Tax Advice for a "Lease Option".

[Kim LeJeune]

Hi,

I have a house that is owned fully by me (no mortgage) that I created a lease option on with a lessee. The FMV is about 165k. I received a 15k down payment and am receiving monthly payments of $1578 for so many years. I pay the insurance. In the paperwork, I show that the lessee receives a small credit towards the purchase price. The credit per month increases over time...a type of amortization if you will. At the end of his lease, it will be paid on and he can "buy it". Can anybody advise me on how to treat this for tax purposes? If I've made mistakes with the structuring of this, please go easy on me, but if you have tips for next time, please do advise. I'm mainly concerned right now with how to handle this with my taxes. Thanks in advance.

[Michael Plaks]

@Kim LeJeune

I have to assume that it was a rental house, as opposed to your personal residence or a flip.

Each monthly payment has 3 components: 

1. interest - taxable as ordinary income
2. return of your principal - not taxable
3. capital gain - taxable at various rates

Your down payment has components #2 and #3.

Interest should come from an amortization table. The formula dividing the taxable and non-taxable portions of the principal is not for manual calculation. It should be handled by your tax software or, better yet, by an accountant.

You also have an option of paying the entire capital gain upfront, which is usually not to your advantage, however in some situations it could be.

[Eamonn McElroy]

@Kim LeJeune

The economic reality of the contract must be examined to determine whether you have a purchase option or deemed sale.  To do that we'd need to examine the contract and the various other factors e.g. the intent of the parties, actual lease payments vs fair market rents, etc.  Different tax ramifications stem from each treatment.

Not enough info in your OP to make that determination.  I recommend you retain a tax professional.

[Kim LeJeune]

@Eeamonn McElroy

The lease price is in line with other FMV lease prices...definitely within 10 percent. The intent of both parties in the contract is as stated. Mine is to allow him to purchase after all payments are made and his is to purchase. If for some reason he backs out of the deal, he does lose everything he's put in. Does this help?

@Michael Plaks Thanks for the advice.  Which form would this be claimed on?  

Also, curious as to what difference it makes if one would be living in the home prior.  What does return of principal mean?  Does the mean that the amount that I’ve invested in the house can be paid back without being taxed?   Technically, if that is the case, I wouldn’t be profitable until several years down the line.  

[Eamonn McElroy]

@Kim LeJeune

It does help, however my intent was not to solicit more information but rather to illustrate the dynamics at play.  Again, I recommend you retain professional assistance if you are not comfortable with the tax reporting obligations and tax treatment.

Best of luck.

[Michael Plaks]

@Kim LeJeune

If you lived there and sell shortly after (within 3 years), you may not owe capital gain tax.

When you ask about the form, it sounds like you intend to wrestle with forms. Don't. It is a job for tax software and accountants. The questions you ask are good ones, but they cover too much territory to answer in an online post.

PS. Forms involved are 6252, 4757, Sch B and Sch D.

[Eamonn McElroy]

@Kim LeJeune

Michael is assuming the transaction is a deemed sale and his advice reflects that.  It's premature to make that conclusion.  We have to start at step 1: "does this contract create a purchase option or is it a deemed sale?"  If the former, Michael's advice is not applicable.  Can't stress it enough...engage a professional familiar with these situations.

[Kim LeJeune]

It’s not deemed a sale.  It’s a lease with the option to purchase at the end of the term. 

[Tony SanFilippo]

Quote from @Kim LeJeune:

It’s not deemed a sale.  It’s a lease with the option to purchase at the end of the term. 

Kim, Can I ask what happened with your lease option and how the taxes worked out for you?