Lease Option and “Subject To” - The Investor’s 1-2 Punch - Part 5 2-6
TAX TREATMENT OF OPTIONS – THE SELLER
If the buyer exercises the option, the option money paid to the seller is
considered part of the sales price of the property and is treated as a down
payment in the year of sale. If the sale is an installment sale, the option money (no
matter when it was paid) is treated as payment in the year of sale and part of the
contract price.
If the buyer does not exercise the option, the option money becomes
ordinary income to the seller as of the date the option expired. The ordinary
income rule applies to all sellers including dealers and investors.
The seller does not have to claim the option consideration as income until
the option is exercised or forfeited.
TAX TREATMENT OF OPTIONS – THE BUYER
Gain or loss from the sale of an option contract is considered gain or loss
from the sale or exchange of property. The option contract takes on the same
classification as the property would have if acquired by the optionee buyer.
Since this is being written for real estate investors we will limit the brief
discuss of taxes to investor situations. So…if the underlying propert y would have
been investment property in the hands of the optionee (investor/buyer), capital
gain or loss is realized.
If the option was "held" for more than one year, the capital loss is long-term.
If one year or less, short-term.
Personal Use Property -If the underlying property would have been real
estate held for personal use in the hands of the optionee, gain is treated as capital
gain. If a loss is suffered, it is personal and not deductible.
TAX ON EXCHANGE OF OPTIONS BY BUYER
Gain or loss from the sale of an option contract is considered gain or loss
from the sale or exchange of property. The option contract takes on the same
classification as the property would have if purchased by the optionee buyer.
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OPTION OR SALE?
Great care must be taken to assure the option is not recharacterized by the
IRS as a contract of sale. This distinction is vital because a contract of sale
creates a taxable event while the option does not. To assure that it is treated as
an option for tax purposes by IRS, the option contract must detail (1) what will
happen if the option is forfeited and (2) what will happen if it is exercised.
An executory* contract to sell land in the future is not an option contract.
(*an executory contract is one in which all or part of the required performance has
not been done. An example would be a contract that requires a series of
payments before title is passed.)
An option contract gives the optionee the right to enter into a separate
contract at a later, specified date. When the option is excised the separate
contract most often would be the sales contract, so that the optionee could obtain
title to the property.
No separate executory contract would be necessary where title would
pass once all the payments were made under a sales agreement. That would not
be recognized by the IRS as an option. In a lease-option deal the lease would
require payments, not the option, so the option could not be characterized as an
executory contract..
A payment for an option contract, even if credited against the purchase
price, is only for the option contract and not for an equitable interest in the
property. This is not true where the buyer is building an equitable interest in the
property by making monthly payments under an executory contract.
A contract that does not bind the owner of the property to deliver the
property is not an option contract entitled to capital gain treatment.
A right of first refusal is not an option.
To make the option contract binding, option money (or something of value)
must be delivered to the Optionor. Option money is called “consideration”.
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This is driven home by a legal case where there was an undated agreement
purporting to give the optionee, who had paid no consideration, the right to
purchase property at a fixed price within six months from the date of the
agreement. This was ruled not to be an option contract, but merely an offer to sell
made by the property owner.
INSTALLMENT SALES
When the buyer exercises his option to purchase the property, he and the
seller can agree to an installment sale. This permits the seller to report the sale on
the installment method of tax reporting. It is not necessary for the installment note
to be secured by the property to qualify for installment tax reporting. Please note:
The terms of the installment sale are not included in the option. Those are
detailed in the purchase agreement executed when the option is exercised.
SALE OR LEASE-OPTION?
Normally, a lease-option agreement presents no difficulty in determining the
date of sale. But some lease-options, carelessly written by the uninformed, take
on all or most of the characteristics of a sale with a financing agreement. Because
the sales date is vital, it's important to understand the difference between a lease
agreement and a sales contract.
Many leases with option to buy are in fact sales agreements, and the IRS
treats them as sales agreements if the taxpayer is audited. How the agreement is
treated depends upon the intent of the parties. Intent is determined based on the
facts and circumstances existing at the time the agreement is made.
The existence of an option does not automatically make it a financing
transaction when carefully created. Ask these questions:
During the option period who assumes the economic burdens and benefits of the
property?
How was the purchase price under the option determined?
Does the rent reflect fair market rent or is it set above or below
market? 2-9
Was the transaction bargained at arms' length?
Is it a substitute for conventional mortgage debt financing?
When the option is exercised does the buyer have a bona-fide ownership interest or
is he merely a tenant?
These questions must be considered if the transaction is structured so it
closely resembles a debt transaction. This can happen if:
There is an option permitting the tenant to purchase the property, and
The lease terms resemble a mortgage agreement more than they resemble
lease financial arrangements.
