Plenty of people will tell you that real estate options are a great way to make money. And, that can be true . . . if you have the right knowledge. By learning how to get the most from options on your real estate investments and rentals, you can increase your profits.
Stand-Alone Purchase Option
One category that can generate profit is the stand-alone purchase option. If you own a property, and someone would like the right to buy that property at a specific price and over a specific time period, this option allows you to receive cash from someone the day you authorize the option. Two things then may happen: 1) the buyer lets the option lapse, and you keep the cash and the property, or 2) the option is exercised, which means you sold your property (and often receive a selling-price bonus).
Here are some of the primary financial reasons people have for leasing their property with the option to buy:
- Increase profits by fixing a higher rent price (typically applying some of this to the option amount).
- Increase profits by requiring up-front cash for the option.
- Protect your real estate by having a tenant who takes better care of the property (because it may eventually be theirs if they use the option).
- Reduce costs by requiring the tenant to maintain the property and take responsibility for repair work.
Of course, if you are on the other side of the transaction and are buying the option, then you’ll want to arrange some kind of reward for yourself should you use the option. Often, people like to structure these options so that they get a better price on the property because they exercised the option (this is the most desirable outcome for the buyer).
Whether you’re buying or selling, options look pretty straightforward, but circumstances can complicate matters. Some options are structured to require that they be exercised. However, if you enter into such an option, it is viewed as a sales contract under tax law. If, for example, the rent for an option is so high that it forces a tenant to buy, tax law ignores the option, and your contract ends up as a sales contract as far as tax purposes are concerned. It turns out options are not as simple as they appear; varying scenarios can butt up against tax and legal obstacles.
In fact, even a lease without the option to buy can end up being viewed as a sale under tax law. How does this happen? If the tenant takes on the majority of rights, responsibilities, and enjoyment to the extent that they act as the owner of the property, the IRS ignores the lease.
Needless to say, it can come as quite a surprise when the IRS decides your lease is to be considered a sale. So, this article aims to provide some practical advice for securing your after-tax profits and navigating the additional rules associated with leases.
Keeping Control of Your Finances
Your after-tax financial results will depend upon how well you understand the rules regarding when a lease with an option to buy turns into a sale. The rules fall into three categories: 1) commercial real property, 2) personal property, and 3) a house or apartment used as the primary residence by the tenant.
By structuring your rent-to-own agreements so that they comply with tax law, you can avoid unpleasant legalities. These legal situations can result in additional consequences, such as negative articles on the front page of national newspapers, an attorney general investigation if you’re under Florida jurisdiction, or corrective legislation in a Texas jurisdiction.
Now that you have an idea of why you need to handle your options correctly, let’s look at a hypothetical scenario. You have a tenant who buys an option from you for $10,000 that allows her to buy your rental property for $300,000 at any point within the next 15 months. The tenant can do one of two things. She could exercise her option, in which case you treat the $10,000 as sales proceeds on the day the purchase option is used. Or, she could choose not to use the purchase option, and you receive normal income from the $10,000 on the day the option lapses.
Regardless of what your tenant decides, you get a good deal for several reasons:
- You receive up-front payment for the option.
- You can use the cash from purchase of the option on the day you receive it because it’s yours no matter which decision the tenant eventually makes.
- You have no income taxes to pay for this money until the option lapses or is used.
As for your tenant, if she decides to exercise the option, the $10,000 acts as additional basis in the property for her. The lapse of the option depends on the nature of the property. If she intends to use it as a rental unit, the same rules apply that would apply to a loss on the sale of rental property.
Given our hypothetical 15-month holding period, your tenant’s loss would be under Section 1231 (which applies only to long-term gains and losses). This is great for her because Section 1231 allows for:
- Net section 1231 gains are tax-favored long-term capital gains, and
- Net Section 1231 losses to be deducted as tax-favored ordinary losses.
However, if the tenant wanted to purchase the rental unit as a personal residence, she would not get the deduction for the option’s lapsing. That’s because a lapsed option for personal property generates a personal loss, which is not deductible. So, options aren’t too difficult to figure out, but they can produce vastly different results under different circumstances.
