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:
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.
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