Lease Purchase for the Seller is a real goldmine if used properly.
You hear a lot about the Lease Purchase Agreement, and its benefits for the Buyer of Investment Real Estate.
But today, you are the Seller, and we are looking at the Seller side, and talking about the advantages of the Lease Purchase Agreement for you, as the Seller.
And to explain the advantages and benefits, we will compare the Lease-Purchase Agreement to the usual situation where you just do a straight-up sale of your investment property.
LEASE PURCHASE ADVANTAGES FOR THE SELLER
This can be a very powerful tool if you use it the right way.
I’ll show you how you can use a Lease-Purchase Agreement to sell your investment real estate, and to do the following:
1.) Get back all of the money you originally used as a Down Payment when you bought the property, get it back in cash, and make it tax-free,
2.) Get back all of the Principal portions of the monthly Note Payments that you’ve already paid out while purchasing the property, and make those tax-free,
3.) Actually continue to own the investment property you are selling for another ten years, with no monthly expenses and no management responsibilities,
4.) Already have a Buyer locked in for the property in ten years from now, and at a price that represents the future Fair Market Value of the property,
5.) And after all that, how to end up, in total, with more than twice the net cash that you would get from an outright sale.
So, let’s get started.
HOW THE LEASE PURCHASE WORKS FOR THE SELLER
Real Estate Investing is really about money.
You know that.
The property itself is almost irrelevant, except for three things- ownership, debt, and management.
In virtually all investing situations,
1.) you own property,
2.) the property has debt against it and you make monthly payments, and
3.) you have to manage the property to produce income.
That describes your situation.
But your success in Real Estate Investing will depend on keeping your eye on the money, in all of your decisions, and considering all of the alternatives.
And you can train yourself to think this way, if you haven’t already done so.
Let’s just look at one situation, which I call Lease Purchase For The Seller, and I’ll show you what I mean.
I’ll use two scenarios, and compare them.
THE CASH-OUT SCENARIO FOR THE SELLER
In this Example, with the first scenario, you’ll see how you can sell an investment property and end up with $64,000 net cash and nothing else.
Or, in the second scenario, you can sell the same property, in a different way, and end up with $150,000 and a lot of other additional benefits.
We’ll do this using the Lease Purchase Agreement.
We will assume the following set of facts.
Take notes and you’ll see how this works.
Or, if you have trouble juggling numbers, just follow the reasoning and logic, and I’ll keep repeating the numbers.
Five years ago, you bought a Duplex for $300,000.
You made a $90,000 Down Payment, and you got a $210,000 Mortgage.
Now, it’s five years later, and the Duplex has a Fair Market Value of $400,000.
The Mortgage has been paid down from $210,000 to a $200,000 remaining Principal Balance.
So, you sell the Duplex for the $400,000 FMV, and your transaction costs are $10,000, leaving you with $390,000 Sales Proceeds.
But you still have to account for the debt on the property.
You pay off the $200,000 balance on the Mortgage.
Your net cash at Closing is $190,000.
Now here is something that took me, personally, a while to learn to look at differently.
I think you’ll find it interesting.
THE NUMBERS BEHIND THE NUMBERS
It’s always important to look at numbers in a transaction, and then look behind them to understand what they really represent.
In this situation, it seems like you made a $190,000 profit, but you didn’t.
Of this $190,000 total, $100,000 of it needs to be pulled out and looked at. And when you do, you’ll see that it represents two things:
1.) the return of your original Down Payment of $90,000, plus
2.) the $10,000 pay-down of your Mortgage balance from the Principal portion of your monthly payments.
This $100,000 essentially represents your own money coming back to you. And you will pay no taxes on this amount.
Your taxable amount will be your profit, your Capital Gains.
And your Capital Gains is the rest of your $190,000 of Net Sales Proceeds, the other $90,000.
Another way to figure your Capital Gains is to take your Net Sales Proceeds of $390,000 and subtract your original purchase price of $300,000. That’s $90,000.
DEALING WITH TAXES
The $90,000 will be subject to Capital Gains Tax, and the tax brackets are 0%, 15%, and 20%, we are just assuming that you are in the 15% Capital Gains Tax Bracket for the sake of simplicity.
So, your Capital Gains Tax will be $13,500. That’s 15% of $90,000.
That leaves you with $76,500.
But there is also another tax that you have to deal with.
It is the Depreciation Recapture Tax, and the amount is your tax bracket for Ordinary Income based on your Adjusted Gross Income (AGI), but not more than 25%, and we are assuming a rate of 25%.
Here’s how that works.
During the five years that you owned the Duplex, you claimed annual Depreciation of $10,000, for a five-year total of $50,000 in Depreciation.
Now, when you are selling the property, you have to pay a 25% tax on this $50,000 amount, called a Depreciation Recapture Tax.
Your Depreciation Recapture Tax will be $12,500.
Subtract that from the $76,500 that you had left after subtracting the Capital Gains Tax, and you now have $64,000 left.
I always like to calculate things two different ways to confirm my outcomes. So, here’s another way.
The total of your two taxes is $26,000. That’s $13,500 Capital Gains Tax plus $12,500 Depreciation Recapture Tax.
You will pay these taxes out of your $190,000 Net Sales Proceeds that you receive at Closing.
That leaves you with $164,000 cash, of which
* $90,000 is just the return or your original down payment,
* $10,000 is your own money, note payments, used to reduce the principal balance of your Mortgage when you made monthly payments, and
* $64,000 is your net after-tax profit on the investment.
