40 -  Tax Treatment of Real Estate Options And Lease-Options With Planning Strategies

By Al Aiello, C.P.A.

I. TAX ASPECTS OF LEASE-OPTIONS FOR THE BUYER/OPTIONEE

A. ADVANTAGES OF OPTIONS FOR THE BUYER/OPTIONEE

B. TAX TREATMENT OF OPTIONS FOR THE BUYER/OPTIONEE

1. When the option is paid for: Tax neutral.

2. When the option is exercised: At this point the buyer includes the option deposit as part of the purchase cost of the property. IRC 1012.

3. If the option is not exercised, it lapses and the buyer forfeits their deposit.

4. The character of the loss: This depends on the type of property.

5. The sale (or exchange) of an option by the buyer/optionee:

GAIN OR LOSS ON OPTIONED LAND

GAIN OR LOSS ON RENTAL /BUSINESS PROPERTY

SO-CALLED "DEALER" PROPERTY

OUICK SALE AFIER PURCHASE OF OPTIONED PROPERTY:

TAX PLANNING FOR TOTALLY AVOIDING TAXES ON THE OPTION SALE ITSELF:

Do a 1031 tax-free exchange on the option, itself?

Use a self-directed IRA to buy and sell the option.

FURTHER TAX ASPECTS AND REPORTING FOR THE BUYER/OPTIONEE

RENT DEDUCTIONS:

OTHER DEDUCTIONS

CAPITAL ITEMS

NO DEDUCTIONS FOR DEPRECIATION ON THE OPTIONED PROPERTY ITSELF:

NO DEDUCTION FOR "OPTION" PAYMENTS:

ANY RENT INCOME RECEIVED BY THE BUYER/OPTIONEE IS ORDINARY INCOME

II. TAX ASPECTS OF LEASE-OPTIONS FOR THE SELLER/OPTIONOR

A. ADVANTAGES OF OPTIONS FOR THE SELLER/OPTIONOR

B. TAX TREATMENT OF OPTIONS FOR THE SELLER/OPTIONOR

REVERSE TAX PLANNING FOR THE RECEIPT OF OPTION PAYMENTS

IRS Reporting Of The Sale Of Optioned Rental-Type Property: (Such As Houses Or Apartments, Other Than Land)

IRS Reporting Of Optioned Land Sales: If the land is held less than one year and one day

If the land is held more than one year and one day

If the option is not excersized

FURTHER TAX ASPECTS AND REPORTING FOR THE SELLER/OPTIONOR

DEPRECIATION DEDUCTIONS ON THE OPTIONED PROPERTY, ITSELF

INTEREST\PROPERTY TAX DEDUCTIONS

OTHER DEDUCTIONS

CAPITAL IMPROVEMENTS MADE BY THE BUYER/OPTIONEE ARE NOT INCOME TO THE SELLER/OPTIONOR, UNLESS THEY ARE A SUBSTITUTE FOR RENT

Alert On Lease-Options As Disguised Installment Sales --Planning Strategies

A. TAX CONSEQUENCES IF A LEASE\OPTION IS DEEMED A COMPLETED PURCHASE AND SALE OR A DISGUISED INSTALLMENT SALE

If This Happens Then There Is No Lease-Option according to the IRS!

1. To The Optionee\Lessee\Buyer -

2. To The Optionor\Lessor\Seller - TAX BREAK: On the other hand, any dealer loss would be ordinary for both rental\busines-use property and land. (*See Goldmine Section 42 for tips to avoid dealer status.)

INDICATIONS OF WHEN A LEASE\OPTION IS A COMPLETED SALE

EXAMPLE - LEASE-OPTION THAT IS REALLY A DISGUISED INSTALLMENT SALE:

STRATEGIES TO AVOID RECHARACTERIZATION OF A SALE

Tax Treatment of Real Estate Options And Lease-Options With Planning Strategies

An option contract, as it pertains to real estate, is generally a unilateral agreement that binds the owner of the property to sell the related property for a fixed or determinable price within a specified time. It is unilateral because only the seller ("optionor" or "grantor") must sell, but the prospective buyer ("optionee" or "grantee") is not required to buy. The option gives 1he buyer a right (or option) to buy a property at a future date. A lease-option is where the option to purchase 1he property is combined wi1h leasing the property.

This portion is targeted for the investor who has acquired a property via an option or lease/option, has made an option payment and who desires to sell it via an option or lease/option. This scenario is somewhat different than someone who bas already purchased a property (as opposed to "have "optioned" the property), has owned the property for a while and then wants to sell creatively via an option or lease\option. This latter scenario is later discussed in part II of this section.

