Tax Strategy: Using Real Estate Options and Leases with Purchase Options

Real estate options and leases with purchase options can enhance your real estate investment profits. Here's a concise guide to help you navigate the potential pitfalls and maximize your returns.

Stand-Alone Purchase Option

A stand-alone purchase option can be highly profitable. Here's how it works:

Immediate cash. You receive cash up front from a buyer wanting the option to purchase your property at a set price within a specific period.
Outcome benefits. If the buyer exercises the option, you sell the property at a premium. If the option lapses, you keep the property and the option payment.

Lease with Option to Buy

This approach offers several financial advantages:

Higher rent. Charge a premium rent, possibly applying a portion toward the option price.
Up-front cash. Require an up-front option payment, which becomes your immediate cash.
Property maintenance. Tenants are more likely to maintain the property well, often handling repairs themselves.
Long-term tenants. Tenants planning to buy tend to take better care of the property.

Legal and Tax Considerations

Understanding the tax implications is vital:

Option proceeds. If the buyer exercises the option, the up-front payment is part of the sale proceeds. If the option lapses, it's ordinary income in the year the option lapses. If the option is exercised, the option payments are considered to be part of the purchase price of the property and are subject to capital gains treatment in the year the option is exercised
Example. If Mary pays $10,000 for an option to buy your property for $300,000 within 15 months, she adds the option cost to her property basis if she buys. If she doesn't buy, the option lapses, resulting in a long-term capital loss for Mary and ordinary income for you.

Avoiding Pitfalls

Options and leases can sometimes be deemed sales contracts by the IRS, especially if

the option forces the tenant to buy due to high rents, or
the lease conveys significant ownership benefits to the tenant.

Eight Rules of Thumb

To ensure your lease-with-purchase-option is compliant and beneficial, be sure to follow this advice:

No equity build-up. Don't apply rent toward equity.
No automatic title transfer. Avoid clauses that transfer ownership after a specific number of payments.
Short-term rent proportion. When renting for a short period, ensure rents are not an inordinately large portion of the total price.
Fair market rents. Ensure rents are reasonable and not excessively high.
No interest equivalents. Avoid building interest equivalents into rents.
Proper investment. Maintain at least a 20 percent investment in the property.
Fair option prices. Set option exercise prices at or above fair market value.
Restrict improvements. Prohibit tenant improvements.