How to treat lease w/ purchase option

[JoshinNC]

Assume these facts.

Party A owns real property. Party B enters into lease agreement with Party A to lease same real property for $1000 per month for 120 months. At end of 120th month the lease agreement allows Party B to purchase the leased real property for $1. If Party B wishes to, they can exercise the purchase option prior to the 120th month at an amount equal to the remaining lease payments plus the $1. The deed for the real property remains in Party A's name until the option is exercised.

Are the payments to Party A rental income and the $1 payment at end of the lease term the selling price for the real property? Or, is this an installment sale from the first payment as it is obvious it is a disguised owner financing, even though the deed is not transfered?

[Gary2]

See Rev. Ruling 55-540, particularly 4.01(b) and (e).

[JoshinNC]

I was aware of this Rev Ruling

But my question is related to real property, not personal property. This ruling seems to only address personal property leases, hence my original question. Would it be prudent that this ruling would so apply to real property? I'm just not sure.

[Gary2]

What aspect of the ruling or its rationale makes you think that the same reasoning wouldn't apply to real property? Or what differences between real and personal make you think that? The ruling is dealing with the structure of the deal, not the nature of the property.

If you look at Pub. 535, in Chapter 3, Rent Expenses, there's a section on conditional sales that pretty much uses the same criteria without any statement of whether it's real or personal property.

[JoshinNC]

The first paragraph

What aspect of the ruling or its rationale makes you think that the same reasoning wouldn't apply to real property? Or what differences between real and personal make you think that? The ruling is dealing with the structure of the deal, not the nature of the property.

If you look at Pub. 535, in Chapter 3, Rent Expenses, there's a section on conditional sales that pretty much uses the same criteria without any statement of whether it's real or personal property.

"The purpose of this Revenue Ruling is to state the position of the Internal Revenue Service regarding the income tax aspects of the purported leasing of equipment for use in the trade or business of the lessee." This sentence leads me to believe that this ruling is only addressing the lease or sale of "equipment for use ina trade or business", but maybe I should assume the IRS really intends this ruling to cover a much broader range of items.

[BOB W]

I dont think this is a rental issue but a disguised installment sale. The buyer wants to deduct against ordinary income the purchase of the real estate. At the end of the term period who would not buy the property for $1. The seller must be desperate to sell to go along with this concept.

[JoshinNC]

Actually

I dont think this is a rental issue but a disguised installment sale. The buyer wants to deduct against ordinary income the purchase of the real estate. At the end of the term period who would not buy the property for $1. The seller must be desperate to sell to go along with this concept.

The buyer is the one that wants to treat it as a sale and the seller wants to treat it as a lease.

[BOB W]

What could be his reasoning?

[JohnH]

Maybe theres a credit problem. Seller really wants to sell, price is very good, but buyer can't get financing. So seller is willing to do a variation on "owner financing" but would keep his expenses lower if he has to evict rather than foreclose in the event of a default. I'm just guessing here, but have seen similar situations in the past. Incidentally, none of them every played out favorably.

[JoshinNC]

Sale Treatment Equals Deductible Interest

If the lease is considered a sale, from the leasee/buyer's side, the interest paid is deductible mortgage interest (second home). The seller does not yet own the property. Basically, the seller is going to buy the property and immediately enter into a lease/purchase option with buyer. This way the bank will front the money to the seller to buy the property (at say 3%) who will then enter into the lease/purchase option at an imputed rate of 5%, so seller pockets the 2% spread over the life of the lease/loan.

[Gary2]

If the lease is considered a sale, from the leasee/buyer's side, the interest paid is deductible mortgage interest (second home). The seller does not yet own the property. Basically, the seller is going to buy the property and immediately enter into a lease/purchase option with buyer. This way the bank will front the money to the seller to buy the property (at say 3%) who will then enter into the lease/purchase option at an imputed rate of 5%, so seller pockets the 2% spread over the life of the lease/loan.

That explains the buyer's motivation, but what about the seller's. If he treats it as a lease, he winds up paying tax on the full amount as ordinary income, and then offsets the principal with a capital loss at the final closing. Unless he has passive losses to use up, or is planning on a separate capital gain in ten years time (hardly likely), it seems like a losing strategy for him. Or maybe he thinks he can't get financing if it's treated as a sale for tax purposes, or it's harder to foreclose than evict, or similar - all of which should be referred to a local real estate attorney who also understands the tax issues.