Real Estate Lease Option

[S T]

I have a Schedule C business client that is renting a facility for the last 20 years, is responsible for all repairs and maintenance to the property, The taxpayer has been trying to purchase from the owner who is elderly for the last 5 years and many legal documents have been entered into, but not honored by the owner/seller.

For what ever reason (partially capital gains tax and depreciation recapture) the elderly owner has delayed selling this real estate property to the taxpayer once again, but has suggested the following offer.

The new offer is that the elderly owner will continue renting/leasing to the taxpayer at $2,100 per month, and that one half $1,050 per month will go to the reduction of an agreed on purchase price, the taxpayer will be named as the beneficiary of the property at the owner's death. The other half $1,050 will be classified as rent.

I have advised the taxpayer to make sure that a real estate/contract/estate attorney review the documents before the agreement is signed. I not only have concerns about whether or not or how the taxpayer can inherit this property and receive the benefit of value of the cumlative $1,050 per month times however many months (until the seller passes away), for the reduction in purchase price,

but the more immediate tax question is how for current tax purposes, is the $2,100 ($1,050 applied to cumalitive purchase price and $1,050 for actual rent) treated on the tax return?

Thanks for any insight and suggestions!

Sandy

[taxxcpa]

Disguised sale

I did some research on this a few months ago. As I recall, this would probably be an installment sale. A lease with option to buy would be treated as a rental if the buying price were not reduced to less than its market value as a result of the lease.

However, if the rent were the equivalent of installment payments, going toward the reduction of the principal amount that would be due upon exercise of the option, then it would probably be classified as an installment sale.

You really need to see a real estate lawyer, since there is more to it that what I've mentioned above--and looks more like a legal question than a tax question.

[S T]

Disguised Sale Possibly

Thanks Taxcpa, my client (taxpayer) is the lessee, potential buyer. I have already advised my client (taxpayer) that the supposed offer/deal is fraught with potential pitfalls and have advised that he seek and pay for competent real estate/contract attorney advise.

It is the seller (not my client) that keeps bringing to the table these very strange scenarios, which I suspect is to try to beat the "taxman". The seller is 79 years old and from what we can discern between he and his advisor does not want to pay any taxes now while he is alive.

My concern is and how to apply to my taxpayer the potential buyer:

1. the structure of the lease payments, now changed to monthly rental after 20 years and only one half applied to rent? How does that affect the tax writeoff for my Schedule C client? Rents only equal one half of $2,100 or $1050,

2. If one half of monthly payment is to be applied to a "future" application to the purchase price how does that affect my Schedule C client in current year and future years? What do we do with the other one half $1,050?

3. Agreed upon sales price on date of death of seller (and we do not know when that will be). How does that enter into the equation on my taxpayer (buyer) side. Can we amortize some type of a lease option? What if it doesn't materialize?

Sandy

[Golden Rocket]

All or Nothing

Sandy, I don't believe there can be a half-and-half treatment. It is either ALL rent, or ALL debt service, as the case may be.

Firstly, there is a compelling need for your client to get a lawyer. There needs to be a contract that is binding and enforceable on BOTH parties, not something that transpires at the option of the owner. If there is no contract, there is no point in reading into the next paragraph, because there will be no criteria to determine anything.

I'm going to lean a little bit into GAAP, and ask for some help from CPAs here. The contract is either all rent or all debt service. The determining factor is whether there is at some point during the "lease", an option for the buyer to close the deal at a bargain price. If so, this is a purchase. If not, it is rent. It is "simple" as that.

"Simple" is what comes out of various discounted cash flow formulae, prevailing interest rates, length of the contract, and in your particular case, possibly even the life expectancy of the lessor. When I was studying lease/buy situations, a "bargain price" would be where the value of the buyout was less than what would result if the remaining contract were discounted at a percentage rate less than 2/3 of the current prevailing rate. Tax treatment followed GAAP for these purposes, and I assume still does.

In this case, the "remaining life of the contract" is the "remaining life of the lessor," so it is indeterminate. I don't know whether cranking out the formulas would allow "average life expectancy" to substitute for the remaining life or not.

