Tax treatment of gain on lease options

6 Replies

Hey All!  I hope you had a great 4th of July!

I'm hoping any of you tax experts can help me out with something...

I have a piece of unimproved property under contract right now in TN, for simplicity's sake let's say it is under contract for $10k.  I have a few options to sell the property and I'm curious what the tax implications are for these scenarios:

1. Straight sale ASAP - Sell for $20k, $10k gain is taxed at regular income (which for me is 24%).  I think I understand this one pretty clearly.

2. Straight sale in 1 year - Sell for $20k.  $10k gain is taxed at long term capital gains which is 15% for me.

3.  Lease option & finance - Sell for $22k.  Get a $2k option payment upfront, then 1 year and 1 day later sell property for $18k with a $8k down payment and $500 a month.  How and when is the gain recognized?  Are the capital gain and gains from financing treated separately?

4.  Lease option - Sell for $20k.  Get a $2k option payment upfront, then 1 year and 1 day later sell property for $18k.  How and when is the gain recognized?

5. Sell ASAP & finance - Sell for $22k.  Get a $10k down payment and collect $500 a month.  How and when is the gain recognized?  Are the capital gain and gains from financing treated separately?

Thanks all for any help!  I'm trying to figure out the best way to structure these deals as I'm hoping to have a lot more of them.

Originally posted by @Andy Bauman :

Hey All!  I hope you had a great 4th of July!

I'm hoping any of you tax experts can help me out with something...

I have a piece of unimproved property under contract right now in TN, for simplicity's sake let's say it is under contract for $10k.  I have a few options to sell the property and I'm curious what the tax implications are for these scenarios:

1. Straight sale ASAP - Sell for $20k, $10k gain is taxed at regular income (which for me is 24%).  I think I understand this one pretty clearly.

2. Straight sale in 1 year - Sell for $20k.  $10k gain is taxed at long term capital gains which is 15% for me.

3.  Lease option & finance - Sell for $22k.  Get a $2k option payment upfront, then 1 year and 1 day later sell property for $18k with a $8k down payment and $500 a month.  How and when is the gain recognized?  Are the capital gain and gains from financing treated separately?

4.  Lease option - Sell for $20k.  Get a $2k option payment upfront, then 1 year and 1 day later sell property for $18k.  How and when is the gain recognized?

5. Sell ASAP & finance - Sell for $22k.  Get a $10k down payment and collect $500 a month.  How and when is the gain recognized?  Are the capital gain and gains from financing treated separately?

Thanks all for any help!  I'm trying to figure out the best way to structure these deals as I'm hoping to have a lot more of them.

1. Straight sale ASAP - Sell for $20k, $10k gain is taxed at regular income (which for me is 24%). I think I understand this one pretty clearly.

- You are probably going to owe  SE tax of 15.3% in addition to your 24%. 

3. Lease option & finance - Sell for $22k. Get a $2k option payment upfront, then 1 year and 1 day later sell property for $18k with a $8k down payment and $500 a month. How and when is the gain recognized? Are the capital gain and gains from financing treated separately?

-This is not a Lease option, more of an option-to-buy. This is a complicated area and has to structured correctly.  If the economic reality indicates that a sale has taken place and the benefits and burdens of ownership of the land have been transferred, the transaction will be treated as a sale, resulting in immediate tax consequences (i.e. gain on the transaction will have to be reported right away).

If the true option exists, For the seller, the main tax benefit is that you receive the amount paid for the option without incurring income tax at that time. That's because there are no tax consequences to the seller until the option lapses or is exercised.

If the option is exercised by the buyer (that is, the buyer buys the real estate), the sale proceeds for purposes of determining your gain on the sale of the land includes the amount you received for the option.

4. Lease option - Sell for $20k. Get a $2k option payment upfront, then 1 year and 1 day later sell property for $18k. How and when is the gain recognized?

- Again there is no lease on the land, so this is no lease option. This is an option-to-buy.  See above

5. Sell ASAP & finance - Sell for $22k. Get a $10k down payment and collect $500 a month. How and when is the gain recognized? Are the capital gain and gains from financing treated separately?

- There is no installment sale if you are considered a dealer. There is an exception if this is a residential unimproved lot, but you will owe interest on the transaction to IRS. 

You might want to rope in the professionals for this. 

@Ashish Acharya - Thanks!  For number 3 and 4, it a true option exists, would the gain be taxed at long term capital gains or ordinary income?

What do you mean when you say 'This is a complicated area and has to structured correctly.'  How would one structure it 'correctly'?

Also, what do you mean by 'you will owe interest on the transaction to the IRS'. ?

@Andy Bauman

What @Ashish Acharya meant when he said "This is a complicated area" was that, well, this is a complicated area. :) It is not something we can fully explain online, because the correct answer depends on many possible factors.

I will add a few pointers to clarify what Ashish said.

- Capital gain or business income? This can get complicated, depending on what else you're doing in real estate, your intention, your involvement and other factors. Business income is taxed at ordinary rates plus self-employment tax.

- Short-term v long-term CG. If it is capital gain, then the rates change after 1 year of holding. The key is to determine when the sale actually happened.

- When did the sale happen? It's also not as easy as it may sound. The sale happens when the buyer cannot back out. Owner-financing does not postpone the date of sale. Options do postpone the date of sale.

- Options. If it's a true option, meaning that the buyer can either buy or walk away - then the option fee is not taxable when you receive it. It is taxable later on when the buyer either exercises his option or forfeits it.

- Substance over form. It does not matter much what you call your transaction on paper. What matters is the economic substance: did the buyer irrevocably commit to the purchase? 

- Owner-financing. When you owner finance, your payments have interest component and principal component. Interest is taxable in the year it is received. Part of each principal payment (including the down payment) is taxed, and part is tax free. What part is taxed depends on numbers. In your example, it's 50%. 

- You mix together different concepts. Options determine when the sale happens and can affect short-term v long-term rates. Owner-financing determines how soon the taxes are paid but does not change the rates.

As my colleagues already mentioned, trying to DIY this business model is risky.