Lease with purchase option

[natiro]

Here's an interesting question. . .

Client is purchasing a lodge and cabins. There is a caretaker on sight who has been with the previous owner for years. The caretaker currently lives on the property. The owners will be absentee so it is necessary for the caretaker to be on the property or very close by. My client is preparing an employment agreement which, aside from all the employment related issues, says that at some future date, my client will build a house for the caretaker, the caretaker will live in it and pay fair rent and then after a year, the caretaker can purchase the home at fair value although the rent paid will be applied to the purchase price.

Under normal circumstances I don't see any problem with this. This would be a lease with an option to buy. However, the attorney is concerned that because this is tied to an employment agreement, there may be some sort of compensation issue here. That is, if the caretaker can apply the rental payments to the purchase price, in effect he would have had use of the property for a year, rent free. Assuming the caretaker would purchase the property at the end of the first year, would this cause the value of the rent free year to be compensation? As a side note, the caretaker will be receiving the same salary while living at the lodge and while renting so there will be no salary change as a result of this transaction.

Just curious to hear any thoughts on this. Thanks to all.

[Bees Knees]

Add a note to the employment agreement that the caretaker is required to live on the employer’s premises for the employer’s convenience, either in one of the rental units or this new house.

That would make any benefit excludable from income under Section 119, and you then don’t have to worry about any fair value to the lease with option to buy contract.

[Gretel]

What comes to my mind is that if employee has to stay on property for convenience of employer than employee can stay there rent free and no compensation issue involved.

Just thinking outloud though.

[natiro]

Lease, etc

Thanks for the quick response. Sorry, I forgot the MOST important point of the question. The new house will NOT be on the employer's property, but will be on adjoining land. So it's not excludable under Sec 119. Currently, the caretaker IS living on the property, so clearly Sec 119 applies.

Any new thoughts, given this info, which was uppermost in my mind but obviously stayed there when I wrote the original post?

[Gretel]

...which was uppermost in my mind but obviously stayed there when I wrote the original post?

Sorry, I had to laugh outloud because this happens to me all the time: Often I don't know if I did or said something already or if I just dreamed it or if I was just thinking.

No more new thoughts from me, though, on your new question. It's above my mind.

[Bees Knees]

Isn't the new house going to be owned by the employer? If the employer owns the property, its on the employer's premises, especially if it is adjacent to other employer owned property. Why can't you just say it is all one big property, maybe with the house way off over in the corner, out of the way of the main business activity.

Apparently, in Commissioner v. Anderson, KTC 1966-19 (6th Cir. 1966), there was a debate over whether highway patrolmen were considered to be eating on the employer’s premises, because the private business restaurant was adjacent to the public highway owned by the employer (the State). The fifth circuit ruled in favor of the taxpayer, although the 6th circuit disagreed. It appears that argument is weak, but why not an argument where property owned by the employer adjacent to other property owned by the employer qualifies under Section 119?

[Roland Slugg]

Compensation or refund?

Natiro, I believe your client has a very good attorney. As explained it sure looks like compensation to me ... or at least some form of income to the caretaker.

Was this scheme devised in order to lock the caretaker into living in the new house for another year, presumably in exchange for continuing caretaker services for the lodge property? Or is the house really being built for the caretaker and at his request, with the lodge owner acting, in essence, as the bank or borrower? By paying rent instead of living rent-free, as in the past, then getting that rent back conditional upon purchasing the new house, the whole thing looks like a financing arrangement to me. If it wasn't, the owner would just sell the house on the open market, and let the caretaker live in it ... or in other lodge property ... for free in exchange for caretaker services until it sold.

The compensation issue could probably be avoided ... assuming the new house qualifies under the free-rent-for-the-caretaker concept ... by eliminating the rent aspects entirely. The "put" requiring the caretaker to purchase the house in one year would probably also need to be eliminated, but if the whole idea is to get the caretaker into the new house anyway, he could just save up all 12 months' rent and use it for the D/P at show time.

[natiro]

Compensation

Thanks for all the interesting replies. . .and thanks Roland for addressing the compensation issue directly. My client is extremely wealthy and is buying the lodge because she owns nearby property and doesn't want anyone else to buy the lodge property and develop the land. The caretaker has been there for years and he and his wife are very happy there and would like to stay indefinitely. My client will be mostly absentee and certainly does not want to work at the lodge. I believe she's making this offer in order to encourage the caretaker to have a vested interest in staying long term. I think the offer originated with my client, and is very generous. In essence, it's really about financing the house for the caretaker. Also, there is no requirement that the caretaker buy the house after a year. It is totally up to him to stay there or not, if he wants the house (I can't imagine he won't want it. My client's husband is an architect and designed my beautiful office. . .I would move there in a heartbeat!)

