Posted by William Bronchick on April 27, 2004 at 20:54:36:
You are correct in your assumption, except that the security deposit issue is not clear. Worst case scenario, $1,000 of income added to your return won’t kill you.
Lease Option + 1031 Exchange - Posted by R. Gardner
Posted by R. Gardner on April 27, 2004 at 16:43:32:
I am the Owner of an investment property (single family dwelling) with a prospective Buyer who wants do do a lease-option of the property. I want to sell the property as part of a 1031 Exchange.
Assume the selling price of the house is $200,000. Assume that I get an option ?fee? of $2000.00 that is non-refundable if the house is not bought but that is credited against the sale price if the house is bought. Assume that I get rent of $1300 per month and security deposit of $1000. Assume that if the house is bought then $100 per month of rent and the security deposit of $1000 will all be credited against the price of the house.
Assume that the house is bought under the lease-option after 12 months. Then, when the house is sold, what is the situation?
Sale price of the house is: $200,000 - $2000 - $1200 - $1000 = $195,800 after all of the credits above are included.
Am I correct in thinking that $4200.00 is ordinary income ? declared as such in the year received ? and that taxes on capital gains included in the $195,800 can be deferred with the 1031 Exchange?
Any other thoughts on this scenario? For example, should I return the entire security deposit, as such, then simply add that $1000 into the sale price ? not counting it as part of ordinary income?
Re: Lease Option + 1031 Exchange - Posted by Dave T
Posted by Dave T on April 29, 2004 at 24:43:35:
I have a different opinion.
Let’s start with the sale price of $200K. You received $2000 in option consideration, you received rent during your lease term that you reported on Schedule E of your 1040. Finally, you received a security deposit which was eventually applied to the purchase.
First, the option consideration is not recognized as income until the option expires or is exercised. When the option is exercised, the option consideration is part of your sale proceeds and is included in your taxable profit on the sale of the property. If you qualify for long term capital gains tax treatment, then this would apply to the option consideration as well.
Secondly, the rent credit is a seller concession. You already received rental income which you reported (should report) on Schedule E. Your rental income was offset by your operating expenses and a depreciation expense. IF you had a net passive income from your rental activity, then your net rental income is taxed at your ordinary income tax rate. I would think it likely that you really would have had a net passive loss from your rental operation. Up to $25K in net passive losses can be used to offset your ordinary income before taxes. The rent credit is a seller concession, which reduces your net profit from the sale.
Lastly, let’s consider the security deposit. The security deposit does not belong to you, it belongs to your tenant. At the end of the lease term, the tenant is entitled to a complete refund of the security deposit. If the tenant-buyer chooses to give you the security deposit to apply to the purchase price, it becomes a down payment (or earnest money deposit) but should not reduce the contract price. The amount of the security deposit becomes part of the proceeds from the sale and is taxed at the appropriate capital gain tax rate.
In summary, I see your deal as a sale at a contract price of $196800 with a $1000 earnest money deposit in hand. You start calculating your taxable profit as if the contract price were $198800 ($200K minus the rent credit given).
In my opinion, if you were to now use this property as the relinquished property in a deferred exchange, the security deposit and the option consideration would be taxable cash boot since you already have constructive receipt.