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I own a house which I'm renting to tenants. We've entered a long-term rent-to-own contract, where the principle portion of each mortgage payment becomes potential equity for the tenant. How do I handle this in bookkeeping?

I would think that I'd create the future sale as an Asset account, decreasing from the value of the sale price, and my tenant's potential equity would be a Liability account which grows from zero. However, since I would be crediting the future sale Asset, I would need to debit the Liability, decreasing it.

I could create my tenant's potential equity as an Equity account, which decreases from zero into negative numbers, but since it's potential equity (realized when he either gets a mortgage and purchases the house, or his potential equity reaches the sale price), that seems wrong.

What is the best way to do this?

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    What happens if the tenants leave in the middle? I.e. if they leave before they have enough equity in the house but after a significant period of time (e.g. at 50% potential equity). Do you owe them money? Or would they have to buy (and sell) the house to realize their potential equity? I'm mostly trying to be sure that I understand what "potential equity" means. – Brythan Aug 17 '16 at 15:19
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    Seems to me this should be in your contract with the tenant. – Xalorous Aug 17 '16 at 15:21
  • In addition to my answer below, I also agree that you should ensure the exact terms of the contract outline what happens when/if the tenant leaves in the middle of the term. This is something you absolutely must have a lawyer review, given the relative value of a house and therefore the weight of the contract. – Grade 'Eh' Bacon Aug 18 '16 at 16:07
  • This contract is designed to be a stop-gap until they are able to obtain a mortgage. If they leave before they've obtained a mortgage, they forfeit any "potential equity." – zwiebelspaetzle Aug 19 '16 at 3:29
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As far as I'm concerned, 'treating the principle like their equity' is exactly how a mortgage would normally accounted for. Consider the history of the transaction:

First, you debit your loan asset, and credit the value of your house [defined by the amount of the mortgage]. In a 'regular' mortgage, a bank would credit their cash handed to the buyer, who will pay the seller. In this case, it is the house itself which you are giving up, not cash.

Each month, you will debit the cash received from the tenant, and credit 2 accounts: Interest Income, and Loan Asset.

By the time the tenants have paid the full value of the house, you will have total cash equal to the value of all payments, historical interest income equal to the interest-portion of all payments, and zero loan asset.

If they happen to break the terms of the contract or for whatever reason do not finalize the deal to purchase the house, you will debit the full value of the house as an asset [at the value you initially assigned in the mortgage], credit the value of your Loan asset for whatever Loan is left, and the remaining credit will be a gain on the income statement.

Don't record the "Equity" for the client; that's the entry which would go on their books, not yours. Although, their "equity" will be equal to the value of all principal paid to you thus far.

  • Caveat - I am not a lawyer, but be sure a lawyer looks over your contract to remove the chance of any surprises. For example, does the tenant have legal title right now, or do you? If you have legal title, then step one as I have it above may be incorrect, as you are not 'giving up your house for a loan asset' at all, because you always own the house. Instead, you may want to set up a "contra-asset" of the full house value, so that the house shows on your financial statements, but is netted out by the contra-asset. – Grade 'Eh' Bacon Aug 17 '16 at 20:00

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