More Tax and Record Keeping Q's

[CC Rider - MI 0]

I’d like to pose a few questions, (none of which are really new to this Forum) to anyone who has actually closed a few deals and correctly reported taxes. This is the best I understand things so far based on previous posts and my own investigations.

 

[it is understood that the true owner reports rents received on Schedule E, and an investor uses C and SE for all moneys in and out; except if a sale doesn’t happen then expired option moneys get reported on D as either a cap gain or loss:]

 

This “simplified” example has just a seller directly dealing with a T/B (this makes more sense if you follow along with a sheet of paper):

 

Pretend a seller paid 100,000 for a house and a T/B agrees to an option with a strike of 130,000. The T/B pays 4000 option money (2500 of which to be used as downpayment, 1500 used to lower the purchase price). He also spends 18,000 in rent, of which he earns $8,000 rent credit (his lender allows 3000 as downpayment, 5000 to lower PP). At the closing, the official, recorded purchase price will be 130k – 1500 – 5k = $123,500. The seller pays taxes on the full rental income during the term, which includes both rent credits and non-RC portions. In the absence of a lease purchase agreement, the seller would owe on a $30,000 gain on an outright sale. However, with a LO agreement he has already pre-paid taxes on 8,000 of that gain in the form of rent.

 

1) True or false: The seller must adjust his cost basis by subtracting any option money used to lower the purchase price, and adding back any rent credits used as downpayment (100k – 1500 + 3k = 101,500). This leaves him with $123,500 (the official, recorded sale price) – 101,500 (new adjusted basis) = $22,000 in capital gains, which should be correct since he already paid on 8k of his 30k.

 

1B) [i am operating under the assumption that the official, recorded sale price cannot be adjusted. Your state and IRS will receive statements showing the sales proceeds. And your tax return had better match those figures in sales proceeds column.]

 

2) True or false: Years later when the T/B sells the property, his cost basis should start at the original agreed upon price (strike price) of 130,000. If he uses 123,500 his “gain” will include 6500 that really didn’t occur. The buyer’s actual cost to purchase was the official price of 123,500 PLUS those option money and rent credits applied to lower the purchase price in advance, totaling the option price of 130k.

 

From the sandwich lease-option investor side of the equation:

3) True or false: Assuming a sale goes through, there is no need to make mention (to the IRS) of option money received, or spent, IF those amounts are used as downpayment money. Because that money doesn’t affect the official, recorded purchase / sale price it will automatically be captured within the sales proceeds and taxed properly. In other words, option money used as downpayment is invisible except in terms of your records and closing escrow.

 

4) True or false: If, however, the option money is used to lower the official purchase price, then that amount also needs to be subtracted from the seller’s cost basis for the house (otherwise he won’t pay tax on it.)

 

5) Record Keeping: Somehow these rent credits and option considerations are “carried on the books” as either a liability (RC granted to your T/B ) or an asset (RC earned from seller, if any). What does this mean? What books? What standards or rules are we supposed to follow to make these books official to any potential audit?

 

Rhetorical: As an aside, since the official, recorded purchase price is actually less than the agreed upon purchase price (due to credits and option money used to lower the price), doesn’t your state get upset at lost property taxes / assessed value?

 

Why do I keep trying to review the tax aspects of this business, instead of the worry-about-it-later attitude? Because in addition to having the responsibility of telling people to seek professional tax advice, I believe you / we have a responsibility to at least have a REASONABLE understanding of the tax implications of the transactions you are selling to your customers.

 

Responses appreciated. Thanks.

[-Tony- 0]

CC Rider - MI,

Could you start over you lost me right after "I’d like to pose a few questions".

[ctrmrz31 0]

This Tony guy is really a handful!

I guess we will have to threaten to send him back to the inlaws in never never land. I know this got your attention Tony!

Only one thing I will need buddy, their (inlaws) address.

Hee! Hee!

Cruz or Brandon?

[CC Rider - MI 0]

All right, the post was quite dense, so I'll take it slow.

 

Using the numbers in the example above (4th paragraph), what does each person write on his tax returns for:

 

Seller's Cost Basis?

Seller's Sale Price?

Tenant / Buyer Cost Basis (in the future when he sells)?

