There are some interesting and lucrative advantages of using lease options as both an optionor and optionee of real estate. Generally speaking, option money is not taxable to the optionor until the option is exercised, expires, or is abandoned.
I.R.C. 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.
Take a loss on your personal residence
A personal residence sold under lease option may still qualify for capital gains exemption. Under the 1997 Tax Reform Act, gains from the sale of a personal residence seller are exempt so long as the gain is less than $250,000 ($500,000 for married couple).
So 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 a rental. See, e.g., Bolaris v. Commissioner, 776 F.2d 1428 (9th Cir 1985).
The 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, his option payments (including monthly rent credits) become part of his tax basis in the property. The tenant’s option payments may be deductible as a capital loss if the buyer is an investor.
For example if you lease option a home to live in, consider using your corporation to take the lease option, then sublease to yourself individually. If you don’t exercise the option from your corporation, have the corporation treat the option money it paid as a loss.
Watch out for “dealer” classification
If you are an active real estate investor, you should be aware of what the IRS calls “dealer status.” If you also buy and sell real estate on a regular basis, you may be considered a “dealer” in real estate properties. A dealer is one who buys with the intent of reselling rather than for investment.
There is no magic formula for determining who is an investor and who is a dealer, 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 deals the investor did in relation to other income.
If you take option consideration on a “dealer” property, you cannot defer taxation of option consideration under Section 1234 of the Code.
IRS reclassification
Occasionally, but rarely, the IRS will reclassify a lease option as a disguised sale. This is more common with equipment leases where the lessee makes rental payments for a number of years 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 whether a sale was intended. For example, if the tenant is paying the taxes and insurance, this looks more like a sale. If a substantial part of the payments on the lease are credited towards purchase, this also looks like a sale.
If the option price declines each year rather than increases with the market…well, you get the idea: If it looks like a duck, and it quacks like a duck, it’s a duck! Most of the reported cases wherein the IRS reclassified a lease option as a sale involved long-term leases. Thus, a lease option of only a few years with your tenant is not likely to be re-characterized as a sale.