There are some interesting and lucrative advantages of using options as both an optionor and optionee of real estate. Generally speaking, option money is not taxable to the optionor until the option is exercised, expires or is abandoned. I. R. C. Section 1234 (subject to “dealer" rules, discussed below). If it expires or is abandoned, it is taxable to the seller as ordinary income at the time it expires or is abandoned.
A personal residence sold under lease/option may still qualify for capital gains exemption. Under the 1997 Tax Reform Act, gains from the sale of a personal residence seller are exempt so long as the gain is less than $250,000 ($500,000 for married couple). So long as the lease was incidental to the sale, court decisions have held that the property would still qualify as a personal residence and not a rental. See, Solaris v. Commissioner, 776 F.2d 1428 (9th Cir 1985).
The lease and option payments made by the tenant are not tax deductible if the property is used as a residence. If tenant purchases the property, his option payments (including monthly rent credits) become part of his tax basis in the property. The tenant's option payments may be deductible as a capital loss if the buyer is an investor. For example if you lease/option a home to live in, consider using your LLC to take the lease/option, then sublease to yourself individually. If you don't exercise the option from your corporation, have the corporation treat the option money it paid as a loss.
Take A Loss On Your Personal Residence
As you may know, you cannot take a loss on your personal residence if you sell it for less than your basis. You can, however, take a capital loss on an investment property.
Move out of your house and lease/option it to a tenant/buyer for a few years. Report it on your Federal income tax return as a rental on schedule “E. " You may now be able to take a loss when the tenant exercises his option to purchase.
Make certain that you make this transaction it look legitimate; the IRS is keenly aware that people in down real estate markets try to “fudge" rental agreements to accomplish a loss on their personal residences.
Watch Out For “Dealer" Classification
If you are an active real estate investor, you should be aware of what the IRS calls “dealer status. " If you also buy and sell real estate on a regular basis, you may be considered a “dealer" in real estate properties. A dealer is one who buys with the intent of reselling rather than for investment.
There is no magic formula for determining who is an investor and who is a dealer, but the IRS will balance a number of factors, such as the purpose for which the property was purchased, how long the property was held and how many deals the investor did in relation to other income. If you take option consideration on a “dealer" property, you cannot defer taxation of option consideration under Section 1234 of the Code.
Occasionally, but rarely, the IRS will reclassify a lease/option as a disguised sale. This is more common with equipment leases where the lessee makes rental payments for a number of years then has the option to buy at the end of the term for a nominal amount, such as $1.
The IRS looks at the terms of the deal and the circumstances surrounding the deal to determine whether a sale was intended. For example, if the tenant is paying the taxes and insurance, this looks more like a sale. If a substantial part of the payments on the lease are credited towards purchase, this also looks like a sale. If the option price declines each year rather than increases with the market. . . well, you get the idea - it if looks like a duck and it quacks like a duck, it's a duck!
Most of the reported cases wherein the IRS reclassified a lease/option as a sale involved long-term leases. Thus, a lease/option of only a few years with your tenant is not likely to be re-characterized as a sale. That's why we give tenant/buyers 1 year leases so there will not be an issue down the road.
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