closing costs to buy the house. You get a house and a $800 a month payment. You probably do some fixup, so lets guess $3000 for some minor items (paint, carpet, some minor repairs). You hold it for two months ($1600 in payments) while you find a tenant buyer. So, you have $6600 invested.

You find a tenant buyer who pays you $5000 in option money and starts paying rent of $1400. Now you have $5000 of the $6600 back. You're getting $1400 a month in and paying out $800 (these are just guesses, put in your real numbers). That's $600 a month. So, after two years, you've collected $14,400. Less the $1,600 you had invested up front ($6,600 you spent less $5,000 in option money), you have netted $12,800.

The tenant buyer exercises the option and purchases the place for $120K. You'll have another $2,500 or so in closing costs. You have to give the buyer credit for the $5000 option money plus $2,400 for the rent credit. So after its all subtracted, you're left with $110,100. You have to use that to pay off the old loan, which is down to (say), $96,000. That leaves you with $14,100. Add that to the $12,800 and you've netted $26,900 on this deal over the course of two years.

That's if things go well. What can go wrong? Well, the tenant buyer would wreck the place and move out in the middle of the night. You'll have to spend some money, fix the place up and repeat the process.

The lender could call the note. That's rare, from what I hear (I've never done a subject to deal). But if interest rates go up in the future, they might. If you don't make a payment, they will. Now you lose the property to foreclosure. The tenant buyer has an option which legally obligates you to sell them the house. A house you no longer own. They sue you.

What could happen that's not that bad but still not what you expected?

The tenant buyer doesn't exercise the option and just walks away. You fix it up and find a new tenant buyer. Hopefully you have a chunk of that $12,800 set aside to deal with the fixup.

The furnace does break and the tenant buyer can't afford to fix it. As the landlord, you have to step in a fix it. Again, hopefully you've accumulated some of that $12,800.

Tenant buyer doesn't exercise the option but stays on as a regular tenant. Now you're a landlord (which you really were all along).

Tenant buyer stops paying rent. You try to evict. The tenant buyer say "hey, I have an equitable interest in the house because of this option." A judge agrees. You have to foreclose to get the tenant out.

The fact you're trying to do a deal like this when you don't really understand it is worrisome. You really need to do some reading and study and be sure you understand the in's and out's of this sort of deal before you get into something you don't understand. Like I said, this is quite a complex deal. It looks attractive, if things go well. But there are LOTS of ways things can go wrong and leave you on the hook.