A. ADVANTAGES OF OPTIONS FOR THE BUYER/OPTIONEE

The buyer\optionee has the right to buy, or not to buy. If the agreement is structured properly, with all of the proper contingencies, the buyer is not really committed to the property at all. The buyer could just walk away and the most they could lose is all or part of their option deposit. They are not further obligated and generally nothing happens to their credit rating.

The option could also allow the buyer enough time to accumulate the necessary funds to purchase the property, either by way of bank financing or private sources. Options can also give the buyer enough time to decide if they want to purchase the property or back out of the transaction with little or no loss.

An. option is an excellent way for the buyer to control property .with minimum cash and minimum risk. For example, a $100,000 property may normally require a $20,000 or $30,000 down payment. However, a much lower option deposit (such as a $1,000 or $2,000) could control the property for the buyer\optionee, while the risk and responsibility of the property remains with the owner (the seller\optionor).

            .           . '

B. TAX TREATMENT OF OPTIONS FOR THE BUYER/OPTIONEE

Again, this portion of this chapter is targeted for the investor who has acquired a property via an option or lease/option, has made an option payment and who desires to sell it via an option or lease/option. (A sandwich option or lease/option).

I. When the option is paid for: Tax neutral.

That is, there is no taxable event at this point.

The option payment is not tax deductible. Regulation 1.1234-1(b).

TAX TIP: If any portion of the option payments are truly lease or rent payments, then the lease portion is deductible as "rent" for an investment property, IRC 162(aX3).

On the other hand, the lease payments will be ordinary income to the owner, IRC 61( aX5).

The tax treatment of income and expenses for both the buyer/optionee and seller/optionor will be later discussed in this section.

2. When the option is exercised: At this point the buyer includes the option deposit as part of the purchase cost of the property. IRC 1012.

EXAMPLE I: You make an option payment of $1,000 toward the future purchase of a property for a price of $100,000.

If the $1,000 is credited toward the $100,000 purchase, then the initial cost basis is $100,000, because the $1,000 is already included in the $100,000.

However, if it is not credited toward the $100,000 purchase, then the initial cost basis is $101,000 ($100,000 plus $1,000).

Here, the $1,000 was not included in the $100,000.

TAX ALERT: The holding period of the option does not tack on to the holding period of the property. Reg. 1.1234-1(a)(I).

Accordingly, if an optioned property is purchased after the option period, a subsequent quick sale of the property (in a year or less), will result in higher-taxed ordinary income (or short-term capital gain) vs. lower-taxed long-term capital gain. For a further discussion, including planning strategies, see number 5 below.

3. If the option is not exercised, it lapses and the buyer forfeits their deposit.

For an investment property, the buyer can deduct the option cost as a loss (subject to any loss restrictions, Reg 1.1234-1 (b). (*For a further discussion of loss restrictions, with planning strategies, refer to Goldmine Sections 25 to 27.)

4. The character of the loss: This depends on the type of property. If the property is a capital asset (such as land held for investment), then the loss is a capital loss, subject to possible limits (see Goldmine Section 44).

If the property is a rental property, business-use property, or dealer property, then the loss is a fully deductible ordinary loss.

The loss is not deductible* for options pertaining to personal-use property such as a first or second home, Reg. 1.262-1(b)(4); Reg. i.165-9(a). *See tax tip, below.

*TAX TIP FOR PERSONAL LOSSES: To convert a non-deductible personal loss to a deductible investment loss, demonstrate that your intent was to hold the property for investment or business purposes, and not for personal use. This intent should be documented in letters-of-intent, purchase agreements, partnership agreements, tax returns, minutes, correspondence, etc. For more about sale-loss strategies, see Goldmine Section 44.

5. The sale (or exchange) of an option by the buyer/optionee:

An option is a different asset from the underlying property. In the creative world of real estate investing, sometimes instead of exercising the option, the buyer sells (or "flips") the option (itself) for a gain (or loss) to another buyer\optionee.

The character of the gain or loss on the sale of an option will depend on the character of the underlying property (such as land, rental property or dealer property), IRC 1234(a)(1). It will also depend on the holding period of the option  Reg 1.1231-1(a).

