Advanced Contracts: Practice Questions & Explanations

An option contract gives the buyer the exclusive right to purchase property at predetermined terms during a specified period, without obligation. Elements: (1) Optionor — the property owner granting the option; (2) Optionee — the prospective buyer holding the option; (3) Option consideration — money paid to the optionor to keep the option open (often non-refundable, usually applied to purchase price if exercised); (4) Option period — the time during which the option can be exercised; (5) Strike price — the price at which the optionee can purchase. The optionee has the right to: exercise the option (buy at the agreed price), let the option expire (forfeit consideration), or in some cases sell/assign the option to a third party. The optionor cannot sell to anyone else during the option period. Common uses: developers locking up land while seeking financing or zoning; investors controlling property without committing; lease-options for tenants who may want to buy. Option contracts are unilateral until exercised (only one party is obligated — the optionor must sell if optionee exercises; the optionee has no obligation to buy).

Right of First Refusal (ROFR) is a contractual right that obligates the property owner to offer the holder the opportunity to purchase at the same terms as any bona fide third-party offer before selling to that third party. Process: (1) Owner receives a third-party offer they want to accept; (2) Owner notifies the ROFR holder of the offer terms; (3) ROFR holder has a specified time (often 10-30 days) to match the offer; (4) If holder matches, they buy at those terms; (5) If holder declines or doesn't respond, owner can sell to the third party at those terms (or sometimes better terms). Distinguished from option: ROFR is triggered by a third-party offer; option is exercisable at the holder's discretion regardless of other offers. Common uses: tenant rights in leases (tenant gets first chance to buy if landlord decides to sell), partnership and shareholder agreements, real estate development deals. Strong tool for tenants and partners who want potential ownership without committing immediately. Must be carefully drafted to specify duration, terms, and procedures.

1031 exchanges (named after Internal Revenue Code Section 1031) allow real estate investors to sell one investment property and buy another without immediately paying capital gains tax — the gain is deferred (not eliminated) and rolls forward into the new property's basis. Key requirements: (1) Investment or business property only — not personal residences; (2) Like-kind property — almost any real estate qualifies as like-kind to other real estate; cannot be exchanged for non-real estate (the 2017 Tax Act eliminated 1031 exchanges for personal property); (3) Identification period — 45 days from sale of relinquished property to identify replacement property in writing; (4) Exchange period — 180 days from sale to close on replacement property; (5) Qualified Intermediary — proceeds must be held by a QI; the taxpayer cannot constructively receive the funds; (6) Equal or greater value — to defer all gain, replacement property must be of equal or greater value and equity must be reinvested. Failed exchanges become taxable sales. Boot — cash or non-like-kind property received — is taxable to the extent received. Common variations: delayed exchange (most common), reverse exchange (buy first, sell within 180 days), build-to-suit. Powerful tool for portfolio building; brokers should know enough to identify opportunities and refer clients to qualified intermediaries and tax advisors.

Liquidated damages clauses specify in advance the amount of damages that will be paid if a party breaches the contract, eliminating the need to prove actual damages in court. Common application: earnest money forfeiture if buyer defaults. The seller keeps the earnest money as full damages, even if actual damages are higher or lower. For the clause to be enforceable: (1) Actual damages must be difficult to determine at contract formation (real estate transactions meet this — losses depend on market changes, time to find a new buyer); (2) The amount must be a reasonable estimate of potential damages, not a penalty designed to punish; (3) The amount must not be unreasonably high relative to actual potential damages. Courts will refuse to enforce excessive amounts as penalties. Some real estate contracts cap liquidated damages at a specific percentage (3% of purchase price in California). Limitations: liquidated damages typically apply only to buyer default (forfeit earnest money); for seller default, the buyer usually has the choice of liquidated damages OR specific performance OR actual damages. Buyer-friendly contracts sometimes give the buyer alternatives. Brokers should explain to clients what liquidated damages means and ensure clients understand the consequence of default.

In an option contract, the buyer (optionee) pays the seller (optionor) option consideration in return for the exclusive right to purchase or lease the property on specified terms during a stated period. The optionee is not obligated to buy — they hold a unilateral right — but the optionor is bound to keep the offer open and cannot sell to someone else during the option term. If the optionee exercises the option, a binding purchase contract is formed. If they let it lapse, they typically forfeit the option money. Options are an 'advanced' contract topic because they differ from a standard bilateral purchase agreement where both parties are obligated.