1031 Exchange With Lease Option

[Hitman712sc 0]

I understood the 45 days and 180 days period for straight sale/exchange. But what about lease option? Is it considered a sale once the lease is signed? I don't think so, but want to be sure because I plan to buy the house and lease option it out.

 

Also, What is the function of the exchange once the exchange/transaction is completed? Thank you.

[Brian - L.V. 0]

I understood the 45 days and 180 days period for straight sale/exchange. But what about lease option? Is it considered a sale once the lease is signed? I don't think so, but want to be sure because I plan to buy the house and lease option it out.

 

You're right about the lease option. It's not considered a sale until the option is exercised. At that time, you can 1031 the gains from the sale into a similar investment property (not a personal residence).

 

Also, What is the function of the exchange once the exchange/transaction is completed? Thank you.

 

If I understand what you're asking, the purpose of the exchange is to defer paying taxes on the gains that you've received. Does that answer your question?

[Hitman712sc 0]

If I understand it correctly, the exchange is an account. I was concerned about servicing fees and stuff. thanks

[Dave T 0]

hitman, I don't think you have a clear understanding. Let me summarize a couple of points.

 

A forward exchange does involve a qualified intermediary who places your exchange funds into an exchange escrow account. The escrow account is needed to facilitate the exchange. The qualified intermediary (your escrow exchange agent) does charge a fee to provide this service.

 

Fees are nominal, around $750 in my area, and a small price to pay to defer taxes on several thousand dollars. On my last exchange, my escrow exchange agent deposited $100K into my escrow account. $750 was a drop in the bucket compared to the capital gains tax and the tax on recaptured depreciation I would have paid in a taxable sale.

 

However, I believe the question is moot. You said that you intend to buy a property then sell it (on a lease option). In my opinion, this is a dealer disposition. The property is not eligible to participate in a 1031 exchange in the first place.

[Hitman712sc 0]

In my opinion, this is a dealer disposition.  The property is not eligible to participate in a 1031 exchange in the first place.

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Now am confused. Would you explain? But I think what you're referring to is dealer property, such as builder's inventory of new homes. We're retail investors. Please clarify. Thanks

[Dave T 0]

You are right. I am referring to dealer property. But you need to look to the IRS definition of a dealer disposition to see what is considered dealer property.

 

The IRS defines a dealer disposition as "any disposition of real property held primarily for sale to customers". Since your intent in acquiring the property is to resell it (for profit), you are engaged in a dealer disposition. Hence, even though you may only have one property in your "inventory", that property is dealer realty.

[Hitman712sc 0]

The IRS defines a dealer disposition as "any disposition of real property held primarily for sale to customers".  Since your intent in acquiring the property is to resell it (for profit), you are engaged in a dealer disposition.  Hence, even though you may only have one property in your "inventory", that property is dealer realty.

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Hmmm...Thanks Dave.

[Brian - L.V. 0]

Not that it's necessarily a horrible thing, but to avoid the dealer distinction you'd have to acquire a property and then just do a straight rental? Even though you're right when you say that the intention is to immediately "sell" the property, a LO is considered a rental but you're just giving them the exclusive right to purchase for a set time in the future. Being that it's not considered a sale by the IRS, wouldn't this circumvent the dealer distinction?

 

If this is not the case, what can we do help shelter the gains if we can't 1031?Thanks for your help, Dave!

[Dave T 0]

Brian - L.V.,

 

The determination of who is a dealer to real estate and who is an investor is a subjective process, clarified somewhat by a lot of case law, but subjective nonetheless. The case law fairly well describes that the determination of a dealer disposition is largely based upon the facts and circumstances of the transaction itself with the taxpayer's intent at the focal point of it all.

 

If the taxpayer's intent in acquiring the property is to sell it for a profit, rather than holding it (indefinitely) for the production of income or for long term appreciation, the IRS will classify the sale as a dealer disposition. The holding period does not matter either, even if the resale happens more than one year after acquisition.

 

There is one case I read about where a taxpayer purchased some raw land and immediately put it on the market. When the land did not sell, the taxpayer just told the real estate agent to keep the listing open and active indefinitely. The listing was maintained for 10 years before a sale occurred. The IRS classified the sale as a dealer disposition, maintaining that the taxpayer's intent was always to sell the property as evidenced by the open and continuous listing for ten years. Since the property was always held out for sale, the IRS prevailed in court. The taxpayer was denied any tax treatment normally available to an investor.

 

With this case in mind, it is not too hard for me to draw an analogy to the lease option transaction. When the taxpayer acquires a property, then quickly markets it for sale, we all agree that the taxpayer is flipping the property and the sale will be a dealer disposition. Well, what if the taxpayer used a lease option technique to facilitate the sale of his recently acquired property? Isn't this still a flip?

 

In my mind it is. The intent all along is to sell the property. The lease option is just a device to facilitate a delayed sale. Because, by the very nature of the option, the "buyer" can purchase the property at any time during the option term, it would be extremely difficult for you to convince me that the property is not always for sale until the option is exercised.

 

Remember, in tax court, the IRS is presumed to be right, it is the taxpayer's duty to prove that his position is correct. When the pattern of activity is to always market recently acquired property for sale (by lease option), how can the taxpayer convince the court that his intent was anything other than to act as a dealer to real estate?

 

Holding the property out as a straight rental for one year before entering a lease option agreement may cloud the situation some more. But here again, if the IRS sees this pattern of activity (probably during an audit, or when a whistleblower calls attention to it), the taxpayer's general reluctance to hold any property for the long term production of income may be inferred as intent to hold the property primarily for sale to customers -- again a dealer activity.

 

Understand that I am just giving you my opinion. I tend to take a very conservative position in tax issues because I want everyone reading my posts to understand the way the IRS could view this strategy. Now that you know the IRS may disqualify investment tax treatment of lease option sales for recently acquired property, you and your tax advisor can discuss the risks involved if you decide to take an agressive tax position.