Creative Financing’s Latest Wrinkle:
the Lease-Option Trust

by

Harry I. Price, Esq.
 

Just when I thought I’d seen it all, a new sales/financing vehicle crossed my desk: a LEASE-OPTION TRUST. A company is marketing the documentation, where in addition to a landlord/seller and tenant/buyer, a trust is created to hold ownership of the property and a third party trustee is introduced. Avoid this unnecessary layering at all costs, because only the company marketing this procedure, which sets itself up as a trustee of a newly created trust, benefits from this creative financing arrangement.

The use of a LEASE-OPTION TRUST agreement, where the tenant has the option to purchase the property at a stated price by a future date, is a form of transferring an interest in real estate that should be used in limited circumstances. Ordinarily, a lease-option agreement can benefit the tenant if the property appreciates during the term of the lease-option; and if the property depreciates, the tenant will walk away from the transaction. A landlord can also benefit, by receipt of a nonrefundable option payment, by avoiding turnover in tenancies, and by securing a motivated tenant who will not only maintain but may actually improve the premises. However, in a super-heated appreciating market, as we have in parts of California, a landlord/seller will not know where to set the price for fear of selling too low. Conservative advice for the landlord is to merely lease the premises, avoid the entanglement of a lease-option agreement, and then sell the property at market value whenever the landlord/seller wants to sell. There are times, however, where a lease-option agreement is appropriately employed.

There are some standard pre-printed form lease-option agreements and sales agreements available. If those are used, the parties should finalize all of the terms of sale in a written sales agreement that will be attached as an exhibit to the lease-option agreement. In that way, when the tenant exercises his option to purchase the property, he only has to provide notice of his election, because all of the material terms will have previously been negotiated. Contrast this to a right of first refusal: the seller may market the property, but the tenant has the right to match an offer. Although this appears to provide a seller with an opportunity to sell the property at market value, in practice selling property subject to a right of first refusal has a dampening effect on the marketability of the property. That is because there are many buyers who will not want to waste a month waiting to see if their purchase offer will culminate in a sale. Consequently, I do not recommend that sellers enter into the entanglement of a right of first refusal.

With this background in mind, why introduce a third party middleman into the transaction of a lease-option? There are some ostensible excuses provided by the proponents of the LEASE-OPTION TRUST, none of which are meritorious:

  1. Maintain the old property tax level - under Prop. 13, a conveyance to a trust created for estate planning purposes is not deemed to be a sale. So what? Under a lease-option, until an election is made to exercise the option, the lessee is merely a tenant, and therefore there is no sale and consequently no triggering event that would raise the property taxes anyway. By the creation of a LEASE-OPTION TRUST known as the “[Seller] Family Trust,” the creators of this legalese are attempting to be artful with an obvious subterfuge to avoid any increase in property taxes by making it look like a transfer to a trust created for estate planning purposes. In actuality the originators of the LEASE-OPTION TRUST are making an unnecessary attempt to perpetrate a fraud upon the local government taxing authority;
  2. Provide the tenant with an interest in the property, so that tenant can legitimately take the interest payments as tax deductions - this is not permissible, and should not be allowed, for the tenant may never exercise option. Why should a seller attempt to transfer any tax benefits to a tenant when he has not yet received the full purchase price? This act is subterfuge, and another attempt to perpetrate a fraud upon a government taxing authority, the IRS;
  3. Provide the landlord with the ability to depreciate property if it is maintained as “investment” rather than “income” property - this is a use of nomenclature as a snow job. Both words are interchangeable when it comes to maintaining a single-family residence as investment/income property. The owner can depreciate the property as long as he owns it as investment/income property and meets all other regulations, without the cumbersome use of a trust. The LEASE-OPTION TRUST provides no additional benefits.
     

In addition to failing to deliver on its promised benefits, the LEASE-OPTION TRUST has numerous drawbacks, including the following:

  1. Layering of expenses to the trustee, for both the tenant/buyer and the landlord/seller, including origination fees, ongoing monthly supervision fees, and fees upon the close of escrow;
  2. Additional layering of expenses payable to third parties, because a trust is a separate entity which will need to file its own annual tax returns, and generate separate fees to a tax preparer let alone tax filings;
  3. The transference of a present interest in the trust to the buyer. Although there are disclosures in the LEASE-OPTION TRUST agreement that the interest transferred is only a personal property interest, and not a real property interest, doesn’t that set up a future quiet title action in the event of a dispute? See Petersen v Hartell (1985) 40 C3d 102, 112-117, 219 CR 170, 707 P2d 232, where the court stopped a lender’s foreclosure sale of a different creative financing device, an Installment Land Sales Contract. The court held that the contract of sale created a security interest which required judicial foreclosure by the vendor/lender, in order to have judicial supervision, rather than merely allow a non-judicial trustee’s sale to occur. The vendee brought an action for specific performance, and the vendor requested a declaration that the vendee’s breach of contract terminated the vendee’s rights under the contract. The court found that the vendee's specific performance action was in effect a demand for redemption, and that even if the vendee did not redeem, the decree terminating the contract without foreclosure would require restitution on down payment monies to the vendee. Can we presume that if faced with a claim of default, rather than walk away from the property and forfeiting his option consideration (read: perceived equity build-up), the tenant of the LEASE-OPTION TRUST may seek judicial intervention? There goes the speedy remedy of an unlawful detainer (eviction) action!
     

In an attempt to provide a balanced article, it is important to point out the positive aspects of the LEASE-OPTION TRUST. Sadly, there are none. All financial benefits flow to the trustee, not to either the landlord or the tenant.