A lease option contract is an arrangement in which a party signs a lease agreement with an “option” to purchase the property by a certain date, at a stipulated price. Sometimes the party leasing the property gives an up-front payment to the owner of the property in “consideration” for the option. During the option period, the party making lease payments is not the owner. The party receiving the lease payments is still the owner. The tax treatment for both the party making the lease payments and the party receiving the lease payments depends on the facts of the transaction.
Lessee Tax Treatment of Option
The lessee is the party making the lease payments. Because the lessee is not the owner of the property, he can’t take a tax deduction for the lease payments made unless the lease is a business lease, in which case the lease payments would be deductible as a business expense. If the lessee made an up-front payment to secure the option, this payment could be added to the lessee's cost basis of the property when he purchases the property. For example, if the lessee pays $5,000 up-front to secure the option and the purchase price paid in two years is $200,000, the $5,000 up-front fee gets added to the $200,000 cost so the cost basis for purposes of gain calculation is $205,000.
Lessor Tax Treatment of Option
The lessor is the party that receives the lease payments and is also the owner of the property. As owner, the lessor is entitled to write off the interest and taxes on the property. If he receives an up-front payment in consideration of a lease option contract, this would be reported as miscellaneous income on his individual tax return. If the option payment relates to a business transaction, it should be reported as other income on the lessor's business schedule of income and expenses.
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Lease Option Versus Installment Sale
If the payments on the option contract are excessively high, or above the estimated “fair-rent” for the area, the Internal Revenue Service (IRS) may determine that an installment sale has occurred. In that case, the IRS treats the transaction as a sale instead of a lease. The same rule applies for an excessively large up-front payment on the option contract. The facts of each transaction determine whether an installment sale has occurred or whether the transaction is a lease option. In audit, sometimes the Internal Revenue Service will rule that a lease option is an installment sale instead.
Lease option contracts are used by buyers to lock in a purchase price on a property they may not be able to buy at the current date. Typically, they get to live in the property without getting the benefit of the tax deduction that an owner has. Option contracts should be reviewed by your tax professional or attorney to verify that the contract is an option and not an installment sale. Lease option contracts are also used by sellers who don’t want to recognize a taxable sale until some future date. During the option period, they only recognize the income from the lease payments instead of a gain on the entire sale of the property.