Contracts

Option Contract Basics

An option contract, or option, is an offer to purchase a specific piece of real estate but without the obligation to buy it. An option contract gives the potential buyer, who is known as the optionee, the right to purchase the property of the seller, or optionor, at some time in the future. The option contract will spell out that timeframe, which is usually from one to three years.

Advantages and Disadvantages of a Land Contract

An installment sales contract is attractive to a buyer who can't obtain regular financing and/or doesn't have enough money saved for a traditional down payment. A seller will traditionally allow an installment sales contract to avoid paying federal capital gains tax all at once; instead, these are paid through percentage payments from installment sale proceeds each year. One disadvantage to this type of arrangement for the buyer is that the buyer doesn't have legal ownership of the property until it's completely paid off. With a traditional mortgage, if you pay on it over time, even if you can no longer make your payments, you can usually sell it for a profit, or at least a return of your equity. Not so with an installment sales contract. The seller may receive many thousands of dollars—even hundreds of thousands of dollars—from a buyer, and if the buyer becomes unable to make payments, the seller can keep all of the proceeds received up until that point and repossess the property.

What happens if the optionee decides to exercise the option?

If the optionee does exercise the option according to its terms and conditions, then a binding contract between the two parties is created. Once that happens, both parties are obligated to fulfill their contractual obligations: the seller sells, the buyer buys, and everyone lives happily ever after.

What makes an option contract different from a regular sales contract?

In a "regular" sales contract, both the buyer and seller are bound to carry out their contractual obligations. In an option contract, only the optionor (seller) is bound by the option contract; therefore, it is a unilateral contract. While the option gives the optionee (buyer) the right to buy the subject property, it does not require the optionee to buy it. This might sound unfair to the seller, who, by law, must not sell the property to anyone else during the option period, but all is fair in love and real estate. The optionee must pay an option fee (consideration) to the optionor, which can be for any amount that both parties agree to. If the optionee decides not to exercise the option to purchase the property, then the optionor gets to keep the option fee—and sell the property to someone else.

Who uses an option contract, and when do they use it?

Option contracts are used in a variety of situations. Commonly, an option can be attached to a lease. It allows the lessee (renter) the option to purchase the property at the end of the lease term or within the timeframe noted in the option contract. This is usually known as a lease option, or a lease with an option to buy. This is often used to give the lessee time to come up with the money to purchase the property. In general, option contracts are entered into to allow the optionee the time to raise money to purchase a property. Sometimes a real estate investor chooses to make the relatively low-risk investment in an option on an undeveloped piece of land—especially if the property is in a prime location—and then take the option period to find investors and developers. The original investor (optionee) charges these investors and developers a higher price than the option amount, and after exercising the option contract, flips the property for a nice profit.

Land contract basics

Sometimes a seller will offer financing to the buyer—often because the buyer can't qualify for traditional financing. Sometimes it's because the seller would prefer to receive the property sale proceeds over time rather than in one lump sum. In such cases, the seller retains the deed until the buyer pays the agreed-upon sales price in full. Retaining the deed is the seller's assurance that the buyer will pay (because the seller, who retains ownership, may repossess the property if the buyer doesn't pay). As the buyer pays installments over time, the buyer begins to pay off the sales price of the property. Once the buyer has paid the contract in full, the seller turns the deed over to the buyer. This type of sale is called by many names: contract for deed, conditional sales contract, installment sales contract, installment land contract, or often just land contract. Due to their complexity, land contracts are best prepared by an attorney.

Doctrine of Equitable Conversion

The doctrine of equitable conversion states that a seller (vendor) of this type of contract retains legal title of the property (ownership interest that is enforceable by law), while the buyer, or vendee, is said to have equitable title rights (financial or "equitable" interest in the property). The seller is restricted from taking any action that would jeopardize the buyer's interest in the property. Note: Equitable title is actually what any buyer holds to a property once the sales contract between the buyer and seller has been signed. The contract is executory before it's fully completed. During this time, the seller retains possession and title, and the buyer has equitable title rights. Buyers in land sales contracts are protected from unscrupulous sellers who take advantage of buyer naivete by repossessing and retaining all proceeds, leaving buyers empty-handed. Buyers may also bring a civil suit against sellers if buyers believe they've been treated unfairly.

While a knowledgeable real estate licensee may have some insight into the option contract process, this is really an area for a real estate attorney. Therefore, as a licensee, your best bet is to advise your client to seek the advice of a real estate attorney who understands the ins and outs of option contracts.

While a knowledgeable real estate licensee may have some insight into the option contract process, this is really an area for a real estate attorney. Therefore, as a licensee, your best bet is to advise your client to seek the advice of a real estate attorney who understands the ins and outs of option contracts.

Option Contract Required Elements

While an option contract is a unilateral contract (in which one party is contractually obligated to keep the duties outlined in the contract), it is still a contract. As such, it must contain all the terms and provisions required by law for a valid contract. These include the following: To be enforceable, there must be consideration (something of value—generally, money) given in exchange for the promises made in the contract. In this case, the optionee (buyer) must pay the consideration (option fee), usually money, to the optionor (seller). The amount of consideration must be stated in the contract. The contractual "promises" are that the optionor will not sell the property to anyone else, and the optionor will sell it to the optionee, if the optionee so chooses, under the terms and conditions of the option contract. It must state how long the option period is; if not, a court will require the optionor to make the option period for a "reasonable time." (The typical option period is often six months. Option periods cannot be "forever," or even be extended indefinitely.) It must clearly state the sales price of the property, or the way in which the price will be determined, if the optionee chooses to purchase the land during the option period. It must comply with the statute of frauds, which means it must be:WrittenSigned by the optionor In addition to these elements, an option contract must clearly state any other terms or conditions that apply to the optionee's exercise of the option to purchase the property. For example, the optionee might, under the contract terms, be required to exercise the option only by written notice to the optionor, or the optionor's attorney.