Commercial real estate transactions do not have to be a straight sale or lease of the property. The lessor and tenant have the freedom to agree to different types of deals, so long as the basic requirements of contract law are met. A lease with an option to buy is a hybrid agreement that is part lease and part sale—if the option is exercised. Here is what lessors and tenants need to know about commercial property leases with purchase option provisions.
The Leases and Options Can Be Flexible
One of the main takeaways is that a lease with an option to buy can be a flexible agreement. The parties have the right to structure it however they want to meet their own particular needs. The option itself can work in a number of different ways.
The option to buy does not have to coincide with the entire term of the lease. You can negotiate the terms for when the option can be exercised. From the landlord’s perspective, it may be better off forcing an earlier decision. For example, if the option is available only during the first two years of a five-year lease, the tenant would be under pressure to exercise the option to secure its future at the property. If the tenant does not exercise the option, the landlord would have three years to negotiate a sale to a third party all during which it has rent coming in from the tenant.
The Tenant Gets Control of Whether and When It Buys
An option to purchase is different from a right of first refusal. With the right of refusal, the purchase price of the property depends on what a third party is willing to pay for the property. The tenant’s right to buy the property is triggered when the landlord chooses to sell the property pursuant to an offer from a third party. The landlord has control over whether and when the tenant will purchase the property at some point. But in a lease with an option to buy provision, the tenant has the absolute decision as to whether and when it will purchase the property.
The Purchase Price Can Be Set in Different Ways
Leases with options to buy can maintain some flexibility in terms of price. The parties can agree on an eventual purchase price at the time of drafting the contract and include it in the contract. Alternatively, it could wait to have the property appraised at the time of sale. It could include a formula in the contract that can be used to determine the price in the future. However, most option agreements fix the price based on a negotiation between the lessor and tenant before the lease is signed.
Pros and Cons for the Tenant
From a tenant’s perspective, the lease with an option to buy gives it several valuable benefits. First, so long as it is leasing the property, the landlord may be responsible for paying for any necessary repairs (but this is something that could vary based on the agreement). Second, the tenant has some time to come up with a down payment for the property. Third, the tenant gets time to consider any other options and to see whether this property is right. Finally, the tenant gets time to see if the property has development and income-earning potential. Even if the tenant chooses not to buy the property, it can still occupy the property for the entirety of the lease.
Lessors and tenants could also use purchase options that are contingent on some event in the future happening. For example, the tenant could have an option to buy the property that is contingent upon receiving zoning approval for a certain type of development. If that event does not happen, the lessor could either walk away from the property or purchase it at a lower price.
At the same time, the tenant must be serious about eventually exercising the purchase option because a lease with an option will cost extra money. First, it will likely need to pay an option fee upfront when the lease is signed. If it does not exercise the option, the option fee is lost. Second, lease payments could be used towards the purchase price, but they become plain rent if the tenant does not buy.
However, there are also drawbacks for the tenant. If there is no set purchase price in the agreement, it may watch as the price of the property increases. What it could have bought at the time the agreement was signed for less may cost them far more in the future. In addition, the option fee could force their hand in the purchase decision it for fear of losing money on the deal.
Pros and Cons for the Property Owner
Property owners often use a lease with an option to buy when it has difficulty selling the property outright. An owner may only want to sell the property at a certain price it can specify in advance in the agreement. Owners get some sort of certainty because they are guaranteed a certain price if the option is exercised. Purchase options could also entice potential lessors when the property is proving difficult to rent. Finally, purchase options could also help the lessor attract the right tenants for a longer duration of time.
On the flip side, the option could also cause difficulties for owners. If the property market drops, the tenant could walk away from the agreement, leaving the owner with a property that is worth less than it could have received had it sold it instead of leased it. Alternatively, the owner could lock in a sales price that does not reflect the eventual increase in the value of the property.
There Are Tax Consequences to Keep in Mind
There are also tax consequences for this type of lease transaction that both sellers and buyers need to consider. At some point, the transaction may be treated as a sale and no longer as a lease. If the rental payments are fair market value, and the option purchase price fairly represents the future value, the agreement remains a lease until the property is purchased. However, the parties’ intentions at the time of the transaction could mean the transaction is treated as a sale. If that is the case:
- The tenant may not deduct their lease payments.
- The tenant may deduct depreciation of the property.
- The rental payments are not income for the seller, but they are part of the selling price.
- The rent payments would be considered a capital gain (or part of a capital loss).
- The lessor may no longer deduct depreciation on their own taxes.
You Should Make the Agreement as Specific as Possible
In general, both lessors and tenants benefit from signing agreements with specific terms. The less terms left open for interpretation, the greater the chance that each party will achieve what it wants in the deal. The parties should even consider negotiating all the terms of the sale at the outset.
Commercial leases with an option to buy can suit the needs of both parties to a deal and be a win-win. However, each party needs to invest a substantial amount of time and effort into the initial agreement to ensure it contains the right terms.
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