Rent-to-own, also known as lease option, is an investing strategy that can be benefit both home buyers and home sellers.
For home sellers, rent-to-own may be the perfect solution to ensure you get top dollar for your home in a buyer’s market. It may even generates some extra income for the seller before the actual sale of the home. The rent-to-own strategy also increases the number of potential buyers for your home to include those who do not qualify for the conventional mortgage from banks.
In a rent-to-own or lease option, the homeowner rents his/her property to a potential buyer (lessee) with the exclusive right to purchase the home within a certain time period, usually 3 years or longer. The homeowner cannot legally sell the property to anyone else during the period defined by the lease option. The homeowner and lessee would negotiate in the beginning of the lease the term of the lease to include the purchase price, option or earnest money, monthly payment in addition to the rent.
Decide if a rent-to-own is for you. Rent-to-own isn't for everybody. If you need all the money from the sale of your home right away, you're better off with a straight sale. In addition, the majority of rent-to-own aren't exercised, so you may have to begin the process of selling your home all over again after the lease terminates.
You might also have to consider if you want to, or aren't able to, keep up with the responsibilities of continuing to own the home. In the a rent-to-own scenario, the homeowner must continue to pay property taxes and insurance and is generally still responsible for major repairs during the lease period.
Do a background and credit check on the applicants. At this point, you have to look at potential buyers as potential tenants, and you don't want to do a rent-to-own with somebody who you wouldn't rent to. Look for someone with good references, a steady source of income, and the ability to pay the rent plus, if applicable, the additional monthly option money.
As far as the applicant's credit history, you probably don't want someone with serious credit trouble, but at the same time you may want to be somewhat lenient. Many buyers who choose rent-to-own do so because they have some blemishes on their credit and want to improve their profile before applying for a loan.
Pre-qualify your lessee. It's a good idea to contact a loan officer or mortgage broker to at least discuss the potential buyer's prospects for obtaining a mortgage at the end of the lease term. There is more uncertainty (and, hopefully, more chance of improvement) the longer the lease term, but both you and the potential buyer can get a realistic idea of whether they'll be able to buy the house.
This step is essential if it's important to you to sell the house at the end of the lease. But ethically, and perhaps legally, it's important regardless of your preference because if you take option money and above-market rent from a tenant who can't possibly buy the house at the end of the lease, you're just ripping the tenant off.
Provide the potential buyer with a seller's disclosure form. The disclosure form lists any known problems with the house. You attest, to the best of your knowledge, to the condition of the house. This form is standard for other purchase transactions but is sometimes left out in a rent-to-own. Make sure you give the buyer this form to help him or her make an informed decision and to protect the integrity of the contract and sale. The buyer should also have an independent home inspection done.
Prepare a lease agreement with option to buy and collect option money. You can get fill-in-the-blank rent-to-own forms online, but you're better off getting them from a local real estate agent or attorney. The contract is sometimes added as an addendum to a standard sales contract. Unless you really know what you're doing, get help with the details of the contract from a real estate attorney, not a or broker.
The most important thing to remember is that you've got to cover not just the money issues but also who is responsible for what types of repairs and other complications that are bound to come up.
◦ Agree on the purchase price of the home, which should be fixed on the lease contract. You'll be obligated to sell at this price, so you want to make sure it's something you can live with. Ideally, the agreed-upon price should be at least at fair market value and maybe slightly more (especially for lease terms of 1 year or more) to compensate for the convenience to the buyer and for the likely appreciation of the property over the term. You and/or the buyer may want to pay for an appraisal to validate the price. Banks and other lenders will only loan against the appraised value, regardless of the price that you agreed on with the buyer.
◦ Determine how much option money to collect. Some states and municipalities have laws specifying a maximum amount of option money that can be taken, but in general the initial option money or option fee can be almost any amount. A typical figure is 2-4% of the purchase price. You will keep this money no matter what. If the lessee decides to buy, the money will be credited toward the down payment or the purchase price, and if the lessee doesn't buy, he or she forfeits the option money to you. Keep in mind that many buyers choose lease options because they can't come up with a big down payment, so don't expect to be able to get a huge amount of initial option money.
◦ Decide how much of the lessee's monthly payment will be credited toward the option. Anywhere from 0-100% of the monthly payments can be credited toward the purchase price, although the amount is sometimes subject to state or local laws. In general, the monthly payment will be calculated at fair rental value plus a set amount that will go toward the purchase price. This, like the initial option money, will either be credited toward the down payment or the purchase price or, if the tenant doesn't buy, will be forfeited to you.
