A few years ago, I wrote an article regarding lease options, and it caused quite a bit of fanfare. Due to numerous hits, we feel it’s time for a refresher as well as to dive into a little more detail. The structuring of lease options needs to be scrutinized to ensure that the IRS does not arrive and re-characterize the lease option as a sale.
A lease option is a traditional lease with a purchase option that gives the tenant the exclusive right to buy the property at the price typically set from the beginning. The tenant can exercise the option at any time during the option period, which usually runs concurrently with the lease period. The seller benefits from market appreciation or can claim depreciation as a tax deduction as long as the option isn’t exercised. Also, the IRS does not deem the arrangement a sale until the option is exercised, so the seller can defer its gains.
With a contract for deed, the buyer makes installment payments and receives equitable title in the property, while the seller holds the legal title as security for the payments. The legal title is transferred after the final payment. Because the IRS considers a contract for deed to be a sale, the buyer reaps the tax benefits of ownership. When the buyer makes the final payment, the entire balance paid constitutes capital gains for the seller, and the seller also must pay any transfer tax.
If it walks, talks, and looks like a sale; it’s probably a sale
What makes a lease option look like a sale to the IRS? First and foremost, intent plays a significant role. At the onset of the lease, if the intent of the buyer is to exercise the option, then it may be considered a sale.
Rents well above fair market value could be another indicator of a sale. This suggests that the split above fair market value (FMV) are payments towards equity rather than true rental payments. This, coupled with low option price, implies that the option price is a down payment and a sale is intended. In addition, does the lessee acquire title upon payment of a stated amount of rents? Finally, it is a portion of the periodic payments specifically designated as interest or is identifiable as the equivalent of interest. All of these can indicate that a sale is intended to occur and the IRS can re-characterize the lease as a sale.
Guidelines from the IRS
The IRS has generously provided guidelines through Rev Proc. 2001-28 that, if followed, will allow the IRS to consider the transaction a lease with an option rather than a sale:
- The lessor’s investment must be at least 20% of the original cost of the property and must remain at 20% throughout the lease.
- The lessor must demonstrate that 20% of the original cost of the property is a reasonable estimate of the FMV of the property at the end of the lease term.
- The lessee cannot have a contractual right to purchase the property from the lessor at a price less than its FMV at the time the right is exercised.
- No part of the cost of the property may be furnished by the lessee or any other party except for the following situations:
- A lessee may pay for an improvement that is readily removable without causing material damage to the leased property.
- A lessee may pay for an improvement that is not readily removable without causing material damage to the property, if the improvement is furnished to comply with governmental standards on health, safety, or the environment; and the improvement does not increase productivity of the leased property to more than 125% of its productivity when first placed in service, or modify the leased property for a materially different use. The cost of the improvement, when added to the cost of all nonseverable improvements previously made to the property, cannot exceed 10% of the cost of the property.
- The lessee may not loan funds to the lessor to acquire the property or guarantee any acquisition debt.
- The lessor needs to make a profit in the lease, aside from tax benefits.
Be Strategic About Lease Structure
If both the seller and buyer are strategic in the structuring of the lease option, then they should survive IRS scrutiny and potential re-characterization. We recommend utilizing an appraiser to ensure market values are used for setting up rent payments and option prices. In addition, having your CPA review the documentation prior to execution will help ensure the structure will hold up under inquiry.