Originally posted by @Brian Gibbons:
Taxation Issues with Lease Options
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.
@Bill Gulley
Any IRS Links?
IMPORTANT!!!!!
THIS THREAD IS ABOUT A COMMERCIAL LEASE-OPTION NOT TO A CONSUMER
Breece Veneer & Panel Co., Ibid. This case is concerned with equipment leases, personal property not real property under Uniform Law
http://www.irs.gov/irb/2014-8_IRB/ar04.html
Covers partnership liability with respect to disguised sales, you can also see the interpretation and reasoning as applicable to any buyer/entity.
http://www.ccim.com/cire-magazine/articles/lease-o...
Brian, IMO, 1 & 2 above are not applicable, this is a Master Lease of an apartment complex, there is no fair market rent that a Realtor (generally) can identify, there is no "market".
#3. The "Option to Purchase" price, needs to be near the market value of the property; however it also can be under that value considering the "Option Price" paid without a credit to the sale price or with incremental credits reflected toward the sale price that exceeds the value of the option. But, this should not exceed the fair market value of the property.
The value of this option, IMO, leans more toward a "financial option" as there is the intent to profit from the management of the complex, showing an intent to actually buy the property can be argued. When you have a "Real" option (nothing to do with it being real estate, the terms are not connected) there is an intent to purchase the asset.
Another way to avoid the tax issues is to clearly state the intent of the option in the contract with a justifiable reason for it being a financial option. Example: The optionee makes this option due to current economic conditions with respect to the ability to obtain financing at favorable interest rates without the intent to purchase at this date.
The value of the option is financially determinable, aspects to consider:
1. The present value of the NOI from operations expected over the term of the contract; and
2. The present value of expected appreciation of the property over the contract term; and
3. The present values being on an after tax basis.
This is a rather simplified approach as there are other models that are statistically valid.
What this option is really buying is a derivative of the property value and its income potential over the term of the contract.
#4 mentioned by Brian, in any option contract there cannot be any requirement of the optionee to perform anything, it cannot be contingent on any type of performance.
In this case, a commercial lease allowing sub-letting, the tenant may have maintenance responsibilities. Any improvement will be capitalized under the tenant's business, not the owner's.
#5. Cannot be avoided as to passing an equitable interest, such is established by paying the option price, of course legal title would not be passed.
A comment about #2, a 3-5 year residential option should really not exceed 10% due to tax and foreclosure matters. A small commercial option generally should come in at the same pricing of 10% as to a "Real Option" a "Financial Option" can take into consideration the NOI as I mentioned above.
As the option term increases the value of the option increases. The discounted present value will be higher. Exceeding 10% of the property purchase price begins to look more like an installment sale contract. That, you don't want.
This "rule of thumb" should be observed in contracts where valuation of the option is more difficult to reach. A residence is rather difficult as you are guessing at fair market rents and appreciation, same with small commercial. But when higher dollar transactions are involved, there are various methods of the value analysis. At this level, $1M plus, I suggest you see a CPA!
#6, I've already mentioned stating the intent of the contract. It is the intent of the contract that is going to be examined, it is the responsibility of the tax payers to show intent and to provide justification, you can't just say I didn't intend to buy it. If the optionee doesn't have the ability to buy or a sale is an impossibility, that is a justification.
It's my understanding that public comment closed last April concerning the accounting treatment of and the equities in option contracts under a proposal by the FASB, and that the IRS will be adopting changes being phased in next year and to 2017. This effects corporate and private accounting and real estate.
I've been looking at lease-option materials on the internet, all of the books, blogs by gurus and their material is outdated! Be it Bill B. the attorney guru or the Option Queen or anyone else, there are still old strategies floating around which can be incorrect or even illegal.
If the material is not current, like this year by a CPA or a law firm (not a guru lawyer) a government agency or a university/school, ignore it! And be careful with "schools" not RE schools set up by gurus.
The OP needs to see a good RE attorney and a CPA. :)