Leases with purchase options are often used in real estate transactions, especially when property owners are having difficulty finding a buyer or when a buyer just isn’t in the position to purchase, but wants the property long term. If you are not careful, though, the IRS might recharacterize the arrangement as a sale in the form of a contract for deed.
Lease with Purchase Option vs. Contract for Deed
A lease with a purchase option is a traditional lease with a purchase option that gives the tenant the exclusive right to buy the property at the price typically set up front. Sometimes the landlord might even credit back some of the rent against the purchase price. The tenant can exercise the option at any time during the option period, which often runs concurrently with the lease period. The seller might benefit from market appreciation if the price is not set up front and can claim depreciation as a tax deduction as long as the option is not exercised. In addition, the IRS does not deem the arrangement a sale until the option is exercised, so the seller can defer its gains.
With a contract for deed, the buyer makes installment payments and receives equitable title in the property, while the seller holds legal title as security for the payments. Legal title is transferred after the final payment. Because the IRS considers a contract for deed to be a sale, the buyer reaps the tax benefits of ownership, such as mortgage interest deductions and depreciation. When the buyer makes the final payment, the entire balance paid constitutes capital gains for the seller, and the seller also must pay any transfer tax.
Signs of a Sale
When determining whether a transaction is a lease with an option or a sale, the IRS looks at the “economic reality.” For example, if the circumstances when the agreement is executed suggest the buyer is very likely to exercise the option, it may be considered a sale. If the IRS were to recharacterize the lease as a sale, the seller may not have the cash to pay capital gains taxes or the timing of the sale may not be beneficial to the seller – the whole reason for the option to begin with.
Another indicator of a sale is an arrangement with artificially high rents and a below-market option price. These features can lead to the conclusion that the buyer is acquiring equity in the property during the lease term (equity = rent paid less fair market value rent). In such circumstances, the option price may be seen as a down payment. The low-priced option alone will not establish a sale, however, if the price is a substantial percentage of the property’s fair market value and the rent payments are not applied to the purchase price.
A lease that requires the tenant to make substantial improvements may also corroborate a sale. As in the case of inflated rents, the theory is that the only way the tenant can recover its investment is by exercising the option.
Proceed with Caution
A lease with a purchase option can provide strategic value for both buyers and sellers, but you must take care to avoid IRS recharacterization. An appraiser can help you set the payments and option price at market values to boost the odds of surviving scrutiny.