◦ Decide on the term of the lease. Lease options typically run anywhere from 6-24 months. Less than six months usually doesn't make sense for the buyer, and more than 2 years (sometimes more than 1 year) may cause tax or legal complications. Shorter lease terms generally result in sales more than longer terms, simply because there are so many variables over the long term, but the length of the lease should be adequate to ensure that the lessee has time to get his or her financial ducks in a row. Keep in mind that if housing prices appreciate quickly, you may be getting a bad deal on a long lease, since you're obligated to sell at the agreed-upon price. If housing prices decline, however, you may be getting a good deal, but if they've declined significantly, the lessee is unlikely to buy the house. You still get to keep the option money, however.
Get the right home insurance coverage. Since you will no longer be the owner-occupant of the house, you may need to update your homeowners insurance policy to a dwelling policy. Check with your insurance agent to determine what policy is necessary and what coverage you need. Your tenant should also be insured to cover his or her liability and, depending on your state, any gaps in your coverage that may result from the lease option.
Collect monthly payments. Now, all you need to do is collect the payments each month. Keep track of the payments received so you'll have a record when the time comes for the lessee to exercise the option (or, in the the worst-case scenario, when you have to go to court to settle a dispute).
Sell the home. At the end of the lease term, the lessee can exercise the option to purchase your home for the price specified on or before the date specified. The total option money paid (including the initial option money plus any credit from the monthly payments) will go toward the down payment. Thus, the buyer already has equity in the home and should find it easier to qualify for a mortgage.
Do you have what it takes to be successful in real estate investing?
Everyone wants to be successful in building wealth. And real estate investing is one of the greatest ways to do so.
The whole real estate investing is about learning how money works, how to find money and "make" money magically. It's this challenge that makes real estate investing fun and exciting.
I started out with using equity in my own primary residence. I don't have any fix-and-flip experience on paper, but I do know how to buy-rehab-rent. I'm currently planning to rent my current home out, and use my owner-occupant status to qualify for a home loan to buy my next property. It's easier to qualify for owner-occupant property loan than an investor's property. Besides, hard money lender won't lend on owner-occupant, and they only lend up to 50-70% of value.
There are 3 basic elements to real estate investing: money, knowledge and deals.
Do you have these 3 elements to succeed?
This is the biggest challenge for most people starting out. Most of us don't have a couple millions sitting around waiting to be spent. Besides, as we all know, Honolulu real estate is one of the most expensive, so the initial cash needed is a big challenge.
But still there are ways to find that money you need. And the word we love to use in real estate investing is "leverage". It basically means stretching what you have to accomplish more.
Remember, this money does not need to be your money. It can be and preferably other people's money.
For example, you have $100,000 sitting in your savings account earning 0.05% interest from the bank. Instead of earning 0.05% and being taxed every year on that earning, you decide to use that money to invest in real estate.
You have 2 options to do so.
One, buy a small condo with the $100,000 all cash. Second option, buy 5 small condos by putting 20% down on each, and mortgage the remainder 80%.
It's true, with the first option, you save on mortgage interest and closing cost. But you're missing out on the earnings.
Say, each of these condo gives you $200 a month cash flow. With 5 properties, your cash flow would be $1,000 per month vs $200. And from the article, Why Buy Rental Properties? you'll realized that you not only have 5 times the cash flow, but you also have 5 tenants paying down your mortgage and building your equity each month, you'll have 5 times the tax-deductions, and your real estate portfolio also appreciates 5 times faster.
So, are you ready to find some money for investing? Here's a list to give you some ideas:
Friends and family - I prefer to not get them involved. Other investors may have a different opinion.
Related articles: Hidden Down Payment
The next thing you need is knowledge. No one is born to know how to invest in real estate. Even seasoned investors spent many years and experienced many failure to become successful.
My motto always is imitate the person who you want to be. If you want to be a successful real estate investors, get a mentor and see what they're doing. Also read up on books and blogs. There are tons of free resources on the internet to start.
Avoid scammers who promise you the Babylon for a big sum of money.
This website is a good place to start. I use this site as my running notebook for real estate investing ideas. I would also be constantly updated the information here as new information appears.
Ok...nothing would happen if there is no deals. This is a tricky one. With Honolulu real estate being notorious for being very expensive, many investors shy away from investing here locally and choose to invest in cheaper mainland location.
I, on the other hand, prefer to invest here. To me, investing out-of-state is risky because you lose all your control. You have to depend on your real estate agent and property manager to manage everything for you. Even those turnkey properties are still not 100% foolproof.
Trust me, you can find good deals here. You just need to know "what" you're looking for. Otherwise, a deal will just fall on your lap, and you wouldn't even notice. I have a bunch of criteria that I'm looking for when I'm hunting for deals. Properties that provide good cash flow, I keep for rentals. Those that provide poor cash flow, they'll be fix and flip.
