Deposit on option to buy

[Gretel]

I searching I found thread from 2008 and this is the last posting (see below), which comes close to my question. I am looking at a 2-year lease to buy contract with a $10,000 deposit, which - per contract - will be applied to purchase price after two years.

Am I right, that this is not income in year received, even though it is non-refundable since it will be applied to purchase price?

Thanks.

02-28-2008, 07:48 PM
FEDUKE404

Isn't it plain vanilla ordinary income?
WOW - I thought this was a simple question until I started reading the answers.

My spin is the recipient of the income has ordinary income, pure and simple. (I'll let others decide if a business could deduct the same payment.)

In the recent past I had a client who received $50k each of several years running as an option to buy his property. Each year the option was unexercised, and each year the income was reported as ordinary income. Eventually they DID excercise the option and bought the property, and all funds (for that year only) went into the total sales prices, Sch D, etc.

[ChEAr$]

Just today a client had a letter (not a 1099) from a company for 4,000, an option to continue their mineral rights out in Taxes. oop, Texas.


ordinary income; schedule e

[Koss]

Option to Buy

This sort of thing is very fact-specific.

Depending on the terms and conditions of the option, it may be construed as an installment sale.

If it isn't construed as an installment sale, then the payment may be ordinary income in the year received, or it may not be taxable until the option is exercised or expires.

In your case, what happens if the guy doesn't exercise the option? Does your client have to give him the money back? Probably not. But that issue alone is not decisive. That's just one factor you have to look at...

I'll see what else I can find on this. It's a very complicated issue, and there are some gray areas.

BMK

[Nashville]

I am looking at a 2-year lease to buy contract with a $10,000 deposit, which - per contract - will be applied to purchase price after two years. Am I right, that this is not income in year received, even though it is non-refundable since it will be applied to purchase price?

Gretel, I've reduced your post to a more simple question without the overtones of whatever was going on three years ago. Sorry DUKE - simplicity prevails.

And I believe the answer depends on whether your client is a cash or accrual-based accounting system. If cash, this is revenue in the year received. If accrual, this is a liability (not revenue), commonly referred to as "customer deposits" or "deferred revenue."
Going forward, it will become income in the year applied if the lease is consummated as planned. If the lease never happens and your client keeps the deposit, this becomes revenue in the year of knowledge of default.

It can get more complicated. If the deposit is taken under terms that are the "normal course of business", the above applies. If this is an unusual deposit outside client's normal business practices and it is non-refundable, then it is IMMEDIATELY revenue under the doctrine of "constructive receipt."

[Gretel]

Oh boy, thanks guys. Here are more details.

Cash basis taxpayer (horse trainer) sells (lease with option to buy after two years) his homestead, which includes stables and such from his business and moves out of state.

If this is deemed an installment sale then I will have two transactions. I hope it is not, tried to find more information but could not.

Buyer has to make initial deposit (non-refundable) to be applied to purchase price in year one. Year 1-3 makes lease payments, which increase in year 2. Year 3 contract closes if buyer does not default and title transfers.

[Gretel]

Just putting back on top, probably wishful thinking.

[Koss]

Lease/Option

Okay, I'll try to address this, but your client may not like my answer...

A properly structured lease with an option to buy will often spell out three different components of the monthly payments:

(1) an amount that is credited toward the purchase price
(2) rent, which is not credited toward the purchase price
(3) an amount that represents the cost of the option

The option means that the seller is effectively taking the property off the market for a certain period of time, or at least giving the option holder the right of first refusal. The option often, but not always, locks in a specific price for the purchase, so the seller is also giving up the possibility of any increase in the fair market value during the life of the option.

Some portion of the monthly payment, or occasionally a lump sum that is paid up front, should reflect the value of the option itself. The idea is that the seller gets to keep this money even if the buyer does not exercise the option. Without this element, it may not be a valid option in the eyes of the IRS.

I am not saying that every valid lease/option arrangement has to have all three of these payment components. One of them could be zero, and two of them could conceivably be wrapped together into one amount that reflects both concepts.

But you better have at least two out of the three. If the entire monthly payment is applied toward the purchase price, the IRS may determine that it was really an installment sale.

The question is whether the lease option has any economic reality to it. The option has to be just that: an option, not an obligation. If the terms are such that the option holder cannot walk away without losing a substantial amount of money, then the transaction doesn't make sense. The IRS may determine that it is a sale disguised as an option.

As I said in my earlier post, it is extremely fact-specific, and there is no one element or issue that is dispositive.

The portion of the monthly payment that is rent, and the portion that reflects the cost of the option itself, are never refunded to the option holder, and they are ordinary income in the year received.

The portion that is credited toward the purchase price may not be taxable until the option is exercised or expires (i.e., the option holder decides not to exercise the option and walks away). I'm not sure it makes a difference whether the option terms call for any refund of that amount. Obviously, if it is refunded, then it is not taxable; if the option expires and the option seller keeps it, it would taxable at that point. If it is applied to the purchase price, it would be taxed as part of the sale transaction, in the year of the sale.

Here's one article that covers some of these issues. It appears in something called the New York Real Estate Journal, but it is written by a CPA.

http://nyrej.com/36369

BMK

[taxea]

Look at the instructions for Installment sales.

[Koss]

Instructions?

A lease with an option to buy is not an installment sale.

In some cases, the IRS may recharacterize a lease with an option to buy, and treat it as an installment sale. But if the lease/option is structured appropriately, it is not an installment sale.

The "instructions for installment sales" tell you how to report an installment sale.

They say nothing about how to determine whether a lease with an option to buy is likely to be recharacterized as an installment sale upon review by the IRS.

BMK

[Gretel]

Thank you so very much, Burton. This is so helpful. I already know that I don't have a properly structured lease and will need to do some more digging into the facts. I tried to search instructions or to find any tax related information to this but could not.

What do you use for your research? It's just incredible how deep your understanding of any subject matter goes that you share with all of us. It's so much appreciated.

[JG EA]

On a regular lease with the option to buy.... You count all payments as rent if there is no actual sale yet. Then when the legal process happens you record the sale. If on the sale papers it shows that past payments are for the option then you amend those open years.

I know this is not your situation, just saying.

[taxea]

A lease with an option to buy is not an installment sale.

In some cases, the IRS may recharacterize a lease with an option to buy, and treat it as an installment sale. But if the lease/option is structured appropriately, it is not an installment sale.

The "instructions for installment sales" tell you how to report an installment sale.

They say nothing about how to determine whether a lease with an option to buy is likely to be recharacterized as an installment sale upon review by the IRS.

BMK

I agree but thought the instructions on how to treat the front money might be of use.