By: Donald J. Valachi, CCIM, CPA
Reprinted with permission from Commercial Investment Real Estate, The Magazine of the CCIM Institute, May/June 2015, Vol. XXXIV, No. 3
(This article, which originally appeared in Commercial Investment Real Estate, July/August 1996, is one of the most popular articles downloaded from the CIRE archive. Here is a condensed version of the original article).
A lease with an option to purchase is a common real estate arrangement. The important income tax question in lease-option transactions is whether the tenant is leasing the property or, as an economic reality, an installment sale has occurred prior to the tenant exercising the purchase option.
The answer to this question depends upon an analysis of all the surrounding factors. As Gerald J. Robinson observed in the Federal Income Taxation of Real Estate: “A collection of telltale signs leads to the conclusion that exercise of the option was virtually certain from the outset, so that treating the entire transaction as a sale is warranted.”
If a lease option is treated as a sale, there are two important tax implications:
• The timing of the property’s transfer of ownership is changed. With a “true” lease option, ownership transfers when the option is exercised. If the transaction is treated as a sale, then ownership transfers when the parties execute the original agreement.
• The nature of the option payment and the rent payments during the lease period are changed.
Because the tax treatment of a purchase transaction is so different from a lease transaction, it is important to understand the factors that may lead the Internal Revenue Service to characterize a lease-option transaction as a sale.
The basic tax question is whether or not the IRS will assume a sale occurred before the tenant actually exercises the option to purchase. If, at the time the lease option agreement is executed, all economic circumstances indicate a high probability that the tenant will execute the option, the IRS will very likely characterize the lease option as a sale. If the tenant acquires equity in the property during the period of the lease, it increases the likelihood that the tenant will exercise the option to purchase, because this is the only way to protect the investment.
The linking of inflated rents and a below-market option price tends to corroborate that the tenant is acquiring an equity interest in the property. For example, assume that Adams agrees to lease an industrial building from Baker for two years at an annual rent of $120,000. At the same time, Adams pays Baker $20,000 for an option to purchase the property at the end of two years for $240,000. At the time the lease option agreement is executed, the fair market value of the property is $500,000 and the annual fair rental is $50,000.
Adams acquires $70,000 of equity per year over the two-year lease period ($120,000 annual rent payment – $50,000 fair market rent). In addition, the total payments made by Adams equal the value of the property ($20,000 option payment + $120,000 rent payment [year #1] + $120,000 rent payment [year #2] + $240,000 option price = $500,000 fair market value). Thus, the economic circumstances at the time the agreement is executed indicate that the lease option is, in economic reality, a sale and that the $20,000 option payment is the down payment.
This lease-option transaction example will be treated as a sale for tax purposes, because the rental amounts are so great that the tenant is economically compelled to exercise the option, and, even more compelling, the inflated rents and the low option price add up to the approximate fair market value of the property.
However, a “bargain” option price will not, by itself, result in the lease-option transaction being characterized as a sale. If the option price represents a substantial portion of the fair market value of the property, the rent approximates the actual fair market rental value, and the rent payments are not applied to the purchase price, the lease-option will not be characterized as a sale.
The IRS may come to the same conclusion in that example if the option price of the property is set at market value, but the rent and the option payments are applied to the option price. For example, assume the same facts as in the previous example, except that the option price is $500,000 and the $20,000 option payment and the two annual $120,000 rent payments are to be applied to the option price. When Adams exercises the purchase option, he pays Baker $240,000 ($500,000 option price – $20,000 option payment – $120,000 rent payment [year #1] – $120,000 rent payment [year #2] = $240,000).
OTHER ECONOMIC CIRCUMSTANCES
In addition to the rental value and option price, other economic factors may be considered in determining whether a lease option should be characterized as a sale for tax purposes. In analyzing lease option transactions, each of the following factors has been considered evidence that indicates a sale:
• The lease requires that the tenant make substantial improvements to the property and the tenant can recoup his investment only by exercising the option.
• A portion of the rent payments can be identified as a substitute for loan interest.
• The agreement calls for the crediting of rent payments against the option price. This is true even when both the rental value and the option price are set at fair market value.
Regarding the situation in the third point, the tenant is paying no more in rent than would be the case in the absence of the option. Thus, the tenant is not acquiring equity during the lease period. However, if the rent may be applied to the option price, the lease option transaction has the appearance of an installment sale with a balloon payment. This is especially true when the rent payments approximate the amount of installment payments the tenant would make, given a loan amortization schedule with a market rate of interest.
But there is no certainty that the tenant will exercise the option. Thus, if the tenant can demonstrate to the IRS that the reason for the lease option is that a sale was not possible because of economic conditions, the lease option will likely be upheld. As Michael P. Sampson says in Tax Guide for Residential Real Estate: “...if you can demonstrate that the reason for the lease option is the impossibility of a cash sale because of economic conditions, the form of the transaction as a lease option will probably stand. This would be the case, for instance, where your purpose is to tie down the property during a tight money market, with the expectation that within the option period you can get institutional financing.”
INTENTION OF THE PARTIES
In some cases, the court has ruled that the intentions of the parties determine whether a lease-option transaction is to be treated as a sale, instead of relying on strictly economic tests. If the parties believed when they entered the transaction that the rent charged reflected fair market rents and that the option price reflected a good faith estimate of the future value of the property, the lease option will very likely be upheld.
Because the party’s intention is subjective, an IRS agent or a judge would need to corroborate these intentions in the economic circumstances surrounding the transaction.
Although the lease option is a valuable strategy, it should be used with great care. Both the rental payments and the option price should be set by the parties with reference to going market values and rents for similar properties. And the parties should be prepared to justify their estimates of rent and purchase price if the transaction is later challenged by the IRS. Rental value and property value are best established through independent appraisal by experts.
TAX CONSEQUENCES TO TENANT AND LANDLORD
If the IRS characterizes the lease option as an installment sale for income tax purposes, the ownership of the property is assumed to transfer at the time the tenant gave the landlord the option payment and the lease commenced. This timing alters the tax consequences considerably for both the tenant and the landlord.
Tenant as Buyer
• The tenant will not be allowed to deduct his rental payments as such.
• The tenant will be allowed to deduct depreciation, based on the portion of the presumed purchase price allocated to depreciable improvements. In addition, the tenant may also deduct other expenses associated with operating the property.
• A portion of the rental payments that the tenant makes will be recharacterized as interest payments and will be treated as deductible interest for income tax purposes. The amount of the interest deduction will be calculated under the “imputed interest rules.” The portion of the rental payments treated as loan principal payments is considered part of the purchase price and, thus, is added to the tenant-buyer’s tax basis for the property.
Landlord as Seller
• The option payment is treated as a down payment. Since the landlord did not receive all cash for his equity, the installment method of reporting would be applicable to the transaction. Thus, the option payment will be treated as an initial payment received in the year of “sale” under the installment method.
• The rental payments received by the landlord-seller under the lease agreement are treated as part of the selling price, and part of each installment payment is taxable gain. Since no interest is stated in the rent payments, it must be imputed.
• The recharacterized rental payments will result in either long-term capital gain or ordinary loss. This assumes that the property was held for more than one year at the time the lease-option agreement was signed, and that the landlord-seller was not a “dealer” in real estate with respect to the property in question.
• Ordinary income (rental income) converts into capital gain (sale proceeds). As a result, the applicable tax rate could be lower. In addition, the amount of reportable income would be limited to the gain, if any, on the sale.
• The landlord would not be allowed to deduct an allowance for depreciation or other rental expenses.
Donald J. Valachi, CCIM, CPA, is a retired clinical professor of real estate at California State University in Fullerton.
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