Question: I’ve read your column in the past where you talked about selling a home with a lease-option agreement. I have a rental house that my renters would like to buy in a few years. I am told that tax-wise, it might be to my benefit if I lease-option the house. How does a lease-option work, and what expenses are the renters liable for?
Answer: First of all, I would not recommend using a lease-option agreement to sell a property “in a few years” unless you don’t really care whether they buy the house or not.
Here’s why: As I have explained in previous columns, the tenant-buyers in a lease-option agreement often fail to exercise their option to buy. This can occur for a number of reasons, such as they don’t like the house after living in it for a while, the buyers lose his or job, or they get divorced.
Many things can go wrong. That’s why it’s usually best to limit the lease-option period to one-year if you truly want to sell the house.
The longer you wait, the greater the odds that something will happen which will cause the tenant-buyers to change their minds.
Another problem with long lease-option terms is that in this state, any lease-option agreement longer than two years triggers the real estate excise tax. In other words, you have to pay the tax immediately, as if you sold your house.
If you want to do a long-term lease option, you can get around this problem by making your option period two years — with an option to extend the term at the end of the option period. You could therefore have a two-year lease-option that would keep rolling over indefinitely.
You asked about the tax benefits of a lease-option. Whether it is actually a benefit depends on your personal tax situation, but here are the tax ramifications of a lease-option agreement.
When you sell a rental house, you immediately incur a taxable capital gain, assuming you made a profit on your investment. However, when you enter into a lease-option agreement, you don’t know whether the tenant-buyers will actually exercise their option to purchase the house.
There is some disagreement among accountants on this, but the more aggressive tax advisers believe that the option consideration you receive during the option period is not immediately taxable. It becomes taxable only at the point when the tenant-buyers either exercise their purchase option or walk away.
For example, let’s say that your renters give you a $2,000 down payment and pay $1,200 per month in rent, of which $200 per month is credited toward their down payment when they buy the house. At the end of one year, your renters will have paid you a total of $4,400 ($2,000 + $200 a month) in option consideration toward the purchase of your house. If they exercised the purchase option, that money would be credited toward their down payment. But if they decide not to buy the house, you keep the $4,400. It is not refundable.
Now, here is how this affects your taxable income: If the tenant-buyers buy the house, the $4,400 is part of your capital gain, but if they fail to exercise the option, the $4,400 is treated as rental income and is subject to your income tax rate.
That’s why you don’t have to pay tax on the option consideration during the option period — because you don’t know whether to treat the money as a capital gain or ordinary income until the end of the contract.
Once the option is either exercised or expires, the whole sum of the option consideration becomes taxable income, one way or the other.
Continuing with the numbers in the example above, let’s say you have a one-year lease-option contract that starts on June 1, 2010 and runs through May 31, 2011. None of the option consideration you received this year would be taxable as 2010 income.
You would pay tax on the total $4,400 in option consideration in the 2011 tax year because that’s when you would know whether the house was sold or not.
If you are not in a hurry to sell your rental house, you can see that it may actually be to your benefit if your renters do not exercise their purchase option because you get to keep the non-refundable option consideration as extra income. You can then turn around and lease-option the house to someone else.
As for who pays what expenses during the lease-option period, that depends on the terms of your contract. Since you retain title to the property during the option period, you would pay the mortgage, property taxes and insurance. You would also continue to deduct property depreciation on your income tax. The owner usually pays for any major repairs during the option period, such as replacing a roof; while the tenant-buyers are usually responsible for minor repairs of up $50 to $100 per month. But, again, this is all subject to negotiation.
A properly drawn lease-option contract is a win-win situation for both the buyer and the seller. The buyer gets to buy a home with little money down, and the seller gets a top dollar sales price because of the attractive financing mechanism of a lease-option contract. Lease-option tenants are generally very good renters because they treat the house as owners rather than temporary residents.
Please remember that this column is for general information only. Consult an accountant for a more detailed analysis of your tax situation before you enter into a lease-option agreement with your renters.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206, or e-mail him at economy@heraldnet.com.
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