Lease w/option to buy

[Jesse]

Client is leasing a building w/business for $2,000/month with option to buy for $155,000. She's got 2 years to decide and if she does opt to purchase the lease payments will go toward the purchase price. If she does not opt to purchase she walks away at the end of the two years with nothing.

I'm thinking that this is a bonafide lease and not a disguised sale so can I deduct these lease payments in full?

[Matt Sova]

Lease with option

I would deduct the payments as rent expense, if she does decide to buy at the end of 2 years the purchase price will be reduced thereby reducing the basis in the building.

[Unregistered]

I think you would still have to capitalize the payments. If the deal falls thru you can take the loss. with the reduction of payments your still getting a good deal in the end.

[Bees Knees]

I think you would still have to capitalize the payments. If the deal falls thru you can take the loss. with the reduction of payments your still getting a good deal in the end.

I disagree. IRS Pub 527, page 2 under the heading “Lease with option to buy” says the following:

“If the rental agreement gives your tenant the right to buy your rental property, the payments you receive under the agreement are generally rental income. If your tenant exercises the right to buy the property, the payments you receive for the period after the date of sale are considered part of the selling price.”


In other words, until the client actually decides to exercise the option to buy, the payments are considered lease payments and are currently deductible. Once the option to buy is exercised, then payments made from then on must be capitalized as part of the purchase price.

[Unregistered]

I think you would still have to capitalize the payments. If the deal falls thru you can take the loss. with the reduction of payments your still getting a good deal in the end.

I agree. You have to treat the transaction as either a sale or a lease. It would be awfully nice to be able to start out as a lease then change your mind later, but it won't fly. If it would, everybody would be doing it to get a much quicker write off of assets instead of having to use those pesky depreciation recovery periods.

[Jesse]

Thanks for the opinions

I'm w/ Matt and Bees Knees. I don't think this is a disguised sale, but I wanted to make sure there is not something else that I might be missing.

If at the end of the lease the option to buy for $1.00 or if the option to buy ran for 6 1/2 years at which time the building would be paid in full it would be different.

[Guest]

Any

other thoughts?

[Unregistered]

Various court cases look at the facts and circumstances. In this case since the sale price is determined at the beginning and all of the payments reduce the ultimate price it's a purchase. Some of the payments (including the final payment)should be characterized as interest and the cost reduced accordingly.

[abby]

have to agree with Bees

An option to buy commonly includes the agreed price - it is a primary reason to have an option to buy - to obtain a set price over a period of time.

If the Taxpayer can walk away without obligation, then the payments are rent until the option is exercised.

It is very different from a lease agreement with a nominal buyout that is correctly treated as a sale.

[Bees Knees]

An option to buy commonly includes the agreed price - it is a primary reason to have an option to buy - to obtain a set price over a period of time.

If the Taxpayer can walk away without obligation, then the payments are rent until the option is exercised.

It is very different from a lease agreement with a nominal buyout that is correctly treated as a sale.

That is what IRS Pub 527 says. I also found several court cases that came to the same conclusion. Until the option to buy is exercised, it is a lease. The only exception is when the purchase price at the end of the lease term is of nominal value or way below FMV.

[Armando Beaujolais]

That is what IRS Pub 527 says. I also found several court cases that came to the same conclusion. Until the option to buy is exercised, it is a lease. The only exception is when the purchase price at the end of the lease term is of nominal value or way below FMV.

I disagree with Mr. Knees on this one.

IRS Publication 535, "Lease or Purchase."

"There may be instances in which you must determine whether you payments are for rent or for the purchase of the property. You must first determine whether your agreement is a lease or a conditional sales contract. Payments made under a conditional sales contract are not deductible as rent expense."

The pub goes on to define "conditional sales contract," saying:

" Whether an agreement is a conditional sales contract depends on the intent of the parties..."

The criteria you cited in this discussion are legitimate, but they're not tests. They are facts and circumstances that "may" indicate a lease vs. a conditional sales contract.

The determining factor is the intent. If the clear intent between the parties is to buy/sell, it's a conditional sales contract. I'd bet the reason that courts tend to find that these arrangements are usually leases is because the cases that get to that stage are cases where the intent is not clearly laid out.

No clear intent: Usually a lease. Clear intent: Conditional sales contract.

The factors cited do not come into play unless the intent of the parties is unclear.

[Bees Knees]

I disagree with Mr. Knees on this one.

IRS Publication 535, "Lease or Purchase."

"There may be instances in which you must determine whether you payments are for rent or for the purchase of the property. You must first determine whether your agreement is a lease or a conditional sales contract. Payments made under a conditional sales contract are not deductible as rent expense."

The pub goes on to define "conditional sales contract," saying:

" Whether an agreement is a conditional sales contract depends on the intent of the parties..."

The criteria you cited in this discussion are legitimate, but they're not tests. They are facts and circumstances that "may" indicate a lease vs. a conditional sales contract.

The determining factor is the intent. If the clear intent between the parties is to buy/sell, it's a conditional sales contract. I'd bet the reason that courts tend to find that these arrangements are usually leases is because the cases that get to that stage are cases where the intent is not clearly laid out.

No clear intent: Usually a lease. Clear intent: Conditional sales contract.

The factors cited do not come into play unless the intent of the parties is unclear.

Mr. Beaujolais,

Please re-read the posts before spouting off irrelevant facts. Who mentioned anything about the parties intending for it to be a purchase? It is a lease with an option to buy. Since when is an option considered an intended purchase? Isn’t the very definition of an option something that could go either way?

The Pub you are quoting from deals with disguised sales, not options to buy. There is a difference. Disguised sales are contracts made to look like a lease with the intent clearly to be a purchase. A lease with an option to buy is not a disguised sale, unless the purchase price at the end of the lease is below market value or nominal.

Please re-read Pub 527 on Lease with Option to Buy and explain why that Pub says it is a lease until the option is exercised.

[Unregistered]

Lease

A lease with an option to buy is not a disguised sale, unless the purchase price at the end of the lease is below market value or nominal.
I don't want to but in, but on the original post, the sales price is $155,000, but after the two years lease, the purchase price will be $107,000. Isn't that below market value?

[Bees Knees]

A lease with an option to buy is not a disguised sale, unless the purchase price at the end of the lease is below market value or nominal.
I don't want to but in, but on the original post, the sales price is $155,000, but after the two years lease, the purchase price will be $107,000. Isn't that below market value?

Yes, and after two years if it is still a lease with option to buy, then it may very well become a capital lease. But not in the beginning, which is what the original post was asking. The person had two years to decide. A substantial reduction in FMV does not occur until towards the end of the two year period.

[JON]

Appreciate Bees and Pal-but

I think unregistered has a great point. Would like to hear more input. My practice usually only deals with operating and finance leases. We capitalize financing leases-determining factor is the "nominal" buyout at the end and operating are left as leases. Somehow I would question the example where the buyout after two years is $48,000 lower than the purchase price. Unless you can show the market lease rate is approximately $2,000 a month. With real estate you can always have the installment sale and repos' with appropriate gains or loses at that time....