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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24 May | June | 2015 Commercial Investment Real Estate against the option price. T is is true even when both the rental value and the option price are set at fair market value. Regarding 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. T us, the tenant is not acquiring equity during the lease period. How- ever, 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. T is 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. But there is no certainty that the tenant will exercise the option. T us, 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 condi- tions, the lease option will likely be upheld. As Michael P. Sampson says in Tax Guide for Residential Real Estate: "...if you can demon- strate 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. T is 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 institutional f nancing." Intention of the Parties In some 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 ref ected fair market rents and that the option price ref ected a good faith estimate of the future value of the property, the lease option will very likely be upheld. Because the party's intention is subjective, an IRS agent or a judge would need to corroborate these intentions in the economic circum- stances surrounding the transaction. Although 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 estab- lished through independent appraisal by experts. Donald J. Valachi, CCIM, CPA, is a retired clinical professor of real estate at California State University in Fullerton. TAX CONSEQUENCES TO TENANT AND LANDLORD If the 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 landlord. Tenant as Buyer • The tenant will not be allowed to deduct his rental payments as such. • The tenant will be allowed to deduct depreciation, based on the portion of the presumed purchase price allocated to depre- ciable improvements. In addition, the tenant may also deduct other expenses associated with operating the property. • A 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. Landlord as Seller • The option payment is treated as a down payment. Since the landlord did not receive all cash for his equity, the install- ment 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. • The 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 imputed. • The 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. • The landlord would not be allowed to deduct an allowance for depreciation or other rental expenses.