Options that are Actually Conditional Sales
An option gives the purchaser the right to exercise a property purchase at terms and price that are determined at the start. Some options, however, are actually masked sales. Obviously, any option that is exercised becomes a sale. But, if the option turns into a sale before it is exercised, then it is a sales contract rather than an option.
Here are a few examples that are not options:
- Nonrefundable deposits—these do not specify terms for a continuing offer for a particular time period
- High option prices that force the use of the option—the force makes it a sale from its beginning
- Incidents of ownership and actions that convey possession imply a sale
You may have noticed that some of these are judged by the particular circumstances. For instance, what is considered a price that’s high enough to force a sale is somewhat subjective and depends upon the property and the parties involved. Because of this, issues of what is a sale or what is an option can be complicated. To add to the matter, an option that includes a lease gets even trickier.
In fact, sometimes the lease itself is considered a sale rather than a lease. That means you can really end up with results far different from what you intended when you combine a lease with an option, and either or both of them could end up actually being sales.
When it comes to taxes, a whole system of rules is in place to determine whether a lease is a lease or a sale. Here’s an example. Some public companies will use synthetic leases in order to make their profits look better to investors. These synthetic leases are reported as leases in their financial statements, but reported as purchases in their tax return. Because this strategy makes their profits look better, it increases the performance of the company’s stock. Because the tax return shows a purchase, the company can also depreciate the deductions.
Another example of a lease that’s considered a sale on taxes is a dealer’s rent-to-own program. One such contract’s status as a sale was determined in IRS private letter ruling 9338002. The IRS’s reasoning is that the lease-with-option-to-buy compels customers to make each of the monthly payments so they can own the item. Additionally, payments in such cases are usually high enough that customers pay market value for the item early on, at which point it makes no sense for them not to continue paying until they own the item. In fact, the IRS ruling states that such contracts produce substantially more revenue than if customers bought the item outright.
According to the IRS, the dealer does not have a true lease for tax purposes because:
- The customer is effectively required to make a purchase by agreeing to the contract,
- The rental payments end up far exceeding the amount necessary to transfer the title, and
- The option price is zero, which contributes nothing towards the item’s fair value when the option is exercised (completion of payments).
The same set of criteria are used when judging real property leases. First of all, the IRS defines three parties in a leveraged lease—the lessor, the lessee, and the lender to the lessor. The IRS will look at the following criteria to determine whether a lease is really a lease:
- The landlord (lessor) is at least 20 percent invested in the property;
- The renter (lessee) cannot purchase the property for less than fair market value when the option is used; and
- The lessee cannot have paid for property modifications, improvements, or additions.
Sometimes these criteria are out of your control. For example, it’s possible that after agreeing to an option, your property dramatically increases in value. That means that when the option is exercised, it will no longer reflect the fair market value, and does not meet the second criterion above. You should also watch out for vacation home tax rules, which you can run into when renting out a property, and are quite different from the tax laws for options.
The purpose of setting up a lease with the option to buy is for you, as the current property owner, to make more money and ensure that your real estate is well care for by the tenant. In order to gain the financial benefits, you’ll need to understand the tax laws surrounding options. So, for your convenience, here’s a bit of advice for meeting the six standards in Revenue Ruling 55-540 and those in Revenue Procedure 2001-28:
- Don’t apply the tenant’s rent to lessee equity.
- Don’t give the property title to the lessee in exchange for a certain amount of rents or payments made.
- If the option is relatively short, don’t make the payments a large portion of the total price to be paid.
- Don’t allow rent prices to exceed fair market value substantially.
- Don’t put add an interest equivalent to the rent due.
- Have at least 20 percent invested in the property.
- Require the option exercise price to be at least fair market value.
- Don’t allow the lessee to make property modifications, improvements, or additions.
Take the right precautions, and you’re more likely for an IRS judgment to go the way you planned.
- IRC Section 1234(a)(1). ↑
- Reg. Section 1.1234-1(b). ↑
- Reg. Section 1.1234-1(a)(1). ↑
- Reg. Sections 1.1234-1(f); 1.1234-1(g) Example (2). ↑
- Black’s Law Dictionary, sixth edition, p. 1094. ↑
- Revenue Ruling 55-540 ↑
- Revenue procedure 2001-28 ↑
- IRC Section 280A(d)(2). ↑