Posted by ScottS on March 10, 2003 at 02:59:40:
If Bronchcick couldn’t convince you I sure won’t be able to. 
Guess we’ll have to let them and their CPA decide when they check oit section 12.34 of the code.
Point well taken though.
ScottS
Tax Benefits of Lease-Option May Be an Illusion - Posted by Jeremy
Posted by Jeremy on March 05, 2003 at 16:01:23:
One reason they said why sellers should have motivations to lease-option their property is that they could defer the income recognition to the extent that such income were credited towards the pre-determined purchase price. I talked to a real estate tax expert. She said this may not be true if the seller is a cash-basis tax payor, and if the seller has immediate access to the monthly rental.
Say the tenant pays you $2500 per month, and based on the contract, $1000 of which will be applied to final purchse price if the tenant chooses to exercise the option. Carleton would tell you that you could defer the recognition of $1000 till the option expires. But actually you could not unless you agree to put $1000 into a separate escrow account and therefore has no immediate access of this amount of cash.
My question is: since most of you individual RE investors are cash basis tax-payers by default, do any of you actually look up the tax laws to make sure there was solid support for the claims of income deferrals? Do you ever run into IRS on this issue? I just do not want anyone to get a surprise from IRS. Your feedback/responses are appreciated!
Re: Tax Benefits of Lease-Option - Posted by JHyre in Ohio
Posted by JHyre in Ohio on March 06, 2003 at 06:46:34:
Out of curiosity, who is this RE tax expert? There are very few of them out there. My opinion: Whether or not you are on cash basis, option consideration is not taxable until the option expires or is exercised. That conclusion arises from case law - and the case law never made an exception for cash method taxpayers. I’d very much like to see a citation to law from your advisor. Otherwise, she’s just theorizing.
John Hyre
Re: Tax Benefits of L/OMay Be an Illusion - Posted by Rich[FL]
Posted by Rich[FL] on March 05, 2003 at 16:20:45:
Option consideration is nothing more than a deposit with a closing several months/years in the future (if it happens at all). It’s part of a one-sided contract, binding on the seller but not the buyer.
For a seller who is selling thier primary residence (which is who I’m assuming your talking about here), there is a capital gains exclusion (i.e., no tax to pay) on the first $250k single/$500k married of “profit” on the sale of the house.
If you pay $1000 today and close tomorrow, no tax to the seller. If you pay $1000 today and close in two years, no tax to the seller. If you pay $1000 today and do NOT close in two years (i.e., walk away from the deal after the option expires), this then is considered income to the seller upon which he has to pay tax.
This is basiclly how options work. I don’t have the references close at hand but you can look it up yourself at the IRS web site (www.irs.gov). Trust, but verify. Not even all professionals have all the answers.
Rich
Re: Tax Benefits of Lease-Option - Posted by John
Posted by John on March 06, 2003 at 15:25:46:
John, thanks for the information. Do you have details about that case law? The person I talked to is not aware of that case, and her reasoning was if you receive the cash and have immediate access to it (i.e. could be spent right away), IRS would argue it is taxable in the year received. Just to make sure that we are speaking the same language, by option considerations, you are not just referring to the lump sum paid upfront, but also the portion of monthly rents credited toward the purchase price persuant to the option contract. Thanks again!
Re: Tax Benefits of L/OMay Be an Illusion - Posted by Jeremy(CA)
Posted by Jeremy(CA) on March 05, 2003 at 16:39:57:
Rich, if I am the seller, the moment I enter into the lease-option contract with you, my house turns from a residential property to a rental investment property. As such, I would not be able to utilize the 250k/500k capital gain exclusion. I could be wrong here, but again, would appreciate your further insights.
