Real estate options and leases with purchase options can enhance your real estate investments profits. Here’s a concise guide to help you navigate the potential pitfalls and maximize your returns.
Real Estate Investments: 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.
Real Estate Investments: 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.
- 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 for Your Real Estate Investments
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.
Tax Strategies for Investment Properties and Rental Property Owners:
Ken Weinberg, Enrolled Agent and tax reduction specialist works with many clients who are landlords, residential and commercial property owners. If you plan to replace a building component, contact Ken-Mar Tax to ensure the best tax benefit, 440-777-2207.
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As an expert in small business tax services and tax consulting Ken-Mar Tax eats, sleeps and breathes small business tax strategies. Being an enrolled agent allows founder, Ken Weinberg, to represent you to the IRS - something only a CPA, tax attorney and Enrolled Agent can do. EAs are the only federally licensed tax practitioners who specialize in taxation and also have unlimited rights to represent taxpayers before the IRS. It also means he is continuously being updated on the new IRS tax codes and taking classes from the IRS that provide guidance on how to file returns so that they are not "flagged."
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