Hello, to everyone reading this post. My question relates to lease options being characterized by the I.R.S. as Installment Sales. I believe that if the transaction is characterized as an installment sale, you will have to pay taxes (capital gains) on the investment property the date that you entered the agreement. For example, if you entered the agreement on December 2, 2006. You will have to pay installment tax on the property when you file taxes for April 2007. In addition, it appears that if the transaction is catergorized as a installment sale, this might have some negative tax consequences for the investor and the T/B might not be able to enjoy some tax benefits.
What factors or wording is essential in a lease-option transaction that will prevent the I.R.S. from charactertizing it as an installment sale?
In addition, will a lease option peformed for the period of 1 year be instantly characterized as a flip or a “dealer” transaction?
Why did you buy the property in the first place? In other words what was your investment plan or exit strategy for the property?
My response to your question depends upon your answer to mine.
Hello Dave T, thanks for responding to my question. This is my investment strategy.I will like to acquire and rehab a property. I have been considering to sell the property on a lease-option as a potential exit strategy in the event that the market is slow and the property can’t be resold quickly. (To reduce monthly holding costs)
Note: I understand that the property in a lease-option transaction may not sell up to a year’s time frame, but I like the idea of receiving the option/premium fee, the tenant/buyer helping me to pay the note and possibly making a small positive cash flow for a year’s time period.
I have read from posts on this site that if the lease-option transaction is not drafted well, the I.R.S. can characterize it as an disguised sale. The I.R.S. characterizing the transaction as an desguised sale can lead to unanticipated tax liabilities. I want to understand the proper way to draft the transaction so I can minimize the chances of dealing with potential tenant/buyer problems or I.R.S. (dealer, capital gain tax, or installment sale/disguised sales) issues.
So, your plan is to rehab and flip the property. Flip property is dealer realty and as such the profit from your sale is taxable as ordinary self-employment income (in the absence of a business entity).
It is my opinion that the property is dealer realty even if the option is exercised after one year. Capital gains tax treatment does not apply. Your stated intent is to acquire a property to rehab and resell. You are simply using a lease option to facilitate the sale, but your intent is to sell the property. Indeed, your property is continuously for sale during your holding period because your tenant buyer can exercise his option at any time. You recognize the income when the option is exercised.
For dealer realty, capital gains tax treatment and 1031 tax treatment and installment sale tax treatment are all denied to you. And, dealer realty can not be depreciated.
Others more familiar with disguised sales will have to answer that question for you.
Just my opinion.
Thanks for the response Dave T. In the event that you flip the property from a Limited Liability Company, what type of taxes can you anticipate to pay upon actualizaton of profits??
As a general rule, the LLC is tax neutral for federal income taxes. That is, the absence or presence of an LLC has no impact upon your tax liability. LLC income will flow through to your personal 1040, where you will pay ordinary income taxes and payroll taxes.
State income taxes, if applicable, will be levied in addition to your federal tax liability.
Thanks for the info Dave T.