EXAMPLE 2 - GAIN OR LOSS ON OPTIONED LAND: You have an option on land you intend to hold for investment You have held the option for a year and one day (or longer). You sell the option. The gain on the sale of the option is long-term capital gain. A loss on the option sale would also be capital. Reason: The underlying property (land) is a capital asset and the option was held for the required long-term capital gain period of one year and one day (or longer).

IRS Reporting: Report the gain (or loss) on the optioned-land on IRS Schedule D, Part n.

EXAMPLE 3 - GAIN OR LOSS ON RENTAL /BUSINESS PROPERTY: You have an option on a property that you intend to hold for rental. You have held the option for a year and- one day (or longer). You sell the option. The gain on the sale of the option is long-term capital gain. However, the loss on this option sale would be a preferential fully deductible ordinary loss (not a capital loss).

Reason: The underlying property is a 1231 asset· and the option was held for the required long-term capital gain period of one year and one day (or longer).

[*Section 1231 rental or business-use property receives preferential treatment in that the gain is capital (except for recapture), yet the loss is ordinary.

For a further discussion of Section 1231 assets, see Goldmine Sections 29 (for gains) and Section 44 (for loses)].

IRS Reporting For Gains: Report the sale as a long-term capital gain (taxed at lower rates) on IRS Form 4797, page 2, part III, "Gain From Disposition of Property Under Sections 1245, . 1250."

Also, use IRS Schedule D, "Capital Gains and Losses", Part II.

TAX TIP: If you are selling and you are near the one-year, one-day holding period, schedule closing so you meet this one-year and one-day holding period and pay lower capital gain taxes.

The holding period begins on the day after the acquisition date and ends on the date of disposition. Thus, the closing day of the purchase is excluded while the closing day of the sale is included.

Revenue Ruling 70-598. (More planning tips are discussed later in this section.)

IRS Reporting For Losses: Report the sale as an ordinary loss on IRS Form 4797 "Sales of Business Property", page 1, parts I and II.

EXAMPLE 4 - SO-CALLED "DEALER" PROPERTY:

You have an option on a property that you intend to develop and sell to customers in the ordinary course of business. Your conservative tax preparer says this is "dealer property".

You have held the option for a year and one day (or longer).

You sell the option.

The gain on the sale of the option is ordinary (not capital), even though it was held for one year and one day (or longer).

A loss on the option sale would also be ordinary, Regulation 1. 1234-1 (d).

Reason: According to your tax preparer, the underlying property is ordinary income* ("dealer") property.

*TAX TIPS: (1) Convert the above ordinary income into long-term capital gain by documenting that you are not a dealer in real estate. See Goldmine Section 42 for a discussion of how to avoid dealer status.

(2) On the other hand, if the loss were going to be a capital loss (such as from an option on a land investment), then it may be advantageous to be considered a dealer, in this transaction.

Reason: The loss would be a fully deductible ordinary loss.

(2A) If you do this, clearly separate this one dealer transaction from the investor transactions.

(3) Plan accordingly and carefully!

TAX ALERT: On selling the property vs. selling the option - The holding period of the option does not tack on to the holding period of the property. Reg. 1.1234-1(a)(1).

Accordingly, if an optioned property is purchased after the option period, a subsequent' quick sale of the property (in a year or less), will result in higher-taxed ordinary income (or short-term capital gain) vs. lower-taxed long-term capital gain.

EXAMPLE 5 - OUICK SALE AFIER PURCHASE OF OPTIONED PROPERTY:

You have a two-year option of $1,000 on an investment property for a price of $100,000.

Just before the end of the two-year option period you receive an offer to the sell the property for $180,000 (net of selling expenses).

This equates to an $80,000 profit ($180,000-100,000).

You exercise your option, close on buying the property for $100,000 and the next day close on selling the' property for $180,000.

Because your holding period is only one day, you have ordinary income of $80,000, or $32,000 in taxes, assuming a top (rounded) 40% bracket.

TAX PLANNING STRATEGIES FOR THE ABOVE:

1. Sell the option itself for the $80,000 profit, which would be a long-term capital gain, because you have held the option for more than a year and one day.

Instead of $32,000, the taxes would be $16,000 (20% of the $80,000 gain).

TIP: Doing it this way could also save on transaction costs, including transfer fees.

2. If you do not sell the option and acquire the property, then hold the property for one year and a day in order to take advantage of the long-term capital gain.

If the buyer needs the property, they could lease it from you for at least one year and one day.

Make sure that the lease is a pure rental arrangement that does not give the optionee any equitable ownership (where they would have the ''burdens & benefits" of ownership).

