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CC Rider - MI

Reporting and Classification Q's

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For the Taxman -

 

I have more than a few questions regarding lease optioning, but I'll just put down a few starter questions relating to taxes; and my apologies if these are repeats from other member questions. [The underlying assumption here is your lease option deals are not recharacterized as sales.] I ask the following from two investor's perspectives; one from a person who may negotiate 1 sandwich lease deal per year, and the other from one who enters 10-12 sandwich or assignments per year:

 

Does the IRS consider you a "dealer"?

For any simultaneous / double closing you participate in, are you considered having "bought and sold" the property? That is, are you deemed having owned the property, even if only for a minute?

What form do you use to report option considerations received and spent?

What form do you use to report monthly rents received and spent; and do you report only non-rent credits?

What form do you use to report your final net received from a closing?

 

The way I see it, and perhaps why I am confused:

If you use Schedule C, you are asserting you are running a business and owe self-employment tax (in addition to income tax?). This is the form a dealer would use. And being labeled a 'dealer' is not what the investor wants.

If you use Schedule D, you are treating your contracts like investments, possibly justifying net amounts paid as your basis, and net amounts received as your "sale" - dubious figgerin'. This avoids employment issues, but your contracts are not standard tradable, negotiable instruments.

If you use Schedule E, you are claiming to be the landlord / owner of the property. A sandwich lease specialist wants nothing to do with actual ownership of property. More than one or two sales identifies you as a dealer or broker. The danger is then selling without a license or being registered.

 

How do sellers / homeowners report their option consideration received, rents received (what form(s))? Are sellers "Active Participants" in the management of their property? Is the investor an "Active Participant" in the management of the property, since the contract pawns off all repair and maintenance to the tenant / buyer?

How do your tenant / buyers report their option consideration paid, and rents paid, if at all (what form(s))?

 

 

I am just looking for guidance so I know what I may be getting into.

 

Thanks

CC

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Does the IRS consider you a "dealer"?
I take a very conservative approach in answering this question. Others may be more aggressive and give you a different answer.

 

The IRS uses a facts and circumstances test on each transaction -- even if you only do one transaction this year, your sale is a dealer disposition.

 

If the only business you do is sandwich lease options, or assignments, then you are dealing in real estate. As such you are engaged in a business whose product (inventory, or stock-in-trade) just happens to be real estate. In the absence of a business entity, your income and expenses would be reported on Schedule C and your self-employment taxes would be calculated on Schedule SE. My answer stays the same whether you do one deal per year or one deal per month.

 

For any simultaneous/double closing you participate in, are you considered having "bought and sold" the property? That is, are you deemed having owned the property, even if only for a minute?
Yes, you will be in the chain of title even though your ownership may be a very short period of time. In a sandwich lease, you are exercising your option to purchase the property from your seller at the same time your buyer is exercising his option to purchase from you. You have to purchase the property you are selling -- hence a double closing is required.

 

 

What form do you use to report option considerations received and spent?

What form do you use to report monthly rents received and spent; and do you report only non-rent credits?

What form do you use to report your final net received from a closing?

Option consideration is not "realized" income until either the option is exercised or the option expires. If the option is exercised, then the option consideration becomes part of the sale proceeds. If the option expires, I would tend to report the option consideration as a short term capital gain, while others would report it as other income on Schedule C. The end result is the same as both treatments are at your ordinary income tax rate. Your tax advisor may find some advantage in reporting income from expired options on Schedule D.

 

Monthly rents received are income reported on Schedule C and Schedule SE. Rent credits are not reported on your tax return as expenses, but are carried on your books as an accrued liability that reduces the contract sale price of the property. If the option expires, then the accrued liability is zeroed.

 

As I mentioned in the answer to your first question, the net proceeds from the sale of your lease option property is reported on Schedule C and Schedule SE.

