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There are some interesting and
lucrative advantages of using 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.
A personal residence sold under lease/option may still qualify for capital
gains exemption. 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, 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 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.
Take A Loss on Your Personal Residence
As you may know, you cannot take a loss on your personal residence if you sell
it for less than your basis. You can, however, take a capital loss on an
investment property. Move out of your house and lease/option it to a
tenant/buyer for a few years. Report it on your Federal income tax return as a
rental on schedule "E." You may now be able to take a loss when the tenant
exercises his option to purchase. Make certain that if you make this
transaction it looks legitimate; the IRS is keenly aware that people in down
real estate markets try to "fudge" rental agreements to accomplish a loss on
their personal residences.
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 - it if looks like a duck, and it quacks like 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.
The purpose of this
newsletter is to stimulate thought for our
clients and professionals with whom we network. One should consult with a qualified
tax planning professional prior to
implementing any tax
planning
strategies. If you are a legal,
insurance, real estate or mortgage
planning professional receiving this newsletter or know of one,
please contact our office to introduce
yourself and your services to us. We
are always seeking to grow our referral
network and expose professional services
to our client base.
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