In this same scenario you may be able to sell the property, tax-free, via a 1031 exchange.

(See Example 8 of this section and Section VIII-16 of The 1031 Money Machine.)

For other planning strategies to reduce, defer or eliminate taxes on the sale of property, see Section 31 of the Goldmine.

TAX PLANNING FOR TOTALLY AVOIDING TAXES ON THE OPTION SALE ITSELF:

1.      Do a 1031 tax-free exchange on the option, itself?

It is not clear if an option (or any contract) can qualify as like-kind property in a 1031 exchange.

To qualify, the option contract would have to be considered an interest in real property.

At least some 1031 experts believe than treating a contract or option as like-kind to a fee interest in real estate is highly questionable.

However, the courts have considered contract rights to purchase real property as real property rights (The author agrees with this conclusion).

See Starker v. US, 602 F2d 1341 (eA9, 1979).

TAX POINTER: Sometimes a contact to purchase real estate extends for a lengthy period of time. Thus, if the contract or option was held for one to two years, then it may have a better chance to qualify for a 1031 tax-free exchange, under the exchange "holding" requirement discussed in Goldmine Section 34.

TAX TIP: Convert the option-purchase into an actual purchase via a cash purchase or installment land contract. 

Then do a Reverse "Starker" 1031 exchange.

Here, you have an legal or equitable ownership into the property, as opposed to just contract rights.

Now you are clearly exchanging real property.

The longer you hold this legal or equitable ownership before the exchange, the better for purposes of qualifying for the exchange.

For a further discussion of 1031 exchanges, see Sections 32 to 34-A.

For a further discussion of reverse "starker" exchanges, refer to 'the 1031 Money Machine, or call

1-800-351-1031.

2. Use a self-directed IRA to buy and sell the option.

Here, the option profit is totally tax-deferred.

See my publication, Creating Tax-Free Wealth With Self-Directed IRA’s.

3. For other planning strategies to reduce, defer or eliminate taxes on the sale of property, see Section 31 of the Goldmine. 

C. FURTHER TAX ASPECTS AND REPORTING FOR THE BUYER/OPTIONEE

1. RENT DEDUCTIONS:

Assuming the property is being lease-optioned for investment, any rents paid by the buyer/optionee are deductible. as ''rent" for an investment property IRC 162(a)(3).

Any property for personal use would not be deductible Internal Revenue Code Section 262.]

- TAX POINTER: Any mortgage payments on the optioned investment property paid by the  buyer/optionee are deductible as rent as per the above.

Frequently, when buying investment properties via lease options, the buyer/optionee will directly pay the property owner's mortgage payment. 

This is done instead of paying the owner rent and then the property owner making the mortgage payment.

Reason: To ensure that the underlying mortgage payment is being paid on the optioned property..

Because the buyer/optionee does not legally or equitably own the property, they are not entitled to the interest deduction on the mortgage (this stays with the owner, as does the deduction for property taxes.

However, even better, the buyer/optionee would deduct the full payment as RENT as discussed above. As discussed in part II in this section, the buyer/optionee’s payment of the mortgage payment is rent income to the seller/optionor.

(Note: This is all provided that the arrangement is a lease/option as opposed to a disguised installment sale as discussed in Section 40-A)

2. OTHER DEDUCTIONS: Any other operating expenses paid by the buyer/optionee (such as repairs or maintenance) are also deductible.

Other deductible operating expenses include:

Advertising, auto travel, cleaning, supplies, insurance, legal fees, other professional fees, management fees, utilities, telephone, office supplies, postage, salaries, publications on real estate, equipment rental, eviction costs, dues for investor associations, tuition for real estate seminars.

For a list of overlooked deductions see Section 23 of the Goldmine.

CAPITAL ITEMS: Any real property ''improvements'' (as opposed to deductible repairs) paid by the buyer/optionee are depreciated over 27-1/2years for residential rental property and 39 years for non-residential property.

They are not depreciated over the lease/option term.

(Note: Whether an expenditure is a depreciable capital improvement or a fully deductible repair is not always clear-cut

For planning strategies to convert improvements into deductible repairs, refer to Sections 17 & 18 of the Goldmine.)

Any personal property (such as appliances) purchased by the buyer/optionee is depreciated over 5 years. For more about maximizing depreciation deductions via 5-year personal property, see Goldmine Sections 12-A, 13, Appendix A and the case study in Section 16-A.

(Note: The seller/optionor would not be entitled to depreciate these items).