 

If you use Schedule C, you are asserting you are running a business and owe self-employment tax (in addition to income tax?). This is the form a dealer would use. And being labeled a 'dealer' is not what the investor wants.
My assertion is that you ARE engaged in a business and are subject to self-employment taxes. Being a "dealer" is not a stigma here. You are a dealer to real estate. The problem with being a dealer is that you run the risk of tainting your legitimate investment property sales and having them reclassified as dealer dispositions. If you do not own any real estate as long term rentals, then you are in no danger of having the sale of one of your long term rental properties recharacterized as a dealer disposition. If you plan to hold long term rentals while you are also pursuing sandwich lease options, then conduct each activity from within a separate business entity. Keep separate books and separate bank accounts. Now the "dealer" status has no affect upon your rental activities' tax treatments.

 

If you use Schedule D, you are treating your contracts like investments, possibly justifying net amounts paid as your basis, and net amounts received as your "sale" - dubious figgerin'. This avoids employment issues, but your contracts are not standard tradable, negotiable instruments.
We get back to the crux of the problem -- the facts and circumstances underlying each transaction. When you engage in a sandwich lease option deal, you are not purchasing property for the production of income (as though you were the owner-landlord for property you own), but instead, you are contracting to act as a master tenant with the right to sublet the property until you decide to exercise your option to purchase. The landlord-seller in this arrangement would report his income and expenses on Schedule E, you report your income and expenses on Schedule C and Schedule SE, your tenant-buyer is a renter with no tax benefits of ownership until after the option is exercised and he becomes a homeowner.

 

The only way, in my opinion, to take investment property tax treatment on Schedule D, is to sell your option to your tenant buyer. If the option was held longer than one year, then the sale of the option is the same as the sale of a capital asset and the proceeds from the sale of the option would be reported on Schedule D as a long term capital gain. If your tenant-buyer exercises his option, forcing you to exercise your option with the landlord-seller, then you are back to ordinary income tax treatment on Schedule C and Schedule SE. Again, just my opinion.

 

The danger is then selling without a license or being registered.
My counter-argument is that you are acting as a principal in the transaction, buying for and selling from your own account. I don't see a real estate licensing issue here at all.

 

How do sellers / homeowners report their option consideration received, rents received (what form(s))? Are sellers "Active Participants" in the management of their property? Is the investor an "Active Participant" in the management of the property, since the contract pawns off all repair and maintenance to the tenant / buyer?

How do your tenant / buyers report their option consideration paid, and rents paid, if at all (what form(s))?

The landlord-seller is renting out his investment property until the option to purchase is exercised. By default, rental activities are a passive activity regardless of the level of active participation. Some active participation is required if the taxpayer wants to offset net passive losses from real estate rental activities against active (ordinary) income. The definition of active participation is broad enough that very few "management" decisions are actually needed to qualify for active participation. Reserving some decisions for the approval of the landlord is sufficient for "active" participation. Don't confuse active participation in a passive activity with "material participation" in a real estate business which converts passive income into active (ordinary) income and profits on the sale of property into ordinary income. These are two completely separate animals with completely different tax treatments.

 

As we discussed earlier, the investor in sandwich leases is engaged in a business and "active participation" in the same context as the landlord-seller is not applicable because no Schedule E is involved for the investor.

 

Option consideration paid by the tenant-buyer (whether that is you, or your sub-lessee) is simply "on deposit" and no tax treatment applies until the option is exercised or the option expires. If the option is exercised, option consideration paid is added to the cost basis of the property. If the option expires, then the individual receiving the option consideration has realized a capital gain, while the individual giving the option consideration has realized a capital loss. There is one tax attorney with whom I have corresponded whose interpretation of the tax codes is that the consideration realized from an expired option is always treated as a short term capital gain regardless of the actual option period. I suggest you consult your own personal tax advisor if this situation applies to yourself.

 

Rents paid by the tenant-buyer are not deductible by the tenant-buyer. They are simply personal housing expenses for which no tax benefit derives.

 

As always, the foregoing reflects my personal opinion and is presented for information purposes only. This information should in no way be construed as either tax or legal advice. Please consult a tax professional for specific details.

