A sublease is a rental agreement or lease between a tenant and a new tenant (called a sublessee) who will either share the rental or take over from the first tenant. The sublessee pays rent directly to the tenant.The tenant is still completely responsible to the landlord for the rent and for any damage, including that caused by the sublessee. Most landlords prohibit subleases unless they have provided prior written consent.

A sublease allows an investor or IRA to obtain the option or right to buy a property and then rent or lease it to another party. Many sellers are willing to offer this type of sublease because they need to move quickly or are financially burdened. In this way, sublease options can create win-win situations for the seller and an IRA investor. Here’s an example to help clarify:

While reading through the local discount newspaper you come across an advertisement that says – “NEED TO SELL TO AVOID FORECLOSURE. BRING ALL OFFERS!” So you place a call to this seemingly motivated seller and discover that this single parent lost his job and is on the verge of losing his home. Above all, he does not want to go into foreclosure, which would complicate buying a home in the future.

This seller is willing to sell for what he owes on the property. Four years prior, he purchased the home for $148,000, which he paid down to $140,000 during that time period. The payments on the property are $1,050 per month, and he is behind $3,450 (three months’ rent and $300 in late fees). Essentially, he needs to pay the mortgage balance ($140,000), his back payments ($3,450) and excise tax for the transfer of title ($2,520 at 1.8%) in order to get out from under the overwhelming debt.

In the last four years, homes in that area have appreciated at a rate of 6% per year. This means that the home he originally purchased for $148,000 is now worth approximately $185,000. After a quick walk-through of the home, you decide to offer this man $148,000. The offer is to have your IRA make up his back payments of $3,450 and rent the home from him for the next five years, at which time you will cash him out. This will net him over $5,000 when your IRA purchases the home (back payments and the mortgage reduction over the lease period). The key is that he will not get paid until your IRA gets paid AND he has to sign over a deed of trust to the property to protect your investment. It is also crucial that you be given the ability to sublease the property.

Shortly after having the deed signed over to you and recording it with the county, you place an advertisement in the newspaper for a “Lease with the option to purchase. No bank financing required. Bad credit? OK!” The advertisement results in many calls. You are able to find a young family that you think would be perfect fit for the home.

The home is currently worth $185,000, for which you are willing to sell the home for within the next two years. For that right (option), you are charging $5,000, which will be credited toward the purchase of the home should the tenant/buyers exercise their option. You are also asking $1,250 per month for the lease of the home. The buyers are able to come up with the $5,000 plus first and last months’ rent. Your IRA has an immediate profit of $1,550, because you paid $3,450 to catch-up the back payment for the previous owner and you took a $5,000 non-refundable option payment. You realize an instantaneous 44% cash-on-cash return. It gets better yet! The tenant is going to pay $1,200 per month, and you only owe $1,050 per month. That is a positive cash flow of $150 that your IRA realizes each and every month. If the tenant/buyers exercise their option to purchase, then the IRA would collect the net difference between the purchase price from the original seller at $148,000 and the sales price after the option credit of $180,000.

So why are so many investors enthusiastic about this sort of investment? If the tenant/buyer did end up purchasing the property, your IRA would profit $37,150 on its original $3,450 investment or 1008% in just two years… tax deferred! What if they do not exercise their right to buy? Then you can do it again! You keep the option payment of $5,000 and the monthly cash flow of $3,600 ($150 over 24 months), and you can acquire another lease option tenant. You negotiated a five-year option, and then you sold a two-year option. That means you have three years left on your original deal. Also, if they don’t exercise the option, it is likely the home will appreciate over those two years. So the next time your IRA sells the option on that home, the new purchase price could be adjusted upwards accordingly.