Which formula is better? Lease option? or land contract? It depends on the situation and your goals.
A lease option transaction is not a sale, so you will benefit from market appreciation if the tenant declines to exercise his option to purchase.
A contract for deed sale will allow you to get more a down payment from the buyer, since it feels more like a sale. In higher priced neighborhoods the rents may not command enough rent to cover your underlying mortgage payments.
A contract for deed (CFD) sale will allow you to collect interest payments, which are generally more than you could collect in rent. On the other hand, a property sold is already sold for tax purposes; thus, you cannot use a 1031 tax-deferred exchange on a property sold by contract for deed when the buyer pays off the debt balance. The entire balance paid on the contract will be due as a capital gain, which can be a huge tax liability if you have a low basis in the property. Furthermore, a defaulting buyer on a contract for deed is generally harder to get out of the property, particularly in a court proceeding.
Summary on the Pros and Cons of Each
In summary, the benefits of lease options are:
- Legal control of the property
- Ability to claim depreciation
- Ability to defer gains by 1031 exchange
The downside of lease options are:
- Less of an incoming payment
- Continued landlording responsibility
The upside of the CFD is:
- More money down
- Higher monthly income
- No landlording headache
The downside of the CFD is:
- Potential tax hit
- Transfer tax due at sale
You must decide on a deal by deal basis which transaction works best for you in terms of work involved, tax issues and, most importantly, cash flow. And, be flexible and know how to do both types of transactions; you can buy on a contract for deed, then resell on lease with option. You can buy on lease/option, sell on lease/option.