4. NO DEDUCTIONS FOR DEPRECIATION ON THE OPTIONED PROPERTY ITSELF:

With a true lease/option, while the buyer/optionee may have substantial control over the optioned property, they do not have legal or equitable ownership of the property itself.

Accordingly, the buyer/optionee is not entitled to depreciation deductions on the optioned property, itself (except for any improvements or personal property paid by the buyer/optionee as discussed in number 3, above).

Instead, it is the seller/optionor who would be entitled to these depreciation deductions. (This is provided that the arrangement is a true lease/option as opposed to a disguised installment sale as discussed in Section 40-A.)

s. NO DEDUCTION FOR "OPTION" PAYMENTS:

Any "option" payments paid by the buyer/optionee are not deductible. Their tax treatment is discussed on page 271 of this section.

6. ANY RENT INCOME RECEIVED BY THE BUYER/OPTIONEE IS ORDINARY INCOME: Frequently, with lease/options, the buyer/optionee has the right to sublet the property and receive rent from a sub-tenant via what is called a "sandwich" or "master" lease. Any such rent received is reported as ordinary income by the buyer/optionee. However, such rent can be offset by the above deductions.

IRS Reporting: The buyer/optionee reports income and deductible expenses on IRS Schedule E.

However, I highly prefer that all business and rental activities be reported on a partnership form ("c,

(1065).

This is because partnerships (general partnerships, limited partnerships 'and LLC partnerships) are audited much less than other business types.

The buyer/optionee then uses IRS Form 1065 to report rental property income and expenses. The bottom-line partnership income or loss is carried to their individual 1 040 return via a K -I. For more about using, and converting to partnerships, refer to Section 5 of the Goldmine. For claiming depreciation on any capital items paid by the buyer/optionee (as per number 3 above), use IRS Form 4562, which is a backup form for any business schedule, such as Schedule E or the highly Preferred Form 1065.

This portion is targeted for the entrepreneur who has already purchased a property (as opposed to have "optioned" the property), has owned it for a while and then wants to sell creatively via an option or lease\option. This scenario is somewhat different than someone who has acquired a property via an option or lease/option. This latter scenario was previously discussed in part I of this section.

A. ADVANTAGES OF OPTIONS FOR THE SELLER/OPTIONOR

Options can be an effective marketing tool for sellers.

Because there is less risk involved, options can entice more prospective Optionees who may eventually buy the property. The receipt of option payments are tax deferred. See next.

B. TAX TREATMENT OF OPTIONS FOR THE SELLER/OPTIONOR

Again, this portion is targeted for the entrepreneur who has already purchased a property (as opposed to have "optioned" the property); has owned it for  a while and now wants to sell creatively via an option or lease\option.

1. When the option payment is received:

Option payments received are tax deferred because it is an open transaction until the option is exercised, sold or expired. See Reg. 1.12341 (b) and Dill Co., 33 TC 196, aft'd, 294 F .2d 291.

An option is a different asset from the underlying property and is treated much like an earnest money deposit . (which is also tax deferred), Lucas v. North Texas Lwnber Co., 281 US 11 (1930).

TAX POINTER: Regulation 1.1234-1(b) does not directly say the receipt of an option is tax deferred. Instead, it does so indirectly by making the presumption that that any taxability of the option only occurs when it later lapses (or is later excersized), and not at the time of its receipt

TAX BREAK: Option payments in the form of cash are still tax deferred even if the owner\optionor does not have to escrow the money or restrict it in any way. Here, the owner can immediately use the tax-deferred cash to reap high yields from other investments.

EXAMPLE 6: RR receives a $10,000 option deposit on one of her properties. While she must take the property off the market and hold it just for the buyer\optionee, RR does not have to escrow the $10,000. She uses the $10~000 to buy a barg3.in property, which she quickly flips for a $5,000 clear profit RR has made a nice 50% return on the use of the tax-deferred option money. (She has used "taxes" to make more money!) Of course, she can continue to use and snowball the accumulated funds into more profitable investments.

TAX TIP: Tax deferred option payments can be spread out over years.

EXAMPLE 7: BB will ~ive a $50,000 annual option deposit on a property over a period of 4 years. Tbat's $200,000 of tax-deferred cash BB can use for other investments (assuming that other interested parties do not require the funds to be escrowed).

TAX TIP ALERT: However, once the option lapses or is excersized, the seller\optionor must report the option as income. They should make sure they have the funds to pay any tax liabilities. But if they plan in advance, they may not owe any taxes. See next.

