What Is an Option to Purchase and How Does It Work?

An option to purchase is a contractual agreement that gives a party the right, but not the obligation, to buy an asset. This agreement provides flexibility, allowing a potential buyer to secure an asset without immediate commitment.

Understanding the Core Concept

An option to purchase is a distinct contract from the asset’s sale agreement. It involves two parties: the “optionor,” the asset’s owner who grants the option, and the “optionee,” who receives the right to buy. The optionor must sell if the optionee chooses to buy, but the optionee is not obligated to purchase.

A key element is “consideration,” a non-refundable payment from the optionee to the optionor for this exclusive right. This payment secures the optionee’s right to purchase the asset within a specified period. It compensates the optionor for holding the asset exclusively for the optionee. If the optionee does not exercise the option, the optionor retains the fee.

The optionee’s payment for the option is not a taxable event when granted. If exercised, the consideration becomes part of the purchase price. If the option expires unexercised, the consideration is generally treated as ordinary income for the optionor in the year the option lapses. For the optionee, a loss from an unexercised option is typically treated as a loss from the sale or exchange of the option on its expiration date.

Essential Terms and Conditions

A written option to purchase agreement includes specific provisions that define the terms of the potential transaction. One of these provisions is the “purchase price,” sometimes referred to as the strike price, which is the agreed-upon amount for the underlying asset. This price is established when the option agreement is created, providing financial predictability. In some cases, especially with longer option periods, the agreement may allow for re-evaluation of the purchase price.

The “option period” or “expiration date” specifies the timeframe during which the optionee can exercise their right to purchase. This period can range from a few days to several years, with common residential options often lasting one to five years. The agreement must also contain a precise “description of the asset” to avoid any ambiguity regarding the property being optioned. This includes details such as address, lot number, and key physical attributes to ensure clarity.

The agreement also clarifies how the initial “consideration amount” paid for the option will be handled. This non-refundable fee can range from a few hundred to several thousand dollars, depending on factors like property value and option period length. If the option is exercised, this fee is often credited towards the purchase price at closing. If the option is not exercised, the fee is typically forfeited to the optionor. Other common conditions may include specific requirements for how the option must be exercised, such as written notification.

Exercising and Expiring an Option

An option to purchase has two outcomes: exercising the option or allowing it to expire. When an optionee decides to “exercise” the option, they formally notify the optionor of their intent to purchase the asset within the specified option period. This notification must adhere to any conditions for exercise outlined in the agreement.

Upon proper exercise, the option agreement typically transforms into a binding purchase agreement between both parties, obligating the sale of the asset. The terms of this resulting purchase agreement are usually pre-defined within the original option contract. At this point, the optionee becomes obligated to complete the purchase, and the transaction proceeds toward closing.

Conversely, if the optionee does not exercise the option within the agreed-upon timeframe, option “expires.” When an option expires, the right to purchase the asset terminates, and the consideration paid for the option is typically forfeited to the optionor.

In this scenario, no purchase takes place, and the optionor is free to offer the asset to other potential buyers. For the optionee, expiration means they lose the non-refundable consideration paid, but they are not obligated to complete a purchase they no longer desire.