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option8

Tax implcations for sellers

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Dave,

 

Can you provide us with a high level summary of the tax implications of a Lease Option for sellers of properties that are free and clear?

 

I'm interested in a comparison of the following 2 scenarios particularly as it relates to sellers after retirement age.

 

1) If they sell it outright, what happens?

2) If they lease option the property (so it becomes a souce of investment income), what can they expect?

 

 

 

Thanks,

option8

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A lease option has two components: A lease and an option to purchase. When exercised, the option results in a sale of the property.

 

The sale of investment property (whether an outright sale, or through an option exercise) is a taxable event. The seller is liable for capital gains taxes and depreciation recapture. The maximum long term capital gains tax rate right now is 15%, while depreciation recapture is at 25%. The age of the seller and the mortgage loan amount (if any) is immaterial to the seller's tax liability upon the sale of investment property.

 

If the seller's primary residence is being sold, and if the seller meets the two year rules, up to $250K in capital gains per taxpayer can be excluded from taxes. If the seller's primary residence was used as a rental (as in a lease option) and the seller otherwise qualifies for the capital gains exclusion, only the capital gains are excluded from taxes -- depreciation will still be recaptured at 25%.

 

While the property is in service as a rental, the owner-landlord reports all income and expenses on Schedule E. In addition to property taxes and mortgage interest, the owner-landlord can deduct expenses incident to ownership and rental operations such as hazard insurance, PMI insurance, advertising, utilities not paid by the tenant, HOA/COA fees, repair costs, and maintenance costs (such as, painting, yard service, snow removal, etc.). As a bonus, the owner-landlord gets to take a depreciation expense. The annual depreciation expense is roughly 3.6% of the property's cost basis. If the owner-landlord has a net tax loss, up to $25K of these (passive) losses can be used to offset other ordinary income (before taxes) on a dollar-for-dollar basis.

 

The option consideration received is not recognized for tax purposes until either the option expires or the option is exercised. Until either of these events, the option consideration -- even though received -- is not recognized as taxable income. When the option is exercised, option consideration is included in the sale proceeds and taxed accordingly. If the option expires, option consideration received is treated as a short term capital gain regardless of the option period.

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