The most important factor in determining if you have a rental option is the timing of the transfer of ownership. In the case of a leasing option, the transfer of ownership takes place when the call option is exercised. Payments made prior to purchase remain rental fees for the tenant and rental income for the landlord. If the option purchase fee paid by the lessee is to be deducted from the purchase price when exercising the call option, it will not be taxed until the option is exercised or expires. Please log in again. The login page opens in a new tab. After logging in, you can close it and return to this page. There can be several tax benefits for sellers using a lease option agreement, but first, let`s look at how the IRS taxes the money you get in a lease option agreement. Rent tax – Rent payments are treated as ordinary income, which means you pay taxes at your normal tax rate (up to 39.6% – 43.4% if you have to pay the net capital income of 3.8%). To determine whether a transaction is an option lease or a sale, the IRS looks at the “economic reality.” For example, if the circumstances in which the contract is performed indicate that the buyer is very likely to exercise the option, this may be considered a sale. If the IRS were to requalify the lease for sale, the seller might not have the money to pay capital gains tax, or the timing of the sale might not be beneficial to the seller — the whole reason for the option at first. All content in this article is for informational purposes only. The issues discussed in this article are subject to change.
For up-to-date information, please contact a James Moore professional. James Moore will not be responsible for any claims, losses, damages or inconveniences caused by any information on these pages or information accessible through this website. The tenant is the party making the lease payments. Since the tenant is not the owner of the property, he cannot deduct tax on lease payments made unless the lease is a commercial lease, in which case the lease payments would be deductible as business expenses. If the tenant made an upfront payment to secure the option, that payment could be added to the tenant`s cost base for the property when purchasing the property. For example, if the tenant pays $5,000 upfront to obtain the option and the purchase price paid in two years is $200,000, the initial payment of $5,000 is added to the cost of $200,000, so that the cost base for calculating profits is $205,000. A lease option agreement is an agreement in which a party signs a lease with an “option” to purchase the property on a specific date at a fixed price. Sometimes the party renting the property gives the owner of the property an upfront payment in “return” for the option. During the option period, the party making the lease payments is not the owner. The party that receives the lease payments is always the owner.
The tax treatment of the party making the lease payments and the party receiving the lease payments depends on the facts of the transaction. Is the price of the option a great price? Another indicator of a possible sale is the sale price of the property (the amount to complete the purchase). If it is an advantageous price compared to the fair market value of the property, the transaction is likely to be considered an installment sale because the tenant is “economically forced” to buy the property at the end of the lease. Tax on the deposit and/or monthly payment of the option – The income from the option is not taxable until your buyer has decided to exercise his option or let it expire. They treat option income as ordinary or capital, depending on whether the buyer exercises the option or lets it expire. If your buyer decides not to buy the home, treat the income from the option as ordinary income. When your buyer buys, treat the option as part of the purchase price, which gives you capital gains. With regard to the situation in the third point, the tenant does not pay more rent than would be the case without this option. Thus, the tenant does not acquire any capital during the rental period.
However, if the rent can be applied to the option price, the lease option transaction has the appearance of an installment sale with a lump sum payment. This is especially true if the rent payments are approximately equal to the amount of instalment payments the tenant would make for a loan repayment plan with a market interest rate. The details of the transaction determine how the lease option is to be treated for tax purposes. It is important to understand the tax consequences of a rental option. Proper processing is necessary to prevent these transactions from being falsely reported to the IRS. This may require you to amend your previous year`s tax returns to correct the processing of the transaction. Tax implications for tenants and landlords If the IRS qualifies the option as an installment sale option for income tax purposes, it is assumed that ownership of the property was transferred at the time the tenant gave the landlord payment of the option and the lease began. This schedule significantly changes the tax consequences for both the tenant and the landlord. If payments for the option agreement are excessively high or higher than the estimated “fair rent” for the region, the Internal Revenue Service (IRS) may determine that an installment sale has taken place. In this case, the IRS treats the transaction as a sale rather than a lease. The same rule applies to an excessive advance payment on the option contract.
The facts of each transaction determine whether an installment sale has taken place or whether the transaction is a lease option. During the audit, the Internal Revenue Service sometimes decides that a rental option is rather an installment sale. If the lease option does not meet the requirements and is instead treated as an installment sale, the transfer of ownership is presumed to have taken place once the original lease is signed. In this situation, the tax consequences for the landlord and tenant are very different: in this case, the tenant or buyer treats the payments as loan payments before exercising the purchase option. The buyer can then begin amortizing the property and deduct the interest charges on the loan payments. A rental option gives tenants the option to purchase the building at the end of the lease. If the tenant exercises the purchase option, is he buying the building at that time? Or did they participate in an installment sale by making the previous lease payments? Another indicator of a sale is an arrangement with artificially high rents and a lower than market option price. These characteristics may lead to the conclusion that the buyer acquires equity in the property during the rental period (equity = rent paid minus rent at market value).
In such circumstances, the option price may be considered a down payment. However, the favorable option alone does not constitute a sale if the price represents a significant percentage of the market value of the property and rent payments are not applied to the purchase price. The benefits of a rental option can be appealing to sellers. You can sell a property while collecting the rent in the meantime. In addition, tenants with a share to buy are more likely to take better care of the building and land. And because it represents an opportunity for those who have trouble buying, it opens up your property to more buyers. In a contract for the deed, the buyer makes instalment payments and receives the appropriate ownership of the property, while the seller holds legal title as collateral for payments. The legal title passes after the final payment. Because the IRS considers a contract for the deed to be a sale, the buyer benefits from the property`s tax benefits, such as mortgage interest deductions.
B and depreciation. If the buyer makes the final payment, the entire balance paid represents a capital gain for the seller, and the seller must also pay any real estate transfer tax. A lease with an option to purchase can provide strategic value for buyers and sellers, but you should be careful to avoid IRS requalification. An appraiser can help you set payments and option prices at market value to increase the chances of surviving the audit. Basics Rental OptionA rental option is a type of contract used in residential and commercial real estate. In a rental option, the rental conditions. Rent payments are only deductible for a property in which the tenant does not acquire the property or hold an equity interest. Two factors suggest that a tenant acquires a stake in a property: leases with call options are often used in real estate transactions, especially when landlords have difficulty finding a buyer or when a buyer is simply unable to buy but wants the property in the long run. However, if you`re not careful, the IRS may requalify the agreement as a sale in the form of an act contract. Whether a lease is treated as a put or lease option depends on the circumstances of the transaction. If it is very likely that the tenant will exercise the option, the IRS will usually call it a sale. If you`re buying or selling real estate through a rental option, don`t underestimate the tax implications involved.
Talk to an experienced real estate accountant to avoid unnecessary surprises. Although the rental option is a valuable strategy in many situations, it must be used with the utmost care. There is always a risk that the IRS will view the lease option transaction as a sale and the lease as a mere financing instrument. Rents well above market rents, combined with a “windfall” option price, suggest that the transaction is likely to be marked as a sale and that rent payments are actually installment payments on the purchase price. Therefore, rent payments and the price of the option should be determined by the parties based on the market values and rents of similar properties […].