Consider the Consequences of Your Options

An option to purchase investment real estate is simply a contract to sell a property at a specified price during an allotted period of time. Options can provide advantages to both sellers and buyers, depending on the circumstances of the market and the property. While options are not appropriate to every situation, commercial brokers should be familiar with the basics of the transaction and the resulting tax consequences.

An option is considered a unilateral contract because it obligates only one party-the seller, who commits to sell the optioned property at a certain price. In exchange for this obligation, the seller usually receives the option payment immediately. But until the option is exercised, the seller retains use of the property and receives any resulting income.

To a buyer, purchasing an option offers several advantages over an outright sales contract:

  • The ability to acquire the property without worrying that someone else will buy it;
  • The necessary time to determine zoning and feasibility issues that may influence the decision to buy;
  • The time to find the best financing arrangement.

For these advantages, the buyer pays the cost of the option-usually a small portion of the total purchase price. If the buyer's option lapses, the seller usually keeps the option fee. Thus, the seller is compensated for taking the property off the market during the option period.

Purchase options involve income tax consequences for both the "optionor" (the person granting the option, usually the seller) and the "optionee" (the person acquiring the option, usually the buyer). Basic tax rules apply when the option is granted, exercised, sold or exchanged, or allowed to expire. However, the outcome and responsibilities are different for the buyer and seller in each situation with respect to taxable income and to whether the gain or loss is ordinary or capital in character.

Granting an Option
Generally, granting an option does not constitute a taxable event to either the optionor or the optionee. The optionor receives cash or other payment, but does not report any taxable income. The optionee makes a payment that has no immediate tax consequences. Granting an option is a nontaxable, open transaction that remains open until the option is either exercised or expires.

However, if the option payment will be characterized as ordinary income regardless of whether the option is exercised or is allowed to expire, then it must be reported as taxable income in the year it is received.

A Cautionary Note
A seller must be extremely careful in granting an option so it is not misconstrued as a sale for tax purposes. The sixth and most recent edition of Federal Income Taxes Affecting Real Estate (New York: Matthew Bender, 1993) recommends the following precautions in granting an option:

  • Document the option in writing. The written agreement should clearly express the fact that it is an option.
  • Set the length of the option period and the price of the option so they substantiate the option agreement. For example, the option price should not be the same as the current fair market value of the optioned property. Also, the option price should not be an amount that could be considered a down payment.
  • Keep the legal title to the optioned property in the optionor's name. The option should not convey either possession or other indications of ownership to the optionee.

Exercising an Option
If the optionee exercises the option and purchases the property, the option payment is simply added to the amount paid for the property. This determines the buyer's tax basis for the acquired property.

The seller considers the option payment part of the property's selling price. Accordingly, both the option payment and the purchase price are included when calculating the amount realized on the sale.

Selling an Option
The optionee may sell or exchange the option at any time during the specified period. The option is considered an asset, and any profit or loss resulting from its sale is subject to tax laws. Section 1234(a) of the Internal Revenue Code states that the optionee's gain or loss from selling the option is of the same nature as the gain or loss from the sale of the optioned property.

Thus, if the optioned property would have been a capital asset for the optionee, any gain or loss from the option's sale or exchange is treated as capital gain or loss. Whether the capital gain or loss is long-term or short-term depends on how long the optionee held the option. If the underlying property qualifies as an Internal Revenue Code §1231 asset-defined as a property involved in trade and business-then a §1231 gain or loss would result from the sale of the option.

If any gain or loss from the sale or exchange of an option does not result in either capital gain or loss or §1231 gain or loss, then it is considered ordinary gain or loss.

Failing to Exercise an Option
If the optionee does not purchase the property before the option expires, there are immediate tax consequences for both parties. The failure to exercise the option is treated as a sale of the option on the date that it expires, and the following results apply:

  • The optionee reports a loss as a result of failing to exercise the option. The rules for determining the amount and the nature of the loss as detailed above in "Selling an Option."
  • The optionor reports the forfeited option payment as ordinary income, taxable in the year the option expires.

Options are not completed sales, and often, a broker will not receive commission unless the option is exercised. However, it is a tool that should be included in every commercial broker's operating kit for successful real estate selling, investing, and asset management. Knowing the tax consequences of the various transactions prepares you to present the "option" of using options to your clients.

Donald J. Valachi, CCIM

Donald J. Valachi, CCIM, CPA, is associate clinical professor of real estate at the University of Southern California. He has been an apartment investor and broker for the past 15 years. Example 1: Granting the Option. Susan buys a two-year option to purchase a small apartment building from John for $500,000. Susan pays John $15,000 for the option. The receipt of the $15,000 option payment has no immediate tax consequences to either Susan (the optionee) or John (the optionor). The receipt of the option consideration is treated as a nontaxable open transaction. The transaction will remain open until Susan either exercises the option or allows it to expire. Example 2: Exercising the Option. Six months later, Susan exercises the option and buys the apartment building for $500,000. Susan\'s tax basis for the property is $515,000 ($500,000 + $15,000). John\'s amount realized from the sale is also $515,000. Example 3: Selling the Option at a Gain. Instead of purchasing the building, after one year, Susan decides to sell the option for $20,000. Since the apartment would have been §1231 property if Susan had acquired it, she reports a §1231 gain of $5,000 ($20,000 - $15,000). Susan\'s sale of the option has no tax consequences for John. Example 4: Selling the Option at a Loss. Assume in Example 3 that Susan sold the option for $10,000 instead of $20,000. Susan reports a §1231 loss of $5,000 ($10,000 - $15,000). Again, the sale has no tax consequences for John. Example 5: The Expired Option. Instead of selling the option, after two years, Susan fails to exercise the option and it expires. Since the apartment would have been §1231 property if Susan had acquired it, the $15,000 forfeited option payment is treated as a §1231 loss. John reports the $15,000 payment as ordinary, taxable income in the year the option expired.