Finding the good deals goes hand-in-hand with your knowledge. You need to know your local market well. This is one reason why I insist on investing only in Honolulu. I live here and know the market well. I can easily drive over the check on a neighborhood. Pictures are great, but you should not trust everything in the pictures.
Related article: Search Short Sales and Foreclosures
I once went to a showing for a multi-family property. The pictures and everything looks great. I went to the location, and found a bunch of people and children sitting by the parking lot. The adults just sitting around chitchatting, and kids running around and riding their bikes. Obviously, a low-income pocket in the area. Even though the house is brand-new and would potentially generate a pretty good cash flow, I skipped this deal. One of my criteria is that the properties have to be in a decent neighborhood.
In real estate investing, we often say "when you find the deal, you'll find the money to close it."
Before you get your feet wet in Hawaii real estate market, you should get yourself familiar with some local real estate terms and laws.
First thing you need to know about Hawaii real estate is that you don’t always own the land when you buy a property.
Sound strange? Yes, it does.
Most people only know of one type of real estate ownership; fee simple, also known as freehold. There are only a handful of states (i.e. Hawaii, New York, Florida) that have another form of ownership known as leasehold.
It is important to know the difference between fee simple and leasehold property. The difference in these two types of land tenure can significantly affect the value of the real property.
Fee simple ownership is probably the most familiar form of ownership to buyers of residential real estate. Depending on where you are from, you may not know of any other way to own real estate.
Fee simple is sometimes called fee simple absolute because it is the most complete form of ownership. The titles of both the property and the land on which the property sits transfer to the new owner at time of closing. The fee simple owner has the right to own, use the land and dispose of the land as he wishes--sell it, give it away, trade it for other things, lease it to others, or pass it to others upon death.
On the other hand, in a leasehold property transaction, only the title of the property is transferred to the new owner at closing. The title of the land on which the property sits is not affected. What you’ll get as the new owner of the leasehold property is the leasehold interest as a “lessee”. This agreement gives you the right to use and enjoy the land as a fee simple owner ONLY for the duration of the lease. At the end of the lease, the land goes back to the land-owner.
Why buy leasehold properties?
Hawaii Property Tax
Honolulu has one of the lowest real property tax rate in the country. As of June 2013, Honolulu home owners pay $3.50 for every $1,000 of the taxable property value. Property taxes are assessed on 100% of the fair market value of the property and are administered by the counties, with each county having different property tax exemptions.
Besides, having the lowest real property tax rate. Hawaii homeowners also enjoy property tax exemption.
Who qualifies for home exemption? You are entitled to the home exemption if:
1. You own and occupy the property as your principal home (“real property owned and occupied as the owner’s principal home”) means occupancy of a home in the county with the intent to reside in the county. Intent to reside in the county may be evidenced by, but not limited to, the following indicia: occupancy of a home in the city for more than 270 calendar days of a calendar year; registering to vote in the county; being stationed in the county under military orders of the United States; and filing of an income tax return as a resident of the State of Hawaii, with a reported address in the county;
2. Your ownership is recorded at the Bureau of Conveyances, State Department of Land and Natural Resources, in Honolulu on or before December 31 preceding the tax years for which you claim the exemption. In the case of a lease, the document must indicate that the lessee has a lease for residential purposes for a term of five years or more and will pay all property taxes;
3. You file a claim for home exemption (Form P-3) with the Real Property Assessment Division on or before December 31 preceding the tax years for which you claim the exemption.
How much is your home exemption?
The standard home exemption on your principal residence in the county of Hawaii (Big Island) is $40,000. If you are age 60 to 69 the exemption is $80,000 and if you are 70 or older, the exemption is $100,000.
The home exemption in the city and county of Honolulu is $80,000. If you are 65 or older, the exemption is $120,000. If you have an existing home exemption on file, you do not need to re-apply. The exemption amount is automatically increased depending on your age. There are progressively higher exemptions if you are 75 or older and your household income is not more than the low-income limits established by the United States Department of Housing and Urban Development.
The basic home exemption in Kauai is $48,000. If you are age 60 to 69 you can claim a $96,000 exemption and if you are 70 or older the exemption increases to $120,000. If your adjusted gross income for the preceding year is less than $40,000 you qualify for an additional $55,000 exemption.
In Maui, the homeowner exemption on your principal residence is $300,000.
If your sight or hearing is impaired or you are totally disabled, you qualify for an additional exemption. This exemption also applies if you have Hansen's disease and are hospitalized or under temporary release. The disability exemption is $50,000 in the Counties of Hawaii and Kauai and $25,000 in Honolulu and Maui.
If you are a veteran and are totally disabled due to injuries while on active duty, your principal home is exempt from all property taxes except for special assessments and the annual minimum tax.
