Commercial Investment Real Estate is the magazine of the CCIM Institute, the leading provider of commercial real estate education. CIRE covers market trends, current developments, and business strategies within the commercial real estate field.
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23 May | June | 2015 CCIM.com A lease with an option to purchase is a common real estate arrangement. T e important income tax ques- tion 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 exercis- ing the purchase option. T e answer to this question depends upon an analy- sis 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 exer- cise of the option was virtually certain from the outset, so that treating the entire transaction as a sale is warranted." If a lease option is treated as a sale, there are two important tax implications: • T e timing of the property's transfer of ownership is changed. With a "true" lease option, ownership trans- fers when the option is exercised. If the transaction is treated as a sale, then ownership transfers when the parties execute the original agreement. • T e nature of the option payment and the rent pay- ments during the lease period are changed. Because the tax treatment of a purchase transaction is so dif erent 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. Lease Terms T e basic tax question is whether or not the IRS will assume a sale occurred before the tenant actually exer- cises the option to purchase. If, at the time the lease option agreement is executed, all economic circum- stances 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. T e linking of inf ated 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 pur- chase 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. Adams 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 pay- ments 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). T us, the economic circumstances at the time the agreement is executed indi- cate that the lease option is, in economic reality, a sale and that the $20,000 option payment is the down payment. T is 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 inf ated rents and the low option price add up to the approximate fair market value of the property. However, a "bargain" option price will not, by itself, result in the lease-option transaction being character- ized 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 sale. T e IRS 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). Other Economic Circumstances In 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 evi- dence that indicates a sale: • T e 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 identif ed as a substitute for loan interest. • T e agreement calls for the crediting of rent payments Editor's note: T is 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. ( ) Fancy Photography/Veer