Hey guys, it's Clint Coons here.
And in this video, I'm going to teach you how to not screw up your next lease
option agreement that you're using to sell your piece of real estate.
Okay, let's get started.
All right, so lease options are really where I'm going with
this video is I want to talk about the tax consequences of entering
into a lease option agreement and where you can get yourself
into some tax issues by not setting them up the right way.
And I
and the reason I thought about bringing this up
is that I've had a number of clients contact me recently
because if you look at the market, interest rates have gone up.
So it's harder for people to qualify now for mortgages.
So what are they looking to do?
Well, they can't come in and buy the property today.
Maybe mortgage rates will go down in the future
and they can qualify for that loans.
They're looking for a way to get into a property
and have homeownership and not make it an outright sale
where they're buying it from you initially.
So what you're going to do is you're going to enter
into a lease option agreement with them where you're going to
they're going to show a track record.
They're going to be paying you
for a set period of time and they're going to give you a little extra money.
They have the ability to buy that property from you at a set point in the future.
That's called the option agreement.
So simple scenario would be, hey, I'm going to lease you this piece of property.
I'm going to charge you $1,000 a month.
We agree that within two years you can buy the property
for $400,000 or its current fair market value.
The greater thereof.
I just gave you a hint there.
When you put together your option agreements, you want to use that language
where a situation where a client, their tenant, DBA, valued
the property through certain actions that they took on the property itself.
That made the property worth about a third of what it would have been worth
had they not done this and they were able to close on the property at that
that massively reduced price.
So you want to put in there fair market value.
You also want to have in there a do not commerce waste clause.
I mean, there's a video just on that alone.
But anyways, so it's two years out and then they're going to pay
you a set sum of money to be able to buy that property for $400,000.
Maybe that that's going to be
you charge them $15,000 to to
lock that in 400 or the current fair market value the greater thereof.
That's how a lease option works.
Now the elements to that right.
When you when you enter into a lease option, you have the purchase price.
We'll just call that that's 400 K.
Okay, you have the option money.
In my example, it's $15,000 and then you have the rent, okay.
Because there's two, two parts of this, there's a purchase in the future
and there's the current lease that's going on.
So the rent is 12 K a year.
And the reason why I want to go through this
before I talk about the tax issues that can come up with your lease options
is so that you have a clear understanding
of how options work from a tax standpoint.
So when I enter into this agreement because I haven't sold it yet
on a lease option
I normally make in 12 year $1,000 a month from the individual,
plus they're giving me 15 K upfront
to lock in the property at 400 K two years
from now for K or fair market value right greater thereof.
Now when I entered in this agreement, they write me a check for $15,000.
All right, this money here is tax deferred.
Okay?
We don't have to report this income yet.
This income gets deferred until the two year point
or until that off or until this person screws up and they violate the agreement.
You kick them out of the property.
So until something happens where they're no longer
eligible or they close on it, you don't have to pay tax on that money
that's tax free in your hands or tax deferred that is now the rent.
Okay, this is income to you. Okay.
So when you rent out your property, this is income.
Now, of course, you can use depreciation to offset your income
because you're still the owner of the property right now
that you've when you've entered into this agreement with this party,
to have the ability to buy that property from you two years out.
So generally speaking, this is the way it works on the front end.
And then when you sell, let's say the exercise it and 400
is the purchase price at that point in time.
Then when you sell now this is going to be long term capital gains.
So be long term capital gains, most likely 20%
in your hands on the gain, not the full 400.
So if I bought that property, my basis in it is 200, then the capital gains.
Long term capital gains would be based on 215 K is what it's going to be.
Where did that 15 come from?
Well, that's
when you pay taxes on that option money again, you're going to pay taxes on it
because it gets added into the the sale price.
So it's $215,000 at 20% if they exercise and they buy it from you.
But that's two years out.
Okay. So where does the problem come in?
And there can be a couple areas where you can screw this up
and it's going to create immediate tax consequences for you when it comes in.
How you structure your deals.
Because I've seen investors do this before.
They want to give assurances to the tenant that, hey,
this is going to be your property. I'm going to entice you to come in.
I want you to buy the property from you.
So I'm going to build it in to make it, you know, it's
not a sale, will treat it as an option, but really is the sale.
Those are the problems you have in court cases.
They always look at that.
What is the intent of the parties?
And you can say
your intent was to treat it as a straight up lease with an option to buy
and that it's not an installment sale.
But the IRS can look at and say, No, you really entered
into an installment sale.
If you don't know what that is.
That means that you've sold it today and you're getting paid out over time
with the balloon payment in two years.
If that's the case, then you have immediate income
recognition on those those payments you're receiving.
And depending on what you are,
if you're a dealer in real estate, if you flip property,
you may be in a situation where that entire amount of that purchase
price is taxable in year one, even though you didn't receive it.
So you got to be careful.
So let me just show you some examples of where people can screw this up
and if they get audited, the IRS will come in and put the finger on it.
So let's assume that we have a property.
Going back to my example, $400,000. All right.
That's what that that purchase price is going to be.
And we tell the tell the person that's coming here want to enter
in this lease option with us.
We want $10,000 down for option.
That's the money you got to give us the option agreement
and we're going to charge you
for this property
$5,000 a month, 5ka month.
All right, so excuse me.
This is the fair market value of the property right here.
It's for an okay, so I'm going to charge you $5,000 month with $10,000 down.
But in year two, when we sell the property.
So when I sell you the property,
the purchase price for you is going to be 270 K.
So two years from now
when you exercise your option, the purchase price will be to 70.
Now remember, the fair market value is 400,
but I'm going to agree to sell to you in two years, 4 to 70.
So how did we arrive at that number?
