Tax Info On Lease Options

INDICATIONS OF WHEN A LEASE\OPTION IS A COMPLETED SALE

1. The primary indicator that may cause the lease-option to be a completed sale is- rent payments substantially higher than the fair rental value, along with a low option price, Haggard, 241 F.2d 288, aff'g 24TC, 11241; Truman Bowen, 12 TC 466; East Coast Equipment Co, 21 TC 112, airel, 222 F .2el, 676.

Large upfront deposits can also be another indicator.

EXAMPLE - LEASE-OPTION THAT IS REALLY A DISGUISED INSTALLMENT SALE:

CC does a 36 month lease\option on a $100,000 property which would normally rent for $1,000 a month.

With the lease\option there are the following terms:

$10,000 upfront option payment to be totally applied toward the purchase price;
monthly payments of$2,200 of which $2,000 is to be totally applied toward the purchase price;
$18,000 option payment to purchase the property at the end of the 36 months.
The sum of the $10,000 option deposit,
$2,000 rent credit for 36 months, and
the final option payment of$18,000 equals the total purchase price of$100,000.
The $200 monthly payment not credited toward the price, is presumably interest

This example demonstrates that the highly inflated rental forces this transaction to be, in substance, a completed purchase and sale at the time of the execution of the "lease-option".

See IRS Revenue Ruling 55-540. (Comment: This one is obvious!)

2. Another factor that could indicate a completed purchase and sale is where the lease requires the lessee to make substantial improvements to the property and the lessee's investment in the improvements can be recouped only by exercising the option, Oesterreich, 226 F .2D 798.

Another factor is the intent of the parties, based on the facts and circumstances.

If the taxpayer can demonstrate that they believed the rent and option price to be reasonable, the lease option arrangement may hold up. Benton, 197 F.2d, 745; Lester, 32 TC, 711.

STRATEGIES TO AVOID RECHARACTERIZATION OF A SALE:

Where the parties want to avoid having the lease/option recharacterized as a sale, the overall planning strategy is to avoid or minimize the above indicators of a deemed sale as follows:

1. The rent should be at or near fair rental value. Breece Veneer & Panel Co., 232 F .2d 319.
Get a written opinion of the rental value from a qualified real estate professional.

2. Keep rent credits toward the option price to a minimum.
Generally, 20% or less is considered reasonable.

3. The option price should be at or near fair market value.
Get a written opinion of the market value from a qualified real estate professional.
Breece Veneer & Panel Co., Ibid.

4. Try not to tie-in substantial lessee improvements with the option exercise.

5. Do not pass legal (or equitable) title to the optionee\lessee\buyer.

6. Demonstrate that you intend to do a lease-option and that you believe the rent and option price to be reasonable. See Benton, 197 F.2d, 745; Lester, 32 TC, 711.

Use arm's length lease-option documents along with the counsel of qualified professionals.