Lease Option or Sale?
What is the economic reality of your transaction?
note: This article, which originally appeared in Commercial Investment Real
Estate, July/August 1996, is one of the most popular articles downloaded from
the CIRE archive. Here is a condensed version of the original article.
with an option to purchase is a common real estate arrangement. The important
income tax question in lease-option transactions is whether the tenant is
leasing the property or, as an economic reality, an installment sale has
occurred prior to the tenant exercising the purchase option.
answer to this question depends upon an analysis of all the surrounding
factors. As Gerald J. Robinson observed in the Federal Income Taxation of Real
Estate: “A collection of telltale signs leads to the conclusion that exercise
of the option was virtually certain from the outset, so that treating the
entire transaction as a sale is warranted.”
lease option is treated as a sale, there are two important tax implications:
- The timing of the property’s transfer
of ownership is changed. With a “true” lease option, ownership transfers when
the option is exercised. If the transaction is treated as a sale, then
ownership transfers when the parties execute the original agreement.
- The nature of the option payment and
the rent payments during the lease period are changed.
the tax treatment of a purchase transaction is so different from a lease
transaction, it is important to understand the factors that may lead the
Internal Revenue Service to characterize a lease-option transaction as a sale.
basic tax question is whether or not the IRS will assume a sale occurred before
the tenant actually exercises the option to purchase. If, at the time the lease
option agreement is executed, all economic circumstances indicate a high
probability that the tenant will execute the option, the IRS will very likely
characterize the lease option as a sale. If the tenant acquires equity in the
property during the period of the lease, it increases the likelihood that the
tenant will exercise the option to purchase, because this is the only way to
protect the investment.
linking of inflated rents and a below-market option price tends to corroborate
that the tenant is acquiring an equity interest in the property. For example,
assume that Adams agrees to lease an industrial building from Baker for two
years at an annual rent of $120,000. At the same time, Adams pays Baker $20,000
for an option to purchase the property at the end of two years for $240,000. At
the time the lease option agreement is executed, the fair market value of the
property is $500,000 and the annual fair rental is $50,000.
acquires $70,000 of equity per year over the two-year lease period ($120,000
annual rent payment - $50,000 fair market rent). In addition, the total
payments made by Adams equal the value of the property ($20,000 option payment
+ $120,000 rent payment [year #1] + $120,000 rent payment [year #2] + $240,000
option price = $500,000 fair market value). Thus, the economic circumstances at
the time the agreement is executed indicate that the lease option is, in
economic reality, a sale and that the $20,000 option payment is the down
lease-option transaction example will be treated as a sale for tax purposes,
because the rental amounts are so great that the tenant is economically
compelled to exercise the option, and, even more compelling, the inflated rents
and the low option price add up to the approximate fair market value of the
a “bargain” option price will not, by itself, result in the lease-option
transaction being characterized as a sale. If the option price represents a
substantial portion of the fair market value of the property, the rent
approximates the actual fair market rental value, and the rent payments are not
applied to the purchase price, the lease-option will not be characterized as a
may come to the same conclusion in that example if the option price of the
property is set at market value, but the rent and the option payments are
applied to the option price. For example, assume the same facts as in the
previous example, except that the option price is $500,000 and the $20,000
option payment and the two annual $120,000 rent payments are to be applied to
the option price. When Adams exercises the purchase option, he pays Baker
$240,000 ($500,000 option price - $20,000 option payment - $120,000 rent
payment [year #1] - $120,000 rent payment [year #2] = $240,000).
addition to the rental value and option price, other economic factors may be
considered in determining whether a lease option should be characterized as a
sale for tax purposes. In analyzing lease option transactions, each of the
following factors has been considered evidence that indicates a sale:
- The lease requires that the tenant
make substantial improvements to the property and the tenant can recoup his
investment only by exercising the option.
- A portion of the rent payments can be
identified as a substitute for loan interest.
- The agreement calls for the crediting
of rent payments against the option price. This is true even when both the
rental value and the option price are set at fair market value.
the situation in the third point, the tenant is paying no more in rent than
would be the case in the absence of the option. Thus, the tenant is not
acquiring equity during the lease period. However, if the rent may be applied
to the option price, the lease option transaction has the appearance of an
installment sale with a balloon payment. This is especially true when the rent
payments approximate the amount of installment payments the tenant would make,
given a loan amortization schedule with a market rate of interest.
there is no certainty that the tenant will exercise the option. Thus, if the
tenant can demonstrate to the IRS that the reason for the lease option is that
a sale was not possible because of economic conditions, the lease option will
likely be upheld. As Michael P. Sampson says in Tax Guide for Residential Real
Estate: “...if you can demonstrate that the reason for the lease option is the
impossibility of a cash sale because of economic conditions, the form of the
transaction as a lease option will probably stand. This would be the case, for
instance, where your purpose is to tie down the property during a tight money
market, with the expectation that within the option period you can get
of the Parties
cases, the court has ruled that the intentions of the parties determine whether
a lease-option transaction is to be treated as a sale, instead of relying on
strictly economic tests. If the parties believed when they entered the
transaction that the rent charged reflected fair market rents and that the
option price reflected a good faith estimate of the future value of the
property, the lease option will very likely be upheld.
the party’s intention is subjective, an IRS agent or a judge would need to
corroborate these intentions in the economic circumstances surrounding the
the lease option is a valuable strategy, it should be used with great care.
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.
J. Valachi, CCIM, CPA, is a retired clinical professor of real estate at
California State University in Fullerton.
Consequences to Tenant and Landlord
IRS characterizes the lease option as an installment sale for income tax
purposes, the ownership of the property is assumed to transfer at the time the
tenant gave the landlord the option payment and the lease commenced. This
timing alters the tax consequences considerably for both the tenant and the
tenant will not be allowed to deduct his rental payments as such.
tenant will be allowed to deduct depreciation, based on the portion of the
presumed purchase price allocated to depreciable improvements. In addition, the
tenant may also deduct other expenses associated with operating the property.
portion of the rental payments that the tenant makes will be recharacterized as
interest payments and will be treated as deductible interest for income tax
purposes. The amount of the interest deduction will be calculated under the
“imputed interest rules.” The portion of the rental payments treated as loan
principal payments is considered part of the purchase price and, thus, is added
to the tenant-buyer’s tax basis for the property.
option payment is treated as a down payment. Since the landlord did not receive
all cash for his equity, the installment method of reporting would be
applicable to the transaction. Thus, the option payment will be treated as an
initial payment received in the year of “sale” under the installment method.
rental payments received by the landlord-seller under the lease agreement are
treated as part of the selling price, and part of each installment payment is
taxable gain. Since no interest is stated in the rent payments, it must be
recharacterized rental payments will result in either long-term capital gain or
ordinary loss. This assumes that the property was held for more than one year
at the time the lease-option agreement was signed, and that the landlord-seller
was not a “dealer” in real estate with respect to the property in question.
- Ordinary income (rental income) converts into capital gain (sale proceeds). As
a result, the applicable tax rate could be lower. In addition, the amount of
reportable income would be limited to the gain, if any, on the sale.
landlord would not be allowed to deduct an allowance for depreciation or other