I have been criticized for pointing out pitfalls when using a lease option as a seller – specifically, that lease options violate the DOSC, and that in most cases, your tenant can claim an “equitable interest”. I point these things out because it’s important that you know exactly what you are doing. Do you know what your are doing? What about the tax consequences of lease options?
How about the IRS and Lease Options? Do you know anything about how the IRS treats your investment? Here is an article: Lease Option or Installment Sale? Determine the “Economic Realty” of Your Lease-Option Transactions–or the IRS Will. By Donald J. Valachi, CCIM, a well-respected real estate authority. Here is his summary:
“Although the lease option is a valuable strategy in many situations, it should be used with great care. There is always a threat that the IRS may view the lease-option transaction as a sale and the lease as merely a financing device. Rents that are significantly above fair market rents, when combined with a “bargain” option price, indicate that the transaction is likely to be characterized as a sale and that the rental payments are, in fact, installment payments on the purchase price. Thus, both the rental payments and the option price should be set by the parties with reference to going market values and rents for similar properties. And the parties should be prepared to justify their estimates of rent and purchase price if the transaction is later challenged by the IRS. Rental value and property value are best established through independent appraisal by experts.” Here is the link to the full article:
http://www.ciremagazine.com/article.php?article_id=691
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This information has been gathered from various IRS pronouncements. The IRS may characterize a lease-option transaction as a sale if one of the following factors is present:
* The lessee acquires equity through lease payments.
* The lessee acquires title to the property after the required number of lease payments has been made.
* The lessee's total lease payments are due in a relatively short time, and the payments substantially cover the amount required to purchase the asset.
* The lease payments substantially exceed the fair rental value of the property, indicating that the transaction is financed over less than the life of the asset.
* The property will be acquired by the lessee at the end of the lease term for a nominal sum.
* The lessee participates with the lessor in the acquisition of the asset by guaranteeing a loan or through similar agreements.
* The lessor has little or no at-risk investment in the property (the IRS looks for a minimum at-risk investment of 20 percent of the asset's cost). THIS MEANS NO SANDWICH LEASE OPTIONS.
I hope this information is informative and helpful. Experts say lease options should only be used with great care. Funny, I’ve heard that before.
Da Wiz