So you’ve really only gained $64,000 in cash for your five years of ownership.
And you no longer own the property.
So that’s the first scenario.
THE LEASE PURCHASE SCENARIO FOR THE SELLER
Now, let’s move on to the second scenario and see how you could end up with a gain of $150,000 instead of $64,000.
That’s an additional $86,000 in your pocket.
You do two things.
Number one, you refinance the $200,000 remaining debt on the property to $300,000 at 5% for 25 years and have a monthly payment of $1,750.
That is a 75% Loan-To-Value Note, and you’ll find Lenders willing to do that.
Now, that gives you $100,000 cash in your pocket, which is non-taxable because it is a loan.
And it will not become taxable later as part of your Capital Gains Tax computation. I’ll explain that when we get to that calculation.
No, this $100,000 represents the return or your original $90,000 down payment, plus the $10,000 pay-down of your Mortgage Principal Balance, just like the first scenario.
But the difference here is that you still own the property, and the property still has $100,000 of equity in it, the difference between the new $300,000 debt and the $400,000 Fair Market Value.
However, at this point, you are still managing the property and making note payments, which you would not be doing if you had sold the property. And you want to change this.
2. LEASE PURCHASE
So, the second thing that you do is a Lease With Option To Purchase on the property, for a period that fits your life plans, maybe 10 or 12 years, for $1,800 per month lease payments.
The Lessee will pay for the insurance, repairs, and taxes, and the Lessee will receive 20% of each monthly note payment amount as a “credit toward purchase” of the property, when the option is exercised.
You should be able to find a responsible individual, a real estate investor or someone wanting to get into the business, who would take a “no-money-down” Lease/Purchase deal on a $400,000 Duplex which already has paying tenants.
Personally, I’d take that deal in a heartbeat!
At this point, you now have $100,000 of non-taxable cash, and you still own the property which has $100,000 of equity, but you no longer have any management duties, just as though you had sold the property.
And you also still have income, which is what makes this work.
THE NUMBERS WITH LEASE PURCHASE
The note payments on your re-fi note are being covered by your lease payments.
Of course, the $1,800 per month in lease payments is taxable income to you under IRS rules, but you can deduct from that $1,800 the more than $1,200 per month in interest that you are paying on part of the new debt.
The interest that is deductible is the the portion of your note that represents the refinance of the Remaining Principal amount of the original debt, the $200.000.
The other $100,000 you put in your pocket and did not invest it, so the interest on that part of the note is not deductible.
You can al deduct the $833 per month in Depreciation that you are still claiming.
So you will have no continuing income tax liability, and probably even a little paper loss.
In 10 or 12 years, when the Purchase Option in the Lease is exercised, the Duplex will probably sell for about $600,000.
After the $43,200 Credit to the Lessee, you will receive $556,800.
After paying off the $212,000 remaining Principal Balance on your $300,000 note, you will clear $344,800 in cash.
Your Depreciation Recapture amount will be $10,000 per year for 15 years, a total of $150,000.
Your Depreciation Recapture Tax of 25% will be $37,500.
Your pure Capital Gains will be $556,800 minus $300,000 which is $256,800.
And your Capital Gains Tax of 15% will be $38,520.
Your total taxes will be $76,020. That’s $37,500 of Depreciation Recapture Tax plus $38,520 of Capital Gains Tax.
Your net cash position will be $344,800 minus $76,020 which is $268,780.
But wait, that’s $268,780 in ten years from now, and we need to change that to today’s money for a fair comparison to our first scenario.
The Present Value today of that $268,780 in the future is about $150,000.
So, that’s what the Lease Purchase For The Seller looks like.
In total, for keeping the property, refinancing it, and leasing it with a purchase option, you will receive:
1.) $100,000 cash,
2.) $268,780 in ten years, which has a Present Value of about $150,000,
3.) The positive benefits derived during that ten years from being the owner of a Duplex with a FMV of over $400,000 with the value going up for the next ten years, without the responsibility of management. These benefits include a very impressive Income Statement and Balance Sheet and a very strong Credit Score. The equity will also be there for you to borrow against, if you need it sooner.
This compares with $164,000 received in an outright sale.
Unless you really need that extra $64,000 in cash right now, the Refinance and Lease Purchase resulting in an extra $150,000 might be a better route for you to go.
And let me point out that our example is for a $300,000 property, but this works with a $900,000 investment property just like it does with our $300,000 property. The math is the same.
But with the $900,000 property, your bottom line would be increased by about a quarter of a million dollars instead of $86,000.
Depreciation plays a large part in the Lease-Purchase transaction, and Depreciation is not all that it appears to be, as I explain in “Depreciation Is A Fraud.”
As you can see, this concept, like most of the world of Real Estate Investing, involves the use of debt. I don’t think there is enough discussion about debt, and I think you might find some interesting information about the After-Tax Cost of Debt on another Blog Post.
I cover this same concept in more than one of my books, but the one with the most detailed information is “Do This, Not That!” and you can find it here on this website. Use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about Seller Financing from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, that might involve lease-purchase or seller financing, and I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
If you are interested in exploring my Catalog of Real Estate Investing books, but don’t know where to start, I suggest these three.
DISCLAIMER: I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. But I am not your Attorney. I would be honored if I were, but I am not. Reading this Blog does not created an attorney-client relationship between us. Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.