TAX TIP: DO A 1031 EXCHANGE. If the option is excersize~ then sell the property to your buyer, tax-free, via a 1031 exchange. This is powerful!

EXAMPLE 8: You lease\option a property (that you have previously owned) for a 2-year . option term, an unfront deposit of $5,000 and an option price of $150,000. Because your tax basis is $80,000, the taxable gain would be $70,000 and your capital gain's taxes $20,000. The tenant/buyer decides to exercise their option and purchase the property from you. Before the closing you hire a Qualified Intermediary ("QI") which executes the proper 1031 exchange documents and escrows the net proceeds from the closing. As a 20% downpayment, the above tax savings of $20,000 allows you to purchase an additional $100,000 of property over the one you sold for $150,000. This means you acquire a $250,000 property, which is in a much better location, generating more cash flow with more potential for appreciation.

 COMMENT: The combination of creative strategies such as lease\options and 1031 exchanges is a virtual tax-free money-making machine!

1031 TAX POINTER: The $5,000 option deposit in this example is taxable boot, but would not disqualify the rest of the 1031 exchange (if properly structured).

1031 TAX TIP: The seller \exchangor in the above example may arguably avoid taxable boot on the $5,000 deposit (and any monthly option payments) by later depositing them in the exchange escrow account prior to the settlement of the relinquished property (IRS Letter Ruling 7952086).

In the exchange documents there should be language that states that all deposits received by the investor are to be assigned to the Qualified Intermediary ("QI").

ADVANCED PLANING 1031 TIP: If at the time of the option, you know you are going to do a 1031 exchange upon the option's exercise, then you should engage the QI before receiving or paying option deposits.

The positive result is that right from the beginning, all deposits will go through the QI and all exchange documentation could be set up in advance.

Any trace of constructive receipt can be totally eliminated.

(Note: You should always engage the QI in advance).

1031 TAX TIP: Engage a QI that specializes in complex exchanges, such as those combined with options and lease\options.

One such QI is National Exchange Services, Inc. (NFSI) who has done exchanges in over 40 different states.

For their special free report, call 1-800-351-1031 0r e-mail at NESI1031EXHANGES@AOL.COM .

On the Web at http://www.nes1031.com/

REVERSE TAX PLANNING FOR THE RECEIPT OF OPTION PAYMENTS: Report the option payments as income if you have enough offsetting deductions that would otherwise be wasted.

It is not mandatory that you have to defer the option payments.   The reported income would then be offset by the deductions and would not have to be reported in a future year when the option is exercised or lapses.

Report the option payments as an ordinary gain on IRS Form 4797, Part n. Plan according to your tax situation.

2. When the option is excercised: The option amount is included in the selling price of the property, IRC 1001(b); Reg. 1.1001-2(a).   

The character of the gain on the property will depend on the character of the underlying property and if there is any depreciation recapture. (See Goldmine Sections 29 & 30).

The character of a loss on the property will also depend on the character of the underlying property. (See Goldmine Section 44). See below for IRS reporting.

IRS Reporting Of The Sale Of Optioned Rental-Type Property: (Such As Houses Or Apartments, Other Than Land).

If the property is held less than one year and one day, report the sale as ordinary income on IRS Form 4797, page 1, part II, "Ordinary Gains and Losses".

If the property is held more than one year and one day, report the sale as a long-term capital gain (taxed at lower rates) on IRS Form 4797, page 2, part III, "Gain From Disposition of Property Under Sections 1245, 1250."

Also, use IRS Schedule D, "Capital Gains and Losses", part II.

TAX TIP: If you are selling and you are near the one-year, one-day holding period, schedule closing so you meet this one-year and one-day holding period and pay lower capital gain taxes.

TAX TIP REMINDER: Even better do a 1031 tax-free exchange. See the previous discussion.

IRS Reporting Of Optioned Land Sales:

If the land is held less than one year and one day, report the sale as a short-term* capital gain on IRS Schedule D, "Capital Gains and Losses", part 1.

*TAX TIP: You still want to report the gain as a short-term capital gain, even though a short-term capital gain is taxed at the same higher rates as ordina1y income.

Reason: You can fully offset capital losses (such as a stock loss) against capital gains.

A capital loss is limited to only $3,000 a year as a deduction against ordinary income (unused losses are carried forward). But capital gains can be fully offset by capital losses.

If the  land is held more than one year and one day. report the sale as a long-term capital gain (taxed at lower rates) on IRS Schedule D, ''Capital Gains and Losses", part II. Again, you can fully offset capital losses (such as a stock loss) against capital gains, short or long-term.