If a purchase, there would be an amortization schedule showing the portion which is interest over the life of the loan. It would be Sch A deductible interest, regardless of what the landlord calls it, and he would have to claim it as income.

Again, it is helpful to enlist the aid of a CPA sometimes -- they have to study this stuff to pass their exam, and many of them use the concept on an everyday basis. You might look up Guido Van Der Hoeven at nearby North Carolina State. A good guy, and I'll bet he is top of this like dragonflies on a swamp. I'll admit to not knowing enough to help any further in this situation, speaking for myself.

But unless your client has a document binding on all parties, he is wasting everyone's time, especially yours.

[S T]

Just trying to find an answer

GR I agree, the best place for this client to go is as fast as possible to an attorney, but we all know attorney's most often times look at only the legal aspect not the underlying tax aspect.

So trying to get some damage control in front! At least from a tax perspective. No I am not practicing legal!

Based on what was presented to me, and this is not the first scenario, my taxpayer is at a real disadvantage. He really wants to consumate a deal on the purchase of the real estate that he has been leasing and improving for the last 20 years, but the owner seems to have an upper hand! And the owner of the property likes to change the terms at each ending option even though there is legal binding document in place.

My taxpayer's attorney comes back and states it will cost you $375 for me to write another letter or document, but you (taxpayer) can go to court and sue and it will cost you approximately $20,000 or more to enforce the prior document.

Oh by the way this taxpayer of mine, this is not the first "unusual" contract that he has entered into. What do you think the outcome is in reality. Yes you got it, My taxpayer usually loses and it costs him a fortune. He just doesn't seem to get it! Deals are not deals!

It is a no win situation, and I just know my taxpayer will lose, even with what I posted above, and particularly when this seller will eventually pass on. The handwriting on the wall is that one of the sellers heirs will contest whatever is in place.

I am just trying to provide my taxpayer with the tax ramifications right now, as in current for tax planning in 2008, as that is when the new agreement can/or will take place. Maybe that will hit him in the "pocket book" and he might take another glance at the "so called good deal"

Ugh!

Sandy

[Golden Rocket]

Tax Ramifications

Sandy, if your presentation to your client is without perusal of an enforceable document, you will not know whether the agreement qualifies as a lease or a purchase.

Maybe the client should simply engage the attorney to pursue, even at the cost of $20,000, as I'm almost certain his equity position would be this much if he wins. But I'm not a lawyer either. I do believe the next agreement I signed would contain reimbursement of legal costs if enforcement had to be pursued in court. Of course, the owner would not want to sign it, as it would totally destroy the strategy he has been using. Sounds like he has been dodging his end for 20 years, and your client has simply grown older waiting on this old codger to deal fairly, instead of pursuing something different.

Good luck, my friend. It doesn't sound good.

[abby]

don't know if this will help

Sandy, you are usually so thorough, that you've probably already reviewed this, but wanted to point you towards this thread in case there's anything that might help shed light on this sticky situation:

http://www.thetaxbook.com/forums/showthread.php?t=535&highlight=option

I was reviewing page 2006 Pub 535 pg 9 about what makes a conditional sales contract depending on intent of the parties - no single test or special combination of test apply.

So, issues of intent aside, if your client can get the owner to agree to create a true option to buy, so that part of each payment is applied to reduce the final purchase price IF he chooses to exercise the option, rather than the contract applying part of each payment to final purchase price now, then you would have rent until the option is excercised.

I understand that his intent is to buy the property, but perhaps having an option that he can walk away from will also protect him in the end, since he has a history of losing in this relationship.

[cpadan]

I agree that there are some flaws in the landlord’s proposal. But before you send the client scooting off to a lawyer, I would review with him how this could be best set up for him tax wise.

It sounds like the landlord is willing to work with him by restructuring the lease and even to will the property to him! I believe the best situation for your client would be to continue to lease the property and then inherit it. The payments would be 100% deductible as rent. Your client would want some assurance that he is indeed on the will; that could be a delicate issue depending on his relationship with the landlord.

The option the landlord proposed might work if he were to sell ½ interests to your client on installment and continue leasing the remaining ½ which your client would inherit. I don’t see anything wrong with that off the top of my head.

