Using an Option to Defer Tax Consequences

In a typical option transaction, the option writer (seller) receives a sum of cash substantially less than the desired sales price that gives the option holder (buyer) the right to purchase the real estate at a set price at some time in the future.

The option holder may exercise the option and purchase the property during the option period.

Tax Effect

If Buyer Exercises  Option

Buyer Tax Effect

If the option is exercised, the amount paid for the option is capitalized (added to)  as part of the cost of the purchased property by the buyer when the option is exercised.

Seller Tax Effect

The option seller recognizes a capital gain on the sale of the option when the option is exercised (if the property on which the option was issued is capital gain property) [Reg. 1.1234-1(a)].

If Buyer Does not Exercise the Option

Buyer Tax Effect

The option holder(Buyer) recognizes a capital loss on the lapse of the option (if the property on which the option was issued is capital gain property) [Reg. 1.1234-1(a)].

  Seller Tax Effect

If the option is not exercised, the option writer (Seller) can keep the amount paid as consideration for granting the option but has no enforceable right of action against the option holder for damages. The option grantor recognizes ordinary gain on the lapse of the option [Reg. 1.1234-1(b)].

If you have decided to move to another residence, but find it difficult to sell your present home, you may consider converting the old residence into a rental property.

One way to weather a soft residential selling market is to rent out your present home until the market improves. If you are thinking of taking this step, you no doubt are fully aware of the economic risks and rewards. However, you also should be aware that renting out your personal residence carries potential tax benefits and pitfalls.

I recommend that we sit down and review together how a rental decision will affect your income and deductions, and your tax breaks as a home seller. Depending on your situation, we may also have to review how your tax situation will be affected if you eventually sell your home at a loss.

You generally are treated like a regular real estate landlord once you begin renting your home to others. That means you must report rental income on your return, but also are entitled to offsetting landlord-type deductions for the money you spend on utilities, operating expenses, and incidental repairs and maintenance (e.g., fixing a leak in the roof). Additionally, you can claim depreciation deductions for your home. You can fully offset your rental income with otherwise allowable landlord-type deductions. However, under the tax law passive activity loss (PAL) rules, you may not be able to currently deduct the rent-related deductions that exceed your rental income unless an exception applies. Under the most widely applicable exception, the PAL rules won’t affect your converted property for a tax year in which your adjusted gross income doesn’t exceed $100,000, you actively participate in running the home-rental business, and your losses from all rental real estate activities in which you actively participate don’t exceed $25,000.

You should also be aware that potential tax pitfalls may arise from the rental of your residence. Unless your rentals are strictly temporary and are made necessary by adverse market conditions, you could forfeit an important tax break for homesellers if you finally sell the home at a profit. In general, you can escape taxation on up to $250,000 ($500,000 for certain married couples filing joint returns) of gain on the sale of your home. However, this tax-free treatment is conditioned on your having used the residence as your principal residence for at least two of the five years preceding the sale. So renting your home out for an extended time could jeopardize a big tax break. Even if you don’t rent out your home so long as to jeopardize your principal residence exclusion, the tax break you would have gotten on the sale (i.e., exclusion of gain up to the $250,000/$500,000 limits) will not apply to the extent of any depreciation allowable with respect to the rental or business use of the home for periods after May 6, 1997, or to any gain allocable to a period of nonqualified use (i.e., any period during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or a former spouse, such as a rental) after Dec. 31, 2008. A maximum tax rate of 25% applies to this gain (attributable to depreciation deductions).

Some homeowners who bought at the height of a market may ultimately sell at a loss. In such situations, the loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income-producing property, and isn’t merely renting it temporarily until he can sell. Here, a longer lease period helps an owner. However, if you are in this situation, you should be aware that you probably won’t wind up with much of a loss for tax purposes. That’s because basis (cost for tax purposes) is equal to the lesser of actual cost or the property’s fair market value when it’s converted to rental property. So if a home was bought for $300,000, converted to rental property when it’s worth $250,000, and ultimately sold for $225,000, the loss would be only $25,000.