For the purpose of this article, we are going to focus on one of the most popular owner financing arrangements - Lease-Option Agreements and the tax implications of entering into one.
Lease Option Basics
A lease option is a type of contract used in residential and commercial real estate. In a lease-option,
- the property owner and tenant agree to an option fee (an initial down payment and/or a monthly-option payment in addition to rent),
- the purchase price, and
- at the end of a specified rental period, the renter has the option of purchasing the property.
There can be several tax advantages to sellers using a lease-option agreement, but first, let's look at how the IRS taxes the money you receive in a lease-option agreement.
Three Different Tax Treatments
Tax on Rent - The rental payments are treated as ordinary income, which means you pay tax at your ordinary income tax rate (up to 39.6 percent - 43.4 if you have to pay the net investment income of 3.8 percent).
Tax on Sale - If the house is an investment or rental home and not your home and you owned the house for more than a year before selling, you treat the income from the sale as long-term capital gains. Capitals gains give you much better tax rates than you face the rental income, topping at 20 percent (23.8 percent if you pay the 3.8 percent net investment income tax).
If the house is your principal residence, you can benefit from the $250,000 single/$500,000 married profit exclusion, which could eliminate your tax altogether.
Tax on the Down Payment and/or Monthly-Option Payment - Option income is not taxable until your buyer chooses to exercise their option or let it lapse. You treat option income as either ordinary or capital, depending on whether the buyer exercises the option or lets it lapse. If your buyer chooses not to buy the house - you treat the option income as ordinary income. If your buyer does buy, you treat the option as part of the purchase price, which will give you capital gains treatment.
Tax Advantages
In a lease-option arrangement, you still own the house until the buyer actually completes the purchase so you keep all tax benefits related to the property. You will still be able to deduct property taxes, expenses, insurance, repairs - and in some cases you can also deduct depreciation.
Watch out for.... IRS Reclassification
Occasionally, the IRS will try to reclassify a lease option as a disguised sell. Avoid this by not crediting rental money towards the purchase price and always paying the taxes and insurance yourself.