[MichaelC 160]

Patience, boys. The man with the answers will be along soon enough with his usual insight into these tax matters.

[Dave T 0]

[it is understood that the true owner reports rents received on Schedule E, and an investor uses C and SE for all moneys in and out; except if a sale doesn’t happen then expired option moneys get reported on D as either a cap gain or loss:]

Generally true, though an expired option is always a short term capital gain for the seller, but could be either a long or short term capital loss for the tenant/buyer.

 

Pretend a seller paid 100,000 for a house and a T/B agrees to an option with a strike of 130,000. The T/B pays 4000 option money (2500 of which to be used as downpayment, 1500 used to lower the purchase price). He also spends 18,000 in rent, of which he earns $8,000 rent credit (his lender allows 3000 as downpayment, 5000 to lower PP). At the closing, the official, recorded purchase price will be 130k – 1500 – 5k = $123,500. The seller pays taxes on the full rental income during the term, which includes both rent credits and non-RC portions. In the absence of a lease purchase agreement, the seller would owe on a $30,000 gain on an outright sale. However, with a LO agreement he has already pre-paid taxes on 8,000 of that gain in the form of rent.

 

1) True or false: The seller must adjust his cost basis by subtracting any option money used to lower the purchase price, and adding back any rent credits used as downpayment (100k – 1500 + 3k = 101,500). This leaves him with $123,500 (the official, recorded sale price) – 101,500 (new adjusted basis) = $22,000 in capital gains, which should be correct since he already paid on 8k of his 30k.

If the strike price of $130K is reduced by $8K in seller concessions (rent credits) then the buyer is really only paying $122K. The option consideration already paid reduces the amount of cash needed at the settlement table, but does not change the amount that the buyer is really paying for the property. If the contract price becomes $122K (strike price reduced by rent credits) with $4K credit given to the buyer as a prepayment (option consideration and downpayment), then the seller will receive a net profit of $22K. This is the seller's taxable profit. The seller's cost basis remains at $100K. The buyer's cost basis is the contract price of $122K.

 

In the event that the lender does not allow the buyer to treat option consideration as a partial downpayment, then the seller's contract sale price will be reduced further. If you grant the seller only $1500 in option consideration, then in this example, the contract sale price becomes $120,500. The seller's cost basis, however, is reduced by the amount of option consideration received and becomes $98,500. The seller's taxable profit is still $22K ($120,500 minus $98,500). The buyer's cost basis is $122K ($120,500 contract price is increased by option consideration given).

 

When the lender allows the buyer to apply option consideration and rent credits to the down payment, then there is no adjustment to sale price. The buyer's cost basis is reduced by the rent credit only and becomes $122K. The contract sale price is still $130K, but the seller's basis is increased by the amount of his profit for which taxes have already been paid (rent credit given). In this example, the seller's cost basis is increased from $100K to $108K. Now, subtracting his adjusted basis from the contract sale price, the seller's taxable profit remains at $22K.

 

Caution: When you only charge a market rent, lenders may not allow a rent credit at all. It is best to only offer rent credits for the amount that would exceed market rents for your area.

 

2) True or false: Years later when the T/B sells the property, his cost basis should start at the original agreed upon price (strike price) of 130,000. If he uses 123,500 his “gain” will include 6500 that really didn’t occur. The buyer’s actual cost to purchase was the official price of 123,500 PLUS those option money and rent credits applied to lower the purchase price in advance, totaling the option price of 130k.

The owner's initial cost basis will be the amount actually paid for the property. In my previous response to the first question, the T/B's cost basis for the property is always $122K for your example.

 

From the sandwich lease-option investor side of the equation:

3) True or false: Assuming a sale goes through, there is no need to make mention (to the IRS) of option money received, or spent, IF those amounts are used as downpayment money. Because that money doesn’t affect the official, recorded purchase / sale price it will automatically be captured within the sales proceeds and taxed properly. In other words, option money used as downpayment is invisible except in terms of your records and closing escrow.

True, but only when the option consideration paid is credited as a downpayment on the settlement statement.

 

4) True or false: If, however, the option money is used to lower the official purchase price, then that amount also needs to be subtracted from the seller’s cost basis for the house (otherwise he won’t pay tax on it.)

True.

