Many real estate professionals use the “lease with option to buy” method of structuring deals, because it enables them to collect higher monthly payments and higher prices overall than they could in a normal transaction. Lease options bring buyers to the table that otherwise wouldn’t have been able to purchase, thus enabling sellers to move houses in a down market.

But, as popular as this method is, both lessees and lessors need to be aware of certain tax implications. If the deal isn’t properly structured, the IRS may conclude that an ownership transfer took place at the beginning, rather than the end, of the lease.
 
Signals of a Sale
If a lease is structured with such high financial incentives to exercise the option that the tenant is economically compelled to buy, the IRS may see a red flag arid recharacterize the lease as a sale. Other charactcri sties that signal a sale to the IRS include:

Lease payments that are substantially more than the actual fair market rental rate of the property or that appear to be “interest in disguise” — the monthly lease payments are close to what they would have been had the agreement been a mortgage instead,
• Lease and option payments that, in total over the life of the lease, approach the fair market value of the property in question,
• Terms that require the tenant to make such substantial improvements to the
property that investment can only be recovered if the option is exercised,
• Terms that credit lease payments against the option price, and
• Terms that offer too much of a “bargain purchase price” at the end of the lease.

The fact that the lease option price is a bargain doesn’t, by itselt, mean the lease was really a sale.

In making lease-sale determinations, the IRS looks at all the factors involved. If the lease payments reflect market value and aren’t applied to the purchase price, and if the option price is a substantial part of the property’s fair market value, the transaction may still be characterized as a lease. Even if lease terms (including monthly payments and the buyout amount) weren’t at fair market value, the IRS considers whether the parties invol’ved believed in good faith that they were.

The Cost of Recharacterization
An IRS determination that a lease was really a sale alters the timing of the transaction, resulting in significant tax consequences for both parties involved. In such cases, property ownership is assumed to have transferred at the inception of the lease. The tenant loses the lease deduction, but is allowed to deduct depreciation and other operating expenses related to the property.

Part of the lease payments will be deductible as mortgage interest — which will be calculated under the “imputed interest rules.” The remaining portion of the payments will be considered as part of the property’s purchase price in computing a new tax basis for the property.

For the landlord-turned-seller, the sale is treated as an installment sale, with what would have been the Option payment now serving as a down payment. As in the case of the tenant, a portion of lease payments is allocated to interest and a portion to thc aching price. Most important, part of the installment payment becomes long-term capital gain or ordinary loss to the seller Qf the property was held for more than a year and the seller wasn’t a ‘dealer” in real estate).

The net result for the landlord-seller is to convert ordinary income (rent) into capital gain or ordinary loss (bascd on proceeds from the sale). The seller’s applicable tax rate could be lower as a resuLt, though any benefit could easily he offset by the loss of depreciation and operating expense deductions.

Sorting Through the Maze
Although the lease option is a valuable strategy in many situations, a number of tax planning issues are involved. To protect against rccharactcrization as a sale, make sure your next deal is structured carefully and uses rental and property values determined by qualified experts.

Patrick Riley, CPA is the President and CEO of Braver PC, the 8th largest accounting firm in Massachusetts.