The lodge is in the middle of no where and is quite beautiful. The area surrounding the lodge is not very developed and there are not that many properties with homes, since most properties include alot of acreage. It's my opinion that it would be hard to prove what the real fair market value of the house would be a year after it's built and that if they just agreed to sell it at an amount that reflects the rent already paid (for example $12,000 less than what they really think it's worth, if that's the rent that was paid), it would be very difficult for the IRS to prove that it was not sold at fair market. The attorney actually likes that concept, but can't draft that into the agreement they're signing. I don't think the rent will be all that high (I can't imagine that it will exceed $1,000 per month and will most likely be lower), so I don't think the difference in the selling price between actual FMV and FMV less the rent paid will be unreasonable. I was just in Colorado and saw a house re-listed at $90,000 less than the original asking price! So who's to say what the FMV really is?

Anyway, thank you for the discussion. I always appreciate being able to toss these ideas around! Oh, and sorry for the wordy reply!

[Snaggletooth]

Smorgasbord

Natiro, this one has a smorgasbord of issues, and in my opinion, they all have favorable solutions.

My observation is that if this property is in Oregon or Washington, it is indeed beautiful. That's about the extent of my knowledge, so I'll let others answer your post.

Just kidding - I'll add my notes as follows: The attorney is obviously better than most of them that I've dealt with - at least (s)he is cognizant of compensation ramifications. This notion of compensation is one I would like to put at rest -- A "fringe" such as this should be coupled with an employment agreement which states the employee must reside on or proximate to the lodge. Should make no difference that it is not on the lodge property -- the whole issue is that the employee is RESTRICTED as to his living quarters for the benefit of the employer. I think this would hold up even if he lived a mile away, so long as the requirement is practical, he can perform his function, and the employee lacks the freedom of choice as to his residential locale.

The next issue, still somewhat related, is whether the house will be sold at FMV or not. If sold at FMV to a willing buyer/employee then there should not be any imputed benefit to the employee and the entire concept of compensation is then moot and should not be up for discussion.

I gather from your conversation that the assessment of FMV is rather "elastic" or stated another way "Beauty is in the Eye of the Beholder." Don't count on this. All you need is an auditor to make his own assessment and [presto!!] all the burden of proof is on you!
Gather data from the tax assessor's office in that county - that should ALL be public information. Then if the sale of this house is considerably less than FMV, the spectre of compensation MIGHT arise if not effectively defrayed by the argument above.

What about "rent" and the declaration that the proceeds be applied to the purchase? I believe you realistically have to consider that a portion of the rent be considered as interest income/expense under the imputed interest rules. This alters the amount attributable to principle, which means the ultimate purchase price of the house is altered as well. However, I don't believe the IRS will assess imputed interest rules if the term is one year or less, so again, this arrangement has dodged yet another bullet. So in this instance, the purchase price can be considered to be the total amount of rents paid in one year PLUS the amount paid lump sum after twelve months.

I'll add one more possible issue, which may or may not be a factor. It's highly possible that the one-year-as-rent terms are designed to give the buyer time to get his own financing, and payment of an entire year's principle lowers the loan amount such that financing would be more attractive to a bank. If your client wishes, this is a golden opportunity to finance the amount for 8% or so and everyone would probably be happy. Your client may not wish to tie up their money long-term for their own reasons, but I'm simply throwing it out as an option -- in fact, they've probably already thought of this. Collection is virtually guaranteed from the paycheck, in fact this might even enter into the payment terms.

By the way, one of the most gorgeous spots in Oregon is Lake Wallowa in the Northeast part of the state, close to the town named after Chief Joseph. If this were the spot of the lodge, your client could probably sell ME a house!!

Regards, Ron Jordan

[OldJack]

employee???

I agree with what has been said and would add that the compensation issue and tax-free fringe benefit issue is also questioned by the fact that the caretaker appears to not have an "employee" taxable wage/compensation status that justifies the employee fringe benefit.

[natiro]

Lease, once more

Ah, Old Jack. . .another tidbit I left out of my original post. The caretaker will be paid a wage, both while living on the premises and after the move to his own house (rented or purchased. . .either way. . . .)

Thank you so much for all the responses!