Do You Know the Tax Implications of a Lease Option?

A lease option is a common arrangement in commercial real estate and can provide benefits to sellers and buyers alike. However, it’s vital to understand whether the IRS sees the arrangement as a true lease or an installment sale of the property—even though the tenant has not yet exercised the purchase option

With the real estate market booming, it’s important to know how this option could affect your tax situation.

What is a lease option?

A lease option is a contract clause that gives a tenant the option to purchase the property at the end of the term. The lease specifies the price, along with additional option fees the tenant must pay to exercise the option.

The benefits of a lease option can be appealing to sellers. You can accomplish the sale of a property while collecting rent in the interim. Additionally, renters with a stake to buy are more likely to take better care of the building and land. And because it presents an opportunity to those having difficulty buying, it opens your property up to more buyers.

The details of the transaction determine how the lease option should be treated for tax purposes.

Is it truly a lease with option to purchase… or a sale?

Whether a lease is treated as a sale or a lease option depends on circumstances surrounding the transaction. If it’s highly probable the tenant will exercise the option, the IRS will generally characterize it as a sale.

Several factors would support the treatment of the transaction as a lease option. If the following criteria are met, the transaction will not be treated as a sale.

  • No portion of the rental payment is specifically designated as interest or otherwise readily recognizable as the equivalent of interest.
  • The lease agreement does not require that the tenant make substantial improvements to the property.
  • The lease agreement does not call for the crediting of rent payments against the option price or purchase price.
  • The rental payments defined in the lease are not significantly higher than the fair market value of rental payments made for a similar lease with no option to purchase.
  • The sum of the lease payments and option fees for the lease option does not represent a substantial portion of the fair market value of the leased real estate property.
  • The option purchase price is not a bargain price compared to the fair market value of the property. This means the total purchase price cannot be significantly less than the fair market value of the property.
  • The lessee does not acquire title upon payment of a stated amount of rents required under the contract. The lessee may only acquire title if they exercise the lease option.

How will this affect my tax situation?

The most significant factor in determining whether you have a lease option is the timing of the transfer of ownership. In a lease option, the ownership transfer takes place when the purchase option is exercised. Payments made prior to the purchase remain rent expense to the tenant and rental income to the lessor. If the option purchase fees paid by the tenant are to be applied against the purchase price upon exercising the option to purchase, they are not recognized for tax until the option is exercised or it expires.

If the lease option does not meet the requirements and instead will be treated as an installment sale, it will be assumed that the ownership transfer took place as soon as the original lease agreement was signed. In this situation, the tax consequences for the lessor and lessee are very different:

  • The lessor or seller treats the lease and option payments as part of the selling price and records the sale in the year in which the original agreement was entered.
  • The seller will not recognize deprecation or other operating expenses as tax deductions.
  • The seller is required to recognize a gain on the installment sale for the payments received each year until the full gain is recognized when purchase option is exercised.

The lessee or buyer in this instance treats the payments prior to the exercise of the purchase option as loan payments. The buyer can then begin depreciating the property and deduct interest expense on the loan payments.

It is important to understand the tax consequences of a lease option. Proper treatment is required to avoid incorrectly reporting these transactions to the IRS. This could result in the need to amend your prior year tax returns to correct the treatment of the transaction.

Talk to an experienced real estate accountant when you’re purchasing or selling property through a lease option to avoid unnecessary tax surprises.

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