 

5) Record Keeping: Somehow these rent credits and option considerations are “carried on the books” as either a liability (RC granted to your T/B ) or an asset (RC earned from seller, if any). What does this mean? What books? What standards or rules are we supposed to follow to make these books official to any potential audit?

This is a question for your CPA. For tax purposes, you do not recognize option consideration as income until the option is exercised or the option expires. In the meantime, you need to reflect the receipt and/or payment of option consideration in your bookkeeping system to make your accounts balance.

[CC Rider - MI 0]

Dave T -

 

Thank you for taking the time to sift through my complicated questions. Believe it or not, now that I've had time to digest your answers, I believe we are in agreement on almost all facets of the transactions.

 

The one area we appear to differ is the effect of rent credits that are used to lower the purchase price. I still assert that all money a buyer pays (option, rent credits, plus balance due at closing) should be included in his cost basis, which always equals the strike price.

 

Consider 2 identical deals: 130,000 strike price; 4,000 paid for option, and $8000 earned in rent credits. Buyer #1 goes to Lender A who says all moneys can be used as downpayment. #1 is delighted and (following your answers above) his cost basis remains at 130,000. Buyer #2 goes to Lender B, who says the option money can be used as downpayment, but all rent credits must go toward lowering the official purchase price. Again, following your examples above, Buyer #2 basis will be $122,000, despite the fact that he paid the seller (or investor) that $8000 to contribute toward the purchase of the property, from his own pocket. When #2 later sells, he will be taxed again on that same $8k - and that's not right.

 

Why should the buyer's cost basis (and his future tax obligation) be decided by the lender who decides how to apply those credits?

 

Just looking for opinions from those out there who have struggled with these questions........

[Dave T 0]

The one area we appear to differ is the effect of rent credits that are used to lower the purchase price. I still assert that all money a buyer pays (option, rent credits, plus balance due at closing) should be included in his cost basis, which always equals the strike price.

The problem for me is that the buyer is not "paying" for the rent credit, instead it is a seller concession. As a condition of the lease, the tenant agreed to pay a certain amount of rent. This money was paid as rent and is not refunded if the tenant-buyer fails to exercise his option.

 

To induce the tenant-buyer to complete the purchase, the seller may offer a "rent credit", but also increases the strike price to compensate for the credit given. The rent credit does not take any money out of the seller's pocket, and does not increase the actual amount of money the buyer pays for the property.

 

Consider 2 identical deals: 130,000 strike price; 4,000 paid for option, and $8000 earned in rent credits. Buyer #1 goes to Lender A who says all moneys can be used as downpayment. #1 is delighted and (following your answers above) his cost basis remains at 130,000.

If you follow my answers above, the buyer's cost basis is $122K. The $130K contract price is reduced by the amount of the seller concessions to arrive at the buyer's cost basis -- which just happens to exactly equal the amount of money needed at the settlement table.

 

Buyer #2 goes to Lender B, who says the option money can be used as downpayment, but all rent credits must go toward lowering the official purchase price. Again, following your examples above, Buyer #2 basis will be $122,000, despite the fact that he paid the seller (or investor) that $8000 to contribute toward the purchase of the property, from his own pocket. When #2 later sells, he will be taxed again on that same $8k - and that's not right.

During the lease term, the tenant agreed to pay a certain amount of rent. Rent is a personal housing expense and would have been paid even if the tenant-buyer did not exercise his option. The seller does not lower the rent, if the tenant-buyer decides to withdraw from the option agreement. The seller keeps all money received as rent, and is under no obligation to refund the amount of the promised "rent credit" if the option is not exercised. The buyer is not paying any more than $122K for the property, and the seller is not receiving any more than $22K profit from the sale.

 

I think you are also using strike price and contract price interchangeably. In your option agreement, you specify the strike price and the conditions under which the strike price could be reduced (such as offering a partial credit for rent paid and giving a credit for the non-refundable option consideration). When the tenant-buyer decides to exercise the option, then you draw up a purchase and sale agreement showing the actual price to be paid for the property after all the "price reductions" are taken into consideration.

 

If you follow the separate lease and option agreement structure Michael provides in his course, all concessions are applied to the "strike" price to reach a lower "contract" price for which the property is actually sold. The buyer must still get his required funding and come up with the downpayment his lender requires for the actual contract price.