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Dave-t,

 

Don't get me wrong but

 

Option consideration is not "realized" income until either the option is exercised or the option expires. If the option is exercised, then the option consideration becomes part of the sale proceeds. If the option expires, I would tend to report the option consideration as a short term capital gain, while others would report it as other income on Schedule C. The end result is the same as both treatments are at your ordinary income tax rate. Your tax advisor may find some advantage in reporting income from expired options on Schedule D.

 

it sounds like the IRS would not even know about this unless you tell them. Like I said don't get me wrong I would be more then happy to pay uncle Sam (that just means I am doing deals). It just seems there is allot of things that someone with less integrity could get away with...

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Taxman -

 

Thank you for the very detailed response. I am printing this page to keep in my binder for future reference and so I can digest it more thoroughly. Lots of sound opinion (notice I didn't use the word 'advice'). I will look more deeply into the distinction between being a dealer, a real estate agent, or a principal in a deal.

 

I am taking a very cautious approach before engaging in this type of business. Counter arguments to pursuing lease options I've come across include: special laws apply if you do more than one or two deals; licensing requirement if you sell more than one or two properties; most lease options could be recharacterized as sales from first day of the lease and therefore trigger a whole pant-load of problems; and there is no specific mention of when to report option consideration in the IRC - most assume you treat like stock options, supposedly not true. Feel free to express additional opinions on the subject. When I've heard enough and done enough due diligence, I'll proceed.

 

CC

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I am taking a very cautious approach before engaging in this type of business.
Always a good idea. But, having said that, I think you are over analyzing this business, CC.
Counter arguments to pursuing lease options I've come across include: special laws apply if you do more than one or two deals; licensing requirement if you sell more than one or two properties;
Who said this? I've done two deals in a week and I haven't run into any problems. And I'm going back about eight years with lease purchasing. Licensing? Unlikely. If you are operating as a principal in the deal, why would we ever need a license to sell a property we have an interest in?
most lease options could be recharacterized as sales from first day of the lease and therefore trigger a whole pant-load of problems;
I'm neither an attorney nor a tax expert, but I pay others who are. I have to believe they would be advising me against this business if I were running afoul of the law. The information you are hearing, well intentioned as it may be, is not accurate.

Heck, well know attorney Bill Bronchick invests in real estate with lease options. He even wrote a course on how others can do the same. Surely, he wouldn't risk his reputation using a technique that is so fraught with risk, nor publish materials advising others how to do so.

Due diligence is fine, CC, but don't cross the line into Paralysis of Analysis. My two cents....

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Option consideration is not "realized" income until either the option is exercised or the option expires.

 

it sounds like the IRS would not even know about this unless you tell them.  Like I said don't get me wrong I would be more then happy to pay uncle Sam (that just means I am doing deals).  It just seems there is allot of things that someone with less integrity could get away with...

Tony,

 

How will the IRS ever know? Let me count some of the ways:

 

1. Your tenant-buyer tells the IRS. Option consideration paid by your tenant buyer who allows the option to expire is claimed as a short term capital loss on the tax return he files with the IRS. I suppose the IRS could try to follow the money trail if the tenant-buyer's return were ever audited.

 

2. Informants also tell the IRS for reward money. Have a spat with your significant other (or co-worker, etc.), make him/her mad enough at you, and you could get reported to the IRS for alleged tax evasion. I have heard that rewards are as much as 10% of the taxes recovered.

 

3. Anyone to whom you mention this tax "avoidance" treatment, and who tries this himself, will point to you for his defense. "Tony" told me he has been doing 10 of these a year for the past five years and you guys never said it was wrong". Not only will this guy get a free pass, but the IRS gets a bigger fish to fry.

 

4. Simply asking the question in an open forum such as this one may get your return flagged for audit. IRS agents are real estate investors too, and may visit forums such as this one.

 

5. You, yourself, might also let the cat out of the bag. Suppose you are engaged in sandwich lease options, you report your income and expenses on Schedules C and SE, but never report receipt of option consideration for your business. The IRS auditors know that the standard practice in structuring a lease option includes option consideration. Fail to report it, and you may have just told on yourself.

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