Lease Options: When the IRS Considers It a Sale
Originally published on September 16, 2025
Knowing how lease options are treated by the IRS is essential whether you rent or own commercial real estate. These agreements often include a purchase option clause, and the tax consequences can vary widely depending on how you structure the lease option agreement. Getting it right avoids surprises at tax time.
What Are Lease Options?
A lease option gives tenants the right — but not the obligation — to purchase the property at the end of a lease. The question the IRS asks is: When does such an option turn a lease agreement into something more resembling an installment sale?
Is It a Lease Option or an Installment Sale?
Here are the key factors the IRS examines under a lease option agreement:
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Likelihood the purchase will occur: If at signing, there is a high probability the tenant will exercise the purchase option (say, because lease payments exceed fair market rent), this may point toward an installment sale.
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Total payments and option price versus fair market value: When the combined payments (lease plus option) approach market value, or the option price is a bargain, the IRS may treat the transaction as if ownership begins at signing.
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Intent of both parties: How both landlord and tenant view the lease payments and the purchase option matters, whether the lease is viewed as purely rental or with ownership in view.
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Required improvements or investments by the tenant: If the tenant must invest in property improvements, this suggests a greater economic stake that can support the idea of a long‑term ownership intention.
How the Classification Affects Your Tax Picture
Whether the agreement is treated as a lease option or an installment sale has big tax implications. Here’s what changes:
| Scenario | When Treated as a Lease Option | When Treated as an Installment Sale |
|---|---|---|
| Timing of ownership transfer | Ownership (for tax purposes) transfers only when the purchase option is exercised. | Ownership is considered transferred at signing of the lease option agreement. |
| Treatment of lease payments | Lease payments remain as rent; expense for tenant, income for landlord. | Early payments are treated like loan payments with interest imputed. Tenant may deduct depreciation and interest; landlord treats the property as sold for tax purposes and stops depreciation. |
| Tax deductions and depreciation | Landlord continues to depreciate (if applicable); tenant cannot take ownership deductions until purchase. | Tenant may begin depreciation and interest deductions at inception of lease; landlord stops depreciation. |
What To Do If You’re Using Lease Options
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Review lease option agreements carefully. Make sure terms like the option price and required improvements are clearly defined.
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Use fair market values and comparable leases to benchmark your lease payments and purchase option price.
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Consult with a real estate tax professional or CPA to determine how your arrangement may be viewed by the IRS.
When you’re purchasing or selling property through a lease option, don’t underestimate the tax implications involved. Talk to an experienced real estate accountant to avoid unnecessary surprises.
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