What we did is when we approached this individual
who wants to get into this property, we said, listen, pay us $5,000 a month.
That's $60,000 a year.
So you're going to do this for two years at 60 K, that's $120,000.
Now we're going to add in the option money.
So that's going to bring this up to 130.
And then we're going to take the $400,000, which we agreed the property's worth.
I'm going to deduct the $130,000 that I've collected from you
over the past two years.
And that leaves a total grand owing on this deal of $270,000.
What did you just do?
You entered into a sale, right?
You're trying to put a, you know, a different
take on it, call it something else.
But now it looks like a duck. Talks like a duck, walks like a duck.
It is a duck.
And that's what we have here.
So in this scenario, the IRS, if they audited you, they would say, hey,
you sold this property in year one.
And so I'd be careful.
You know, you don't want to structure deals like this
where you're reducing the fair market value.
If they see that, hey, there's this huge reduction, they know you're crediting it.
The other
giveaway here, too, is the rent look at 5ka month
maybe in that area, $400,000 house.
It's going for $800 a month.
So we know right away, hey, this is way above our monthly market rate.
So this is definitely a sale and it's not a true lease option agreement.
We're releasing the property to someone
and then at the end of the lease, if they want to buy, they can buy.
Now, we intended to sell it to them today.
Now, people can spin this another way as well.
They can agree to keep that purchase price
at $400,000.
So I've seen them set up this way before.
They'll say, Oh, no, no, we're going to sell to you for $400,000.
Right?
But what we agree to do, if you exercise that option in year two,
we're going to take what you paid us over the course of two years.
As long as you're current on all your payments
and you make these payments, we will give you a credit for $130,000.
So at closing, you're only going to pay us 270 on the purchase of that property.
So again, if you look in the lease option agreement, if you get audited,
the IRS looks at it and they say, all right,
let me see what your your option terms were.
It says there's going to be a credit for everything that you were paid.
That is a sale.
Now, another issue that I've seen come up before, you know, people again,
investors are always trying to get creative.
And a lot of times you'll see this
if you're dealing with property, if you're going to introduce
a lease option for commercial property or maybe undeveloped land,
you set it up and you say, all right,
I'm going to sell you this property
for $500,000.
Right now, when we enter into this agreement,
we're going to I'm going to charge you 2ka month rent.
Okay.
So that's your rent on a monthly basis and you're going to pay me a 50
K option fee for this.
But here's the other thing.
You're going to invest $400,000 into this property to develop it.
So now you've got somebody coming into the deal
and they want to enter into what's called a lease option with you,
but they're going to make a massive investment into this property.
And then in two years out, they get to buy it for $500,000.
Now, you could just look at this deal and you know something's off here, right?
Because if I had this tenant
invest $400,000,
okay, almost the entire value of the property into this deal.
What is the value of that property now?
Easily, let's say it's a mill, right?
Easily. It'd be $1,000,000.
You put $400,000 in, you're going to get the equity in there.
So it's worth a million bucks.
But in two years they get to buy it for 500 K.
This is a scenario where the IRS might look at it and say, all right,
the intent here was to sell the property, but structure it as a lease.
So this business owner that's in this deal right away doesn't have to take
ownership, can do all their investing to get this up.
And of course they get to write off the cost of the lease in depreciated.
So there's a scenario where they would say
this is definitely a sale and it wasn't a true lease option.
So if you ever have, you think you can structure where you just give them
the ability to make this huge investment that can be a problem as well for you.
So what actually would work if you wanted to do a lease option
with someone you wanted to sell your house on a lease option
where it's
going to work out the best for you is when you use reasonable terms.
All right. So you set it up and you say,
let's assume my example again, it's $400,000.
Is that that purchase price of
we charge $20,000 for the option.
All right.
And then on a monthly basis that maybe the market rate
is $800 a month, but I'm going to charge you 20 $500.
Okay.
I'm going to charge you 20 $500 a month.
And I'm going to credit you
$700 towards
your purchase price if you choose to, to go through with this.
Now, if you look at this, it's not it's not a lot relative to the overall terms.
We've increased by 700. We're giving them a credit.
So it's still in a scenario there.
We in this area where it's not an outright sale,
they're not fully invested to the point where, you know, oh my gosh, they've got
what's at 700 times 12, 86, $17,000 it would give up plus the option money
if they walk away.
It's a lot different
than the scenario where I gave you before, where they give up 120, $520,000
if they walk away or $400,000 improvements here, it's a lot less.
So the IRS is then tend to respect this type of arrangement
because it's more in line with what someone may be willing to pay
for an option to get into a piece of property
to see if they can't build up a little bit of cash.
Maybe you structure it depending on your scenario
where, hey, this is going to be held in reserves.
So if you go back with maybe credit back 50% of this
to you or something like that, if you don't go through with it.
So you can get creative here
as far as trying to entice people to come into these lease options
because they definitely want to help them out.
And you want to sell your property, you want to move it,
you want to collect rent on the front side.
But it's important that you keep it in that context
because when you enter into lease options, remember how those numbers work out.
As far as taxes, you don't want the IRS to come in and say,
hey, this is a sale because at 20 K that money to you is is free money right now.
Right. You can take that and you can reinvest it.
You have to pay taxes on it until that that two year mark.
So the tax side of the lease options, it can be a little confusing,
but it really comes down to don't be too creative here, make it look like a sale,
because if you do get audited, it's going to get compressed down on you
and you're going to have to pay taxes
and penalties for not accurately reporting it.
It guys, hope you learned something there about lease options.
Be sure to check out the show notes from for some important links
about other content that I have on my channel.
And you can then, if you like, sign up for my upcoming
tax and asset protection event. Take care.