TIP: Follow the same tax tips as for the above type rental-type properties.

3. If the option is not exercised; it lapses and the seller/optionor keeps the deposit:

Here the gain is ordinary income, regardless of the character of the underlying property and regardless of the holding period of the property, Reg 1234-1(b); For IRS reporting, see below.

IRS Reporting: Report the gain from the option-lapse as ordinary income on IRS Form 4797, page . 1, part II, "Ordinary Gains and Losses".

TAX TIP: Use a SDIRA

If the property was originally acquired in a self-directed IRA (SDIRA), then neither the lapse nor the exercise of the option will cause taxability.

The option profit is further tax deferred.

See my publication, Creating Tax-Free Wealth With Self-Directed IRA'S.

c. FURTHER TAX ASPECTS AND REPORTING FOR THE SELLER/OPTIONOR

1. DEPRECIATION DEDUCTIONS ON THE OPTIONED PROPERTY, ITSELF:

Because they are still the legal owner of the property, the seller/optionor would be entitled to the depreciation deductions on the property, itself.

(This is so provided that the arrangement is a true lease/option as opposed to a disguised installment sale as discussed in Section 40-A.)

Note: The buyer/optionee is entitled to depreciation deductions on capital items that they paid for as discussed in part I of this section .

            .           .

2. INTEREST\PROPERTY TAX DEDUCTIONS: Because they are still the legal owner of the property, the seller/optionor is also entitled to deduct the mortgage interest and property taxes.

TAX POINTER: This is so even if the mortgage payments on the optioned property are paid directly by the buyer/optionee as discussed in part I of this section. However, the buyer/optionee's payment of the mortgage payment is, in effect, rent income to the seller/optionor as per number 5 below. (Note: This is all provided that the arrangement is a true lease/option as opposed to a disguised installment sale as discussed in Section 40-A.)

3. OTHER DEDUCTIONS: Any other operating expenses paid by the seller/optionor (such as repairs or maintenance) are also deductible. Other deductible operating expenses include the following:

Advertising, auto, travel, cleaning, supplies, insurance, legal fees, other professional           (--.

fees, management fees, utilities, telephone, office supplies, postage, salaries, publications on real estate, equipment rental, eviction costs, dues for investor associations, tuition for real estate seminars. For a list of overlooked deductions see Section 23 of the Goldmine.

4. CAPITAL IMPROVEMENTS MADE BY THE BUYER/OPTIONEE ARE NOT INCOME TO THE SELLER/OPTIONOR, UNLESS THEY ARE A SUBSTITUTE FOR RENT:

Any improvements paid by the buyer/optionee are not income to the owner (seller/optionor), unless they are a substitute. for rent If they are a substitute for rent, then the owner (seller/optionor) reports the cost of the improvements as ordinary rent income. On other hand, the buyer/optionee could deduct the cost of the improvements as rent expense.

Whether such improvements are rent would depend on the terms of lease or other "surrounding circumstances", Regulation. 1.61-8(c). The fact that the improvements increase the value of the property does not, by itself: constitute rent income to the owner (seller/optionor), Blatt, 305 US 267.

Provided that it is clear that the parties do not intend the improvements to be rent, then it is immaterial if the improvements are to become the property of the owner upon the lease termination (or in this case, default by the buyer/optionee), Cunningham, 28 TC 670, aff'd, 258 F2d, 231.

TAX TIP: If the parties do not intend the improvements to be rent, then this should be clearly stated in the lease.

TAX POINTER: If the buyer/optionee's improvements are not rent, then the buyer/optionee claims depreciation on them. However, if they are for rent, then the buyer/optionee fully deducts their cost as rent expense and the seller/optionor reports the cost as rent income and then the seller/optionor would be entitled to depreciate these items and not the buyer/optionee.

TAX TIP: The parties to the lease/option should structure the payment of such improvements so that the one party who needs the deductions the most, gets them. For example, if the lessor is a self-directed IRA, then the lessee could fully deduct the cost of the improvements as rent yet the self-directed IRA would not be taxed on this because it is a retirement plan. This could also work with an entity in a low tax bracket such as a family limited partnership.

5. ANY RENT INCOME RECEIVED BY THE SELLER/OPTIONOR IS ORDINARY INCOME: However, such rent can be offset by the above deductions.

TAX REMINDER: Mortgage payments on the optioned property paid directly by the buyer/optionee are the equivalent of rent income to the seller/optionor.