An agreement may be considered a sales contract by the IRS and not a
lease if any of the following is true:
The agreement applies part of each "rent" payment the seller receives toward an
equity interest in the property. (Part of monthly payments could be credited
toward option consideration to avoid this point.)
The "tenant" pays rent to you that is much more or less than the current fair
rental value of the property.
The "tenant" has an option to buy the property at a price that is small
compared to the total amount required to be paid under the lease.
The "tenant" has an option to buy the property at a price that is small
compared to the value of the property at the time he may exercise the
option. This value is determined at the time of the agreement.
The lease designates some part of the "rent" payments the seller receives as
interest.
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TO MUCH?
Some may say that what you have just read is more than you really wanted
to know about leases and options. Our guess is that about 95% of the investors
using LO techniques aren’t aware of the narrow line they are walking.
If you will just read over the details we have presented here a couple of
times you will be far better equipped to avoid trouble. The truth is that if you
consistently use a set of well thought out and drafted documents you will be on
firm ground. Seldom, if ever, will you face legal challenges if you deal honestly
and fairly with everyone.
Recapping the essentials of a valid option:
1. Price: For the option to be valid the buyer must provide the seller with option
consideration. That usually means cash. One dollar is enough, although more
money is usually required. If you are leasing the property from the Optionor that
can be consideration. If the buyer fails to exercise the option the cash
consideration is not refundable.
2. Term: The option contract must contain a firm date by which the buyer must
exercise the option or the option is forfeited and becomes worthless.
3. Means of Exercising: The option contract must specify exactly what actions the
buyer must take to exercise the option. Usually this is simply written notice to the
seller that the buyer will exercise.
4. Option consideration is not taxable to the optionor until the option is exercised
or forfeited.
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When will you use lease/options (LO)? Often! Many times the LO will allow
you to control property with little or no cash. When the TV real estate gurus
proclaim that those who buy their material will learn the secret of buying property
for $10… they are usually talking about $10 in option consideration.
IT WORKS LIKE THIS
All creative real estate starts with finding a motivated seller. There are
plenty of those in YOUR area. A good marketing program will produce them for
you.
As we explain in “Postcard Power”, most real estate investors fail because
they fail at marketing. “Postcard Power” is a practical system that anyone can find
the time to put into action on a reasonable budget.
Let’s start by explaining how the authors use lease options in our own
investing program. We prefer to buy or control “pretty houses”. Nice homes in
nice neighborhoods where nice people live. That type of home is our first choice,
because it will attract good quality tenant-buyers. Yes, we prefer pretty homes,
but LO is a powerful technique for every type of property.
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Our pretty home tenant-buyers will be family people who will love the home,
pay their rent on time and many will spend money adding a few improvement to
the property. After all… they look on it not so much as a house they are leasing,
but a home they are buying. That attitude means we seldom have any contact
with them expect if they occasionally drop off the rent check in person. That’s
right, we seldom hear the kind of complaints ordinary landlords are showered with.
We create mailing lists of neighborhoods where we would like to own
homes. We, like real estate agents, call these areas our “farms”. We prefer areas
where the homes were built in the last one to five years. The price range of the
homes in our farms falls between $130,000 to $295,000. Since the homes are
close to new, so are the appliances. That means they seldom need repair or
replacement during the one to five years we own or control the property. Most
appliances, including heating and air conditioning, will still be under warranty.
Homes in that price range are selling well in our area under the current
financial climate… easy money and low interest rates. When money markets
tighten and interest rates rise we will lower our sights to less expensive homes so
that more buyers will be able to afford them.
When we get a response from a motivated seller in these areas they
typically have little or no equity. Often they purchased with a down payment of
from zero to 3% of the purchase price. During the short period they’ve owned the
home the mortgage pay-down is minuscule. If there was rapid appreciation in the
area many owners have refinanced and spent the proceeds on a lifestyle they
really couldn’t afford. They don’t have much equity and so they soon understand
that they will not receive much cash if they want to sell quickly.
Sometimes these owners have not be able to list with a real estate broker,
because a sale just won’t produce enough cash above the mortgage pay-off to
pay a real estate broker’s commission and closing costs.
You can see that we, as buyers, will be controlling a rather thin slice of
equity when we pick up one of these homes… usually $8,000 to $15,000.
During our friendly, low key negotiation we start by offering to buy the
property “subject to” the existing financing. This is often the very best deal an
investor can make and we strive for it without applying high pressure sales tactics. This document and accompanying materials are designed to provide authoritative information in regard to the subject matter covered in it. It is for illustration purposes only and presented with the understanding that the author and publisher are not engaged in rendering legal, accounting or other professional opinions. If legal advice or other expert assistance is required, the services of a competent professional should be sought. |
