Renting With the Option to Buy

Maybe you're not absolutely ready to be a homeowner. Or maybe your finances aren't where they should be, so you can't get conventional financing. Perhaps you're uncertain about a location that you're interested in. If any or all of the above apply to you, you may be a good candidate to rent a home with the option to buy.

Renting with the option to buy means that you have a rental contract with the owner of the home that provides you with the opportunity to purchase the home at a certain price. The contract also specifies that a certain portion of your monthly (or bi-weekly or whatever the terms are) payment be designated as a credit toward the purchase price. This type of arrangement is most often used with homes that have been up for sale for quite awhile and/or need renovating and repair.

The amount of the credit can be up to 100 percent, but usually ranges from 20 to 35 percent. The amount of the rent credit has to be high enough where it is of value to the renter/prospective owner, but profitable for the owner as well.

Renting with the option to buy has benefits for both the seller and the buyer. For the reasons mentioned above, someone thinking about buying can benefit from this type of arrangement. It also means that money won't be thrown away on rent, but be going toward equity in a home. This type of arrangement is also a great way of saving toward a down payment for a home, which is often a big stumbling block toward home ownership and getting financing on the best terms. If you would be paying rent anyway, at least you know that a portion of it will be applied to purchase the home you're renting if you make that decision.

Benefits for sellers. The benefits for sellers include:

• unloading a home that isn't selling;
• being able to charge rent above the market because part of it is being credited toward the purchase of the home;
• locking in a purchase option price for the home close to or at their asking price; and
• knowing that the tenants they are renting to will be more likely to take good care of and repair the home because they have a vested interest in its condition.

A renting with the option to buy arrangement may also have a tax benefit for sellers who are having trouble selling their personal, primary residence. If a seller satisfies the ownership and use requirements, eligible proceeds from the sale of a primary residence may be exempt from tax.

Example Charles decides he wants to sell his house and buy a bigger one with his fiancee, Emily. The house is his only residence and qualifies as his primary residence. He puts it on the market, where it stays for seven months without a nibble. The house needs major updates and it seems like no one wants to undertake the project, even when he lowers the selling price. His fiancee talks to her younger brother, Luke and his wife, Jane, who just graduated from the police academy, and asks them if they would be interested in buying Charles' house at a good price. Luke and Jane were planning on renting because they didn't know where they would be permanently assigned and are low on down payment money. They sign a rental agreement with the option to buy with Charles for one year. At the end of the year, Jane and Luke find out their permanent assignments are with a nearby, local precinct. They exercise their option to purchase Charles' house at the pre-agreed price, using their rent credit toward the down payment amount to obtain more conventional financing. Meanwhile, in the past year, Charles has been living in a condo he purchased because he and Emily broke up, and he had no need for a big house. When Charles receives the proceeds from the sale of his house to Luke and Jane, the amount will be exempt from tax even though the house was no longer his primary residence and had not been his primary residence for over a year. A person who sells their primary residence must own and occupy it for an aggregate of two years during the five years before the sale. Even though Charles hasn't lived in the house for over a year, it was his primary residence for the four previous years. Therefore, by using a rent with the option to buy agreement he was able to satisfy the IRS requirements and still get his tax exemption on a large sum of money.

A renting with the option to buy agreement can be for any duration, but usually it's for at least a year. For buyers, a longer term is usually better because it locks in the purchase price of the home and gives them time to build up a down payment. However, there are circumstances when a longer lease term isn't to the buyers' benefit. For example, if the market value of homes in the area go down, or if the buyers decide that they are not interested in purchasing the rental and now are stuck paying a higher than market rent.

Tip Feel free to ask the seller or renter of a home if they are interested in a renting with the option to buy arrangement. You may find that they take you up on your offer even though they didn't specifically advertise for this type of arrangement.