IRS Reporting of Income & Expenses: Essentially the same as the buyer/optionee as discussed in part I of this section.

The next section discusses lease-options as disguised installment sales.

40-A -  Alert On Lease-Options As Disguised Installment Sales --Planning Strategies

A. TAX CONSEQUENCES IF A LEASE\OPTION IS DEEMED A COMPLETED PURCHASE AND SALE OR A DISGUISED INSTALLMENT SALE

If This Happens Then There Is No Lease-Option according to the IRS!

1. To The Optionee\Lessee\Buyer - The lease payments are non-deductible, &US, 28 TC 1133, aff'd, 261, F. 2d 176.

If the property is a rental or business-use property, the buyer will be entitled to depreciation and other property expenses. Also, part of the monthly payments may be allocable to deductible interest, Wilshire Holding Corp., 262 F.2d 51; Revenue Ruling 72408.

Therefore, the combination of deprecation, property expenses and perhaps interest may approximate the amount of rental payments (especially if you use my Multi-Component Land Residual Method for computing larger depreciation deductions. See Goldmine Section 12-A).

2. To The Optionor\Lessor\Seller - The tax consequences are generally more detrimental to the seller.

First off: the seller will forfeit depreciation deductions as they are no longer the equitable owner.

The lease payments will be part of the selling price.

If the seller is not a dealer and the property has been held for the required holding period, the payments are capital gain (outside of imputed interest and any depreciation recapture, which are ordinary income).

The investor-seller can also elect installment sale reporting under IRC 453 (Section 35) and/or, for the cash portion of the arrangement, elect a 1031 exchange· (Goldmine Sections 32 to 34).

*T AX ALERT: Usually the cash portion (such as upfront deposits) in lease/options is not that significant Therefore, if the lease/option is recharacterized as an installment sale, there will be little opportunity (if any) to do a 1031 exchange.

Reason: The "paper" portion of the transaction does not qualify for a 1031 exchange; only the cash potion does.

(For a further discussion of seller financing and 1031 exchanges, see Section VIII  19 of The 1031 Money Machine.)

Another negative here, is that the seller will no longer be entitled to depreciation deductions.

TIP: Any loss on the deemed sale would be ordinarily for rental or business-use property, and capital for land held for investment

ALERT: For a dealer*, the tax consequences of a gain are more severe in that there will be higher-taxed ordinary income and the ineligibility to defer taxes via installment sale, or a 1031.

TAX BREAK: On the other hand, any dealer loss would be ordinary for both rental\business-use property and land. (*See Goldmine Section 42 for tips to avoid dealer status.)

B. INDICATIONS OF WHEN A LEASE\OPTION IS A COMPLETED SALE

1. The primary indicator that may cause the lease-option to be a completed sale is-  rent payments substantially higher than the fair rental value, along with a low option price, Haggard, 241 F.2d 288, aff'g 24TC, 11241;

Truman Bowen, 12 TC 466; East Coast Equipment Co, 21 TC 112, airel, 222 F .2el, 676.

Large upfront deposits can also be another indicator.

EXAMPLE - LEASE-OPTION THAT IS REALLY A DISGUISED INSTALLMENT SALE:

CC does a 36 month lease\option on a $100,000 property which would normally rent for $1,000 a month.

With the  lease\option there are the following terms:

$10,000 upfront option payment to be totally applied toward the purchase price;

monthly payments of$2,200 of which $2,000 is to be totally applied toward the purchase price;

$18,000 option payment to purchase the property at the end of the 36 months.

The sum of the $10,000 option deposit,

$2,000 rent credit for 36 months, and

the final option payment of$18,000 equals the total purchase price of$100,000.

The $200 monthly payment not credited toward the price, is presumably interest

This example demonstrates that the highly inflated rental forces this transaction to be, in substance, a completed purchase and sale at the time of the execution of the "lease-option".

See IRS Revenue Ruling 55-540. (Comment: This one is obvious!)

2. Another factor that could indicate a completed purchase and sale is where the lease requires the lessee to make substantial improvements to the property and the lessee's investment in the improvements can be recouped only by exercising the option, Oesterreich, 226 F .2D 798.

Another factor is the intent of the parties, based on the facts and circumstances.

If the taxpayer can demonstrate that they believed the rent and option price to be reasonable, the lease option arrangement may hold up. Benton, 197 F.2d, 745; Lester, 32 TC, 711.

C. 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.