Lease Option and Equitable Interest

Many investors are concerned about selling a property on lease option because of the possibility that the tenant buyer will claim equitable interest.

If you sell the property by lease with option to purchase, it's not really a sale at all. The lease is a landlord-tenant relationship and the option gives the buyer the right to purchase the property during the lease term at a specified price within a certain time. If the tenant/buyer stops paying rent, you evict him like any other tenant. However, once you go into court, the tenant buyer could say that they have equitable interest and the property and that we have to foreclose to get it back. In essence, the tenant buyer is arguing that the lease option agreement is essentially the equivalent of a sale, similar to an installment land contract. The tenant could ask the judge to rule that they the buyer owns the property even though title has not passed. They are essentially saying that the landlord is the equivalent to a lender. If this was true, you the landlord must now proceed with a judicial foreclosure process instead of an eviction which takes several months versus weeks in a typical eviction.

Normally one would go through small claims court to get the eviction completed. However, if the judge in this court says that the tenant buyer has equitable interest then they make you go to the next level court to fight it out which is usually a county court or district court. Certain courts cannot hear foreclosure cases or property ownership disputes. If this happens, the judge cannot decide the dispute because he lacks jurisdiction. The judge will have to transfer the case to the general jurisdiction court (like a district court) for a hearing. This may cause a delay of a few weeks to a few months. If you suspect that the tenant plans to fight the eviction, it is best to start in the right court to eliminate delays so ask you attorney for the appropriate court.

In most cases in the correct court, the court will reject the tenant buyer's argument of equitable interest and permit the landlord's eviction. This is because the tenant buyer is asking the court to use its equitable powers to rule that a lease option is not a lease option, but a sale. The court is being asked to turn a document into something it isn't in the matter of "fairness". Obviously, it's a judgment call for a judge but from talking to many attorneys it rarely happens.

The judge will consider how long the tenant been in the property, how big was the default, how were the documents drafted, has the tenant done improvements and most of all how much money did the buyer put down and what's the difference between the tenant's option price and the current market value of the property. These last two factors are most relevant since it shows how much equity is at stake. If there is no equity, then probably not an issues but if the person put a large amount down and the property is worth a lot more than the strike price of the option then there may be an issue. Of course, if there is a lot of equity then paying an attorney to foreclose for a few thousand will be worth it.

Bottom line, most lease options will not require a foreclosure. Make sure you have a well drafted lease and option that are separate from each other and this will avoid most issues. Want more in-depth insight into lease options? Then register for Marko's next live training this coming October in Chicago!