Tax consecuence of long term lease/options.

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Tax consecuence of long term lease/options.

Luis Castillo
Real Estate Investor · Whittier, CA · Member since 2012 · 92 posts · 19 votes

Can someone give me a general answer to the following situation.

Let's say I buy a duplex for $100k and I give you an option to buy it for 20 years.
As option money you give me $20k. I purchase it with a 15 year full amortized loan of $80k. As per the terms of the option, I collect the rents and am responsible for keeping the property in good condition.

The purchase price on the option is $20k plus the balance of the loan at the time of purchase. If you wait 15 years, you will pay $30k and the property is yours free and clear.

In that scenario, I purchased the property for 100k and sold it for a total of $50k.
$20 for the option up front and another $30k of actual purchase price. This being the case, shouldn't I have a loss of $50k that I could write off.

I will have to recapture my depreciation, which I estimate will be a little over $10k if I depreciate 75% using a straightline method over 27.5 years. Recapturing 15 years that I will have written off and paying 25% tax.

The benefits to me is I can buy unlimited properties with 20% down that should cash flow a little immediately and plenty in years 5-15. In addition at the time of sale I will have a loss of $50k and I will collect a cash infusion of $30 at the time of sale.

Benefits to the buyer. You control a property with 20% down, you never have to qualify for the property. The buyer never has to manage the property. The buyer receives all the appreciation and the property is free and clear when he/she purchases the property in 15 years. The option will allow the future buyer to finance the $30k to purchase the property when the property is purchased in the future, so the buyer only needs to pull money out of their pocket at the beginning for the option money.

If appreciation is strong, the optioner can purchase the property at anytime. Therefore, if the property doubles in value in 5 years the price to buy would be the balance of the loan (just to use a figure, let's say $78K) plus $30k for a total of $118k and they can sell it for $200k.

There are more details, but given the above scenario, please give me some feedback on the negatives. I want to know why this won't work. I know areas depreciate and management will be very important. But assume that I am buying correctly in good areas and at good prices.

Thank you.

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  • Tom C.
    Investor · Kingwood, TX · Member since 2012 · 97 posts · 21 votes
    13y

    In my view this is not a good deal for you, but GREAT FOR "THE MAN" and I am not sure your math makes sense.

    Here is my more pessimistic (or conservative summary) [Devil's advocate] I hope you take this as it is intended... as constructive feedback. So you buy an asset for $100K and effectively beleive you will sell it for a $50K loss ($100K - $20K - $30K). To offset this loss, you would have the generate $50K of pretax earnings to breakeven over the life of the agreement ($3.3K in earnings a year). [actually, more since you wouldn't get the $30K until the 15th year]

    AND don't forget, you also agreed to operate that asset for 15 years and generate $80K of after tax cash flows (since repayment isn't an expense) to buy down the note (to the benefit of the option holder). That is an average of more than $5.3K/per year (after tax) you would need to generate each year. On a $100K property, I would be suprise if this scenarios would cash flow. Assuming your note was interest-free, you would need a cap rate of about 10% to make this work. And interest isn't free.

    You will note that from your example, you actually wouldn't want to pay off the debt. (there is no incentive to you) You would want to just hold the asset and take the cash flows. The option holder unless they had some reason to trust you would see the incentive you have to just not pay the mortgage and collect rents until the bank foreclosed. Afterall, the MAN foreclosing (calling the property) and the bank foreclosing are pretty similar economically to you.

    In short, what you get is the ability to operate unlimited properties for the MAN, where you strive to repay the 80% loan on each property, only to have the MAN call the property away from you in the end.

    And don't get confused by the money you perceive getting. All of it in this deal is pumped into financing a property that ultimately goes to the MAN.

    I would prefer a partnership where you had some upside. The structure may not be broken, but the economics you get in the example sure are!

    FYI - You don't need to recapture depreciation when you sell an asset at a loss. In this case, you wouldn't have to recapture. Also, if I did a deal like this, I would have the option require a notice period and 1031 Exchange cooporation language, although this tax loss wouldn't need it.

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  • Luis Castillo
    OP
    Real Estate Investor · Whittier, CA · Member since 2012 · 92 posts · 19 votes
    13y

    Tom, thanks for the quick reply. Let's see if these numbers help my situation.

    Let's say the duplex rents for $1,500 per month, minus 40% vacancy and expenses. After a payment of $675 per month on a 15 year fully amortized loan at 6%That would leave a positive cash flow of $225 per month. The idea is to purchase at least 25 properties in one area in order to make management worth it. It still only leaves a salary basically. ($5625 per month) But in the 7thyear (figuring a 3% rent increase per year) you'll start clearing $10,000 per month on every 25 properties. If you did this 4 years in a row after 7 years you would be clearing approx. $32,000 a month on 100 duplexes. When the properties are purchased on the 15th year, you would pick up another $3,000,000 tax free.

    This works even better in areas where you can pick up a fourplex with rents around $2,000 per month on each property. The monthly numbers make it sound alot more attractive.

    Remember, the optioner is giving me the 20k for the down payment, so I can buy unlimited properties. If I want to make more money on the front end I can buy a fixer-upper for $55-$60k put $20k to fix it and option it at the $100k number. That way I pick up an extra $20-$25k on the front side.

    By the way, I am not offended by you being pessimistic or conservative. That's exactly what I am looking for.

    Thanks for your time.

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  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    13y

    Your plan sounds more like a disguised sale than a lease purchase arrangement. This could be a big negative if the IRS agrees with me.

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  • Aaron Junck
    Real Estate Investor · Sioux Falls, SD · Member since 2013 · 415 posts · 84 votes
    13y

    I agree with Dave T. Be careful .. The IRS will consider it an installment sale if you collect "rent" that is not in line with the "fair rent" in your area. Also If you collect a large amount of "option consideration" upfront they may view it as an installment sale as well... now what these figures are I am not sure but if your going to get a ballpark of 20% upfront that seems pretty high, well atleast for my area, most lease options around here have between 3-5% of option consideration upfront.

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    13y

    This thread is old; however, Dave T is correct in that it sounds like a disguised sale. Looks like a situation to avoid to me.

    -Steven

    [email protected]224-381-2660
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  • Luis Castillo
    OP
    Real Estate Investor · Whittier, CA · Member since 2012 · 92 posts · 19 votes
    13y

    Thanks guys. That's the information I needed. Since taxes aren't my strong suit, I had never even heard the term "disguised sale"

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