Intent To Rent: Capital gains vs Income Tax?

Question

Hi All,

I’ve been tossing over in my mind my current situation. I buy SFRs and use the rent-to-own model with them. My model is a little different in the sense that I treat the house more like a rental. Here’s a few examples:

1: I don’t require a large upfront non-refundable down-payment.

2: First and last months rent & security deposit are all that is needed to move in.

3: No penalty for the tenant moving on.

4: After they are approved and moved in, we pair them up with a credit repair service and local mortgage brokers.

5: We have a non-verbal agreement that we are willing to sell the house to them in 1-3 years after moving in for the appraised price at time of purchase.

I have a CPA but wanted a second opinion.

If I consistently sell homes to people that have been renting them for 1-3 years, would it be safe for it to be taxed as capital gain? Or is that viewed as an inventory situation instead and taxed as income?

Secondly, I have someone that came to me that may be pre-approved for a loan. If I decide to sell it to him upfront before he even moves in, I changed my intent from renting to selling. Since this is a holding period of waaay less than the normal one year minimum for an investment property, will it be treated as short term capital gain as my CPA says?

I don’t mind being aggressive with my taxes. I just don’t want to be stupid. Thanks in advance..

Natalie Kolodij · Answer

If it's a rental but the person has an option to buy down the road it's still a rental and capital gains.

If day 1 you officially SOLD it to them using an installment sale agreement- then that's a flip.

If you acquire it intending to improve and re-sell it that's ordinary income.

I don't think the tenant having an option converts it from a rental. Not until that option is exercised. If they had the chance to buy it day 1- then yes. If it's main "use" was rental. nah.

Mike Miller · Answer

@Natalie Kolodij

Thanks for your thoughts, I always appreciate your practical explanations. To clarify, there is no installment sale or rent credits going on. The house is simply treated as a rental till the occupant buys, which they are under no obligation to do.

Mike Miller · Answer

@Eamonn McElroy

I should also clarify that the handshake and verbal agreement is not that they will or must buy the house. It is only a consent on my part that I will sell it to no other person but them if they so desire in the future. In the meantime, they are only renting.

Mike Miller · Answer

@Eamonn McElroy

I should also clarify that the handshake and verbal agreement is not that they will or must buy the house. It is only a consent on my part that I will sell it to no other person but them if they so desire in the future.

Eamonn McElroy · Answer

@Mike Miller

I'm not seeing an option here.  A purchase option is a contract that involves value for value.  The value received by the optionor is the option fee, typically paid in cash.  The value received by the optionee is that the optionor's hands are bound -- the property may not be sold to another party during the option period.

I'd be more concerned that the IRS would assert dealer status if most of your tenants do end up purchasing your properties after 1-3 years.

Again, your CPA is in the best position to advise you on these matters.

Mike Miller · Answer

@Eamonn McElroy

A couple of clarifications:

1- We do not require or accept any option fee or down payment whatsoever. The home is treated as a rental. To move in, the tenant must have first and last months rent and security deposit. Nothing more..

2- What is a non-verbal agreement? That’s what I’m wondering as well. 😂 That was a typo, my bad.. We have a verbal agreement, a handshake agreement, just like the good old days. I have references available for them to verify my integrity, such as past tenants and home buyers. I appreciate the cash flow from renting but have no problem with them buying the house. I connect them with a credit repair company if needed and also with a mortgage broker. Predatory practices are not my modus operandi.

3- As far as I know, my way is compliant with Dodd Frank which is of obvious concern to anybody trying to do “rent to own” lease options.

Thanks for your input!

Eamonn McElroy · Answer

@Mike Miller

The case law in this area deals with the "economic reality" of the real estate option.  What this means is that if it's a true purchase option, you're in the clear.  If the tenant is deemed to have built or to be building equity however, the IRS can and will most likely re-characterize the option as a sale.  Also, structuring the option or terms of the option in a way that ensures the tenant will more likely than not exercise the purchase option lends itself more to a sale and less a purchase option in the eyes of the courts.

A few observations of concern:

"I don’t require a large upfront non-refundable down-payment."

You don't require a large upfront payment?  So the tenant can provide one and you accept it?

"We have a non-verbal agreement"

What is a "non-verbal agreement"?  A written agreement?  One ascertained via body language?  Do you have a written purchase option contract that is distinct and separate from the rental agreement?

It's not possible to give the stamp of approval based on what you laid out.  The option agreements would need to be analyzed, as well as the rental agreements, fair market rents in comparison to what you're charging, and what comparable option fees in the area go for.

I do assume you are collecting an option fee...

Your CPA is the best position to provide advice as he/she has the holistic view of your facts and circumstances.  If you want a second opinion, you should reach out to CPA firms in the slow season, and be prepared to provide documents they request.

Michael Plaks · Answer

@Mike Miller

I see no problem with capital gain treatment, based on what you described.

There is no one year requirement, which works both ways. You can have a rental for 6 months and sell it as a rental. You can also work on a flip for 2 years, and it remains a flip (a very bad one, likely, but a flip nevertheless)

Mike Miller · Answer

@Michael Plaks

Thanks, Michael,

A couple of points:

I had every intention of renting until I found out that he may be pre-qualified. At that point, I ran some numbers and decided that it wouldn’t be a bad idea if we could agree on price, etc..

Interestingly enough, I sold a potential rental in the exact same situation a year or two ago. A potential tenant made me an offer I couldn’t resist. My CPA treated that as short-term capital gain. I’m hoping the IRS doesn’t think this is a long-term business plan.

I was under the impression that case precedent has loosely determined that you should at least have the rental property for a year to show the IRS that it’s actually not a disguised “flip”.

Mike Miller · Answer

@Ned Carey

Thanks, Ned,

Yes, I am taking use of depreciation.

Intent To Rent: Capital gains vs Income Tax?

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