Lease options are often used in real estate transactions, especially when property owners run into difficulty finding a buyer. If you’re not careful, though, the IRS might recharacterize the arrangement as a sale in the form of a contract for deed.
Lease option vs. contract for deed
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, alternatively, can claim depreciation as a tax deduction as long as the option isn’t exercised. In addition, the IRS doesn’t 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 legal title as security for the payments. 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, such as mortgage interest deductions. 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.
Signs of a sale
When determining whether a transaction is a lease option or a sale, the IRS looks at the “economic reality.” For example, if the circumstances when the agreement is executed suggest the buyer is very likely to exercise the option, it may be considered a sale.
Another indicator of a sale is an arrangement with artificially high rents and a below-market option price. These features can lead to the conclusion that the buyer is acquiring equity in the property during the lease term (equity = rent paid less fair market value rent). In such circumstances, the option price may be seen as a down payment. The low-priced option alone won’t establish a sale, though, if the price is a substantial percentage of the property’s fair market value and the rent payments aren’t applied to the purchase price.
A lease that requires the tenant to make substantial improvements may also evidence a sale. As in the case of inflated rents, the theory is that the only way the tenant can recover its investment is by exercising the option.
Proceed with caution
A lease option can provide strategic value for both buyers and sellers, but you must take care to avoid IRS recharacterization. An appraiser can help you set the payments and option price at market values to boost the odds of surviving scrutiny.