A Lease Option
A lease option, is a well-known terminology, used by estate agents and in the property world. It signifies, not only a lease tenancy, but a lease with perhaps an added extra to allow a purchase. The question asked for income tax purposes, in these lease-option transactions, is to find out, if the tenant is leasing the property, legitimately, or an instalment sale has taken place, before the tenant has decided to execute a purchase option.
In economic reality, there are lots of surrounding factors, to take into consideration, before answering this question. There isn’t just one single factor to determine, whether a lease option could be classed in economic reality as a sale. A noted tax authority, echoed these thoughts, in the Guardian, in stating factors that needed to be considered were the terms of the lease, economic circumstances, and the intention of the concerned parties. If signs lead to a conclusion that exercising the option, was there at the beginning it could be clear to think the transaction was a sale, and should be accepted as such.
A lease option, may be thought of as a sale, but beware there are tax implications.
* To transfer, the ownership of the property, may cause the timing of the transfer to be changed. With a lease that is registered as a true option ownership will be transferred, when the option is processed. If the transaction, is considered as a sale, then full ownership is transferred, when the agreement is executed by the parties.
* The option payment, and rent payment during the period of the lease, are changed by their nature.
Lease and purchase transactions, are treat differently, by the taxman. It is important to understand how the Inland Revenue Service (IRS) relate to, and register that a lease transaction maybe regarded as a sale.
A Sale or a lease option?
the tax question, basically is concerned, with whether or not the IRS will assume, and need verification, that a previous sale happened, prior to the tenant exercising the option to purchasing the property. Generally, indications, may highlight a high probability that the lease option agreement, went through as a sale, not just as a lease option. The tenant, may acquire equity in the property, while leasing, this will increase the possibility of a purchase. One way to protect their investment.
The terms of the lease
Rent payments, can be received, and are only deductible, when a tenant has no equity interest. Factors that may substantiate the fact, that a tenant is developing an equity interest in the property could be:
* The rental sum, and payments, and the option price for the market price of the property.
* The rent payment, that is much more than the market rental value of the property.
Rents that are inflated, and a below-market option price, together tend to point to an equity interest in the property. To illustrate this, and to have a clearer idea of what we mean, imagine James leases a building from John, for approximately two years, for an annual rent of £120,000. At the same time, James pays John £20,000 for an option, to buy the property. At the end of the two years, for £240,000 the lease option agreement at the time is executed, and the fair market value of the property, is £500,000 and the rental is £50,000. James gains £70,000 of equity per year over the lease period of two years. £120,000 rent payment, £50,000 fair market rent. Plus, in addition, payments made by James, which equal the property value £20,000 option payment and £120,000 rent.
Circumstances, at the time, the agreement is taken out, can confirm that the lease option, can be as a sale, and the £20,000 option payment, could be the deposit payment.
The example outlined above, would be thought of as a sale, for tax purposes. The rental amounts, are such, that the tenant is financially compelled to take up the option. The evidence, showing the raised rents, and the low option price, added together to the fair market value of the property. The option price, may be thought of a s a bargain price, but could be categorized as a sale. A large portion of the fair market value of the property, is represented by the option price. The rent payments, aren’t applicable to the purchase price, if this is acceptable, the lease option, won’t be thought of as a sale.
For more information on lease options and whether they work speak to one of our advisor’s today.