After you have come up with a plan that works for your client it's time for him to see a lawyer.

Good luck
Dan

[DTS]

Sandy

Are the legal documents you mentioned in your original post sales contracts? If so, why hasn't your client pursued this and made the owner adher to his agreement? I understand he may not want to ruffle feathers, so I'm just curious about the reason he won't pursue this before now.

Dennis

[S T]

Past Documents

Taxpayer and Owner of Property have signed several option agreements which have contained expiration dates and were drafted by an Attorney.

Each time, when Taxpayer is ready to exercise the Option to Purchase the Owner of the Property comes up with a new plan or an excuse, etc.

Taxpayer's attorney has advised that the Option Agreements are legal and binding, however, to pursue with an action against the Owner of the Property, it would be tied up in court and cost a minimum of $20,000 in legal fees and court costs.

The current option is expiring on 12/31/07, taxpayer discussed with owner of property and is ready to exercise, taxpayer even has the 20% down payment in the bank and has already received preliminary loan approval for the balance.

Owner of property came back and said no, and thereby the new scenario as posted above.

Sandy

[Golden Rocket]

Sell It

Sandy, is this property in California?

Let's focus on the binding contract that expires 12/31/07 -- the one which would cost $20,000 to enforce. Your client should sell this purchase contract to Pacific Gas & Electric at a discount.

NOW let's see the landowner squirm out of this one! He gets to choose his neighbor. He can either have your client or PG&E. If PG&E is not interested try Roth Tannery - a tannery uses chemicals which cause people's eyes to water for days. Jordan Rabbit Farms is another potential buyer, etc. etc.

[DTS]

Choice

I think GR's suggestion is great!

Without wanting to sound like a hot-head, I would haul that landlord into court in a heartbeat and make him live up to his agreement with me. This is assuming my attorney told me I had a fairly solid case. If I win, all attorney's and court fees are on the landlord. I would not feel like I could let this pass, $20,000 or not, assuming that figure is accurate.

Has your client expressed his comfort zone to you?

Dennis

[S T]

Passive Taxpayer

This taxpayer of mine for 20 years, is relative passive. Part of that is the business that he operates, which is Developmentally Disabled Homes, under State of California. So there are some licensing issues, as the licensing is not only for the Administrator/Owner, but also the Property that they provide for the "Residents".

As mentionned the taxpayer has operated this home for 20 years, and is cautious due to the Calif State Licensing, It is my understanding that the licensing is non-transferrable, so to move to a new location involves a lot of issues and paperwork with State of California, and if he has to move the facility to a new location it might not be approved, and this is a profit making venture. Therefore the taxpayer is passive with the owner of the property, whom I do believe understands that he possibly has the taxpayer "over a barrel" so to speak. Besides, the taxpayer has had to put forth all of the expenditures on the property according to the Calif State Licensing requirements, so there have been a lot of improvements to the residential property.

From a tax standpoint (as that is my function) not from a legal standpoint, I want to be able to provide enough information to the taxpayer, so the taxpayer can meet with his attorney for the legal aspects, and then present a new "agreement" to the owner once again.

My guess, and I am not a betting person, but if history repeats itself, the new agreement will also expire, or if the owner passes away in the interim, there will be another issue and this taxpayer still will not receive the property. There are some children of the property owner, so I would suspect they would intercede if they don't inherit the property. I could be "doom and gloom" but going with my feelings, I just don't see how this taxpayer will ever acquire this property!

So I am really focused on how to structure the current lease payment for the best advantage for the taxpayer. The attorney can worry about the legal issues!

Sandy

[S T]

Thanks

Abby, thanks for the link, I missed that one. A lot of great information, so I am leaning toward the fact that no matter what, I think this taxpayer is just entering into another lease option once again, which probably won't come to fruition.

On the surface anyway, it would seem, until the document might be prepared by the taxpayer's attorney, it will still be a lease option, not a conditional sales contract.

Sandy.

[joanmcq]

I would've scooted off to court in an instant as long as the contract was solid. $20,000 in recouperative legal fees isn't much when you consider he's paying $25,200 in rent a year and being strung along.