There are some interesting and lucrative advantages to using options as both an elective and a real estate option. Generally speaking, option money is not taxed for the option or until the option is exercised, expires, or is abandoned. IRC 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 a lease / option may still qualify for the capital gains exemption. Under the Tax Reform Act of 1997, proceeds from the sale of a personal residence seller are exempt as long as the gain is less than $ 250,000 ($ 500,000 for a married couple). As 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 as a rental. See, Solaris v. Commissioner, 776 F.2d 1428 (9th Cir 1985).
Lease and option payments made by the tenant are not tax deductible if the property is used as a residence. If the tenant purchases the property, their option payments (including monthly rental credits) become part of their tax base on the property. The tenant’s option payments may be deductible as a principal loss if the buyer is an investor. For example, if you rent / opt for a house to live in, consider using your LLC to take the rental / option and then sublet for yourself individually. If you do not exercise your corporation option, have the corporation treat the option money you paid as a loss.
Take a loss on your personal residence
As you may already know, you cannot take a loss on your personal residence if you sell it for less than its base. However, you can take a capital loss on an investment property.
Move out of your house and lease / opt for 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 their purchase option.
Make sure you make this transaction look legitimate; The IRS is well aware that people in the declining real estate markets try to “manipulate” rental agreements to achieve a loss on their personal residences.
Be careful with the “dealer” classification
If you are an active real estate investor, you should know what the IRS calls “dealer status.” If you also buy and sell real estate on a regular basis, you may be considered a real estate “dealer.” A distributor is one who buys with the intention of reselling rather than investing.
There is no magic formula for determining who is an investor and who is a merchant, 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 transactions the investor had. made in relation to other income. If you take option consideration on a “concessionaire” property, you cannot defer payment of option consideration taxes under Section 1234 of the Code.
IRS reclassification
Occasionally, but rarely, the IRS will reclassify a lease / option as a concealed sale. This is more common with equipment leases where the lessee makes rental payments over several years and 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 if a sale was intended. For example, if the tenant pays taxes and insurance, this looks more like a sale. If a substantial portion of the lease payments are credited toward the purchase, this also looks like a sale. If the price of the option decreases every year instead of increasing with the market. . . well, you get the idea: if it looks like a duck and squawks like a duck, it’s a duck!
Most of the reported cases where the IRS reclassified a lease / option as a sale involved long-term leases. Therefore, a lease / option of only a few years with your tenant is not likely to be characterized as a sale again. That is why we give tenants / buyers 1 year leases so there are no problems down the road.