Widows or widowers of totally disabled veterans are also eligible for this exemption as long as they remain unmarried. Once you are granted a disability exemption you do not have to re-file each year as long as you meet the disability requirements.
Lanai is the sixth largest island in the Hawaiian Island chain. It is located in between Maui and Molokai.
In local language, Lanai also means balcony in Hawaii.
From finding tenants to fixing faucets, renting out a home can be a lot of work. If that doesn’t dissuade you, you’ll appreciate collecting the rent checks and taking advantage of tax deductions.
In fact, you can use many rental properties expenses to offset your rental income. IRS Publication 527 has all the details.
Writing off Rental Properties Expenses
Many rental home expenses are tax deductible. Save receipts and any other documentation, and take the deductions on Schedule E. Figure you’ll spend four hours a week, on average, maintaining a rental property, including recordkeeping.
In general, you can claim the deductions for the year in which you pay for these common rental property expenses:
Cleaning and maintenance
Commissions paid to rental agents
Homeowner association/condo dues
Less obvious deductions include expenses to obtain a mortgage, and fees charged by an accountant to prepare your Schedule E. And don’t forget that a rental home can even be a houseboat or trailer, as long as there are sleeping, cooking, and bathroom facilities. Moreover, the location of the rental home doesn’t matter. It could even be outside the United States.
Limits on Travel Expenses
You can deduct expenses related to traveling locally to a rental home for such activities as showing it, collecting rent, or doing maintenance. If you use your own car, you can claim the standard mileage rate, plus tolls and parking. For 2014, it’s 56 cents per mile.
Traveling outside your local area to a rental home is another matter. You can write off the expenses if the purpose of the trip is to collect rent or, in the words of the IRS, “manage, conserve, or maintain” the property. If you mix business with pleasure during the trip, you can only deduct the portion of expenses that directly relates to rental activities.
Repairs vs. Improvements
Another area that requires owners of rental properties to tread carefully is repairs vs. improvements. The tax code lets you write off repairs—any fixes that keep your property in working condition—immediately as you would other expenses. The costs of improvements that add value to a rental property or extend its life must instead be depreciated over several years. (More on depreciation below.)
Think of it this way: Simply replacing a broken window pane counts as a repair, but replacing all of the windows in your rental home counts as an improvement. Patching a roof leak is a repair; re-shingling the entire roof is an improvement.
You get the picture?
Depreciation refers to the value of property that’s lost over time due to wear, tear, and obsolescence. In the case of improvements to a rental home, you can deduct a portion of that lost value every year over a set number of years. Carpeting and appliances in a rental home, for example, are usually depreciated over five years.
You can begin depreciating the value of the entire rental property as soon as the rental home is ready for tenants and you hold it out for rent, even if you don’t yet have any tenants. In general, you depreciate the value of the home itself (but not the portion of the cost attributable to land) over 27.5 years. You’ll have to stop depreciating once you recover your cost or you stop renting out the home, whichever comes first.
Depreciation is a valuable tax break, but the calculations can be tricky and the exceptions many. Read IRS Publication 946, “How to Depreciate Property,” for additional information, and use Form 4562 come tax time. You may need to consult a tax adviser.
Profits and Losses on Rental Properties
The rent you collect from your tenant every month counts as income. You offset that income, and lower your tax bill, by deducting your rental home expenses including depreciation.
If, for example, you received $9,600 rent during the year and had expenses of $4,200, then your taxable rental income would be $5,400 ($9,600 in rent minus $4,200 in expenses).
You can even write off a net loss on a rental home as long as you meet income requirements, own at least 10% of the property, and actively participate in the rental of the home. Active participation in a rental is as simple as placing ads, setting rents, or screening prospective tenants.
If your modified adjusted gross income (same as adjusted gross income for most persons) is $100,000 or less, you can deduct up to $25,000 in rental losses. The deduction for losses gradually phases out between income of $100,000 and $150,000. You may be able to carry forward excess losses to future years.
Let’s say that for the year rental receipts are $12,000 and expenses total $15,000, resulting in a $3,000 loss. If your modified adjusted gross income is below $100,000, you can deduct the full $3,000 loss. If you’re in a 25% tax bracket, a $3,000 loss reduces your tax bill by $750, plus any applicable state income taxes.
Tax Rules for Vacation Homes
If you have a vacation home that’s mostly reserved for personal use but rented out for up to 14 days a year, you won’t have to pay taxes on the rental income. Some expenses are deductible, though the personal use of the home limits deductions.
The tax picture gets more complicated when in the same year you make personal use of your vacation home and rent it out for more than 14 days.
Read more at Residential Rental Properties