Re: Tax Benefits of Lease-Option - Posted by JHyre in Ohio
Posted by JHyre in Ohio on March 06, 2003 at 15:43:54:
Jeremy (That’s what the email said, so I’m assuming it’s the same guy who posted the original question, the name in the “name” box notwithstanding),
Just as I thought - she’s theorizing. Normally, when you receive cash, it’s treated as income. BUT there are exceptions, such as loans and sums that fall under the so-called “open transaction” doctrine. An option is a lot like a contingent loan…you may get to keep the money, you may have to indirectly give it back by crediting it towards the purchase price of the optioned property…you aren’t taxed until it’s clear that you get to “keep” the money. If option money paid with the rent is TRULY option money (i.e. - applies to the purchase of the property AND is in excess of FMV rent), then such money should be treated the same as any original option money…that is, the transaction is held “open” and the taxation of the money is deferred until the transaction is “closed” via exercise or expiration of the option. I am aware of no case law that has exactly the facts you describe…but the VERY consisent treatment of options as “open transactions” in the case law gets us to that result. It is an exception to the idea that cash received is taxable income.
I’m pretty busy billing hours and not inclined to search for the citations to cases describing the taxation of options. If your advisor has access to Westlaw or similar resources, she can find the case law that covers options via a word search. A review of the Bureau of National Affairs Tax Portfolios will also provide some good cites, and those can in turn produce more cases & examples via a citator search (The “Shepards” book for the lawyers out there).
Trust me, true options aren’t taxable until exercise or expiry.
John Hyre
Re: Tax Benefits of L/OMay Be an Illusion - Posted by Rich[FL]
Posted by Rich[FL] on March 05, 2003 at 17:49:56:
Jeremy, the tax law states that if you’ve lived in the house 2 of the last 5 years, the gain is excluded. It doesn’t matter which 2 years you’ve lived there: the first two, last two, the middle two, the first year and last year, etc.
During the lease/option period, the seller will have monthly income they’ll have to report on their tax return, but also they’ll have offsetting expenses (their monthly mortgage payment), plus other expenses that goes along with the lease of their property, including depreciation. So they may very well end up with a tax SAVINGS while their property is under lease.
There is also no limit on how many times you can do this (minimum - once every two years so you can qualify for the exclusion).
One of the few really beneficial things congress gave the people back in the 1997 tax reform act.
Rich
Re: Tax Benefits of Lease-Option - Posted by ScottS
Posted by ScottS on March 07, 2003 at 12:17:11:
There’s no real reason to look for case law. The IRS code spells it out specifically as to how option consideration is to be treated and you are correct. It is taxed when the option is defaulted, not exercised, or exercised. Meaning you can have the funds for as long as you like until one of those events happen.
I have tapes in my vehicle I just listened to this part yesterday and it told the specific section of the IRS code to look in. I’ll listen to it again and post with the section later.
ScottS
Re: Tax Benefits of Lease-Option - Posted by jeremy (CA)
Posted by jeremy (CA) on March 06, 2003 at 16:04:19:
John, thanks for an very well written email. I specialize in mutual fund taxation and dealt with lots of security option contracts. I failed to recognize that RE lease-option is no different from any security options by nature. What you said is exactly the tax treatments we are applying to those put/call options. Anyway, it has been an very informative discussion for me. Thanks for your time and good luck on everything.
Jeremy
Re: Tax Benefits of L/OMay Be an Illusion - Posted by jeremy (CA)
Posted by jeremy (CA) on March 05, 2003 at 17:59:01:
Rich, thanks for the response which clarifies many things. I also went to the IRS website as you suggested and basically reached the same conclusion. It seems reasonable to think the seller will have to recognize all considerations currently if the option last at least five years (though options rarely go that long) since it will disqualify the owner from taking the capital gain exclusions. I hope this argument makes sense to you. Again, thanks for your time and good luck on everything.
Actually… - Posted by JHyre in Ohio
Posted by JHyre in Ohio on March 07, 2003 at 13:12:08:
the Code section, in my view, spells out how the option consideration is taxed, not when. Bronchick and I had that disagreement some time ago. Fairly moot, as the result is the same.
John Hyre
Re: Tax Benefits of L/OMay Be an Illusion - Posted by Rich[FL]
Posted by Rich[FL] on March 05, 2003 at 18:16:58:
Whether or not the seller has to recognize the capital gains after 5 years (in actuality it’s only 3 years; beyond that, he hasn’t lived in the property for 2 of the last 5 g) is immaterial to the issue of option consideration. Option consideration is only recognized when the option is exercised or when it expires, whether it is tomorrow or 10 years from now.
Rich