The Exchange Update
A Newsletter For 1031 Tax-Deferred Exchanges
Structuring an Option with a 1031 Exchange
An option is a unilateral agreement between the property owner and a potential buyer. In a typical situation the buyer makes a one-time cash payment to the owner. In return, the buyer receives the exclusive right to purchase the property at a set price during the option period.
A lease with an option to buy is a similar tool that many investors turn to as a way to move their deals forward. This structure has benefits for both parties. In addition to the payment for the option right, the property owner receives monthly rental income and the knowledge that a committed buyer is waiting in the wings. The tenant benefits by having the present use of the desired property, while locking up the future acquisition of the property at a pre-determined price.
So what does this mean in the context of a §1031exchange? Can a lease be used to extend the exchange period? How are option payments treated? Can an option be exchanged?
Lease with Option to Buy
A lease with an option to buy is a legitimate way for the property owner to attempt to lock in a buyer, and for the buyer to lock in a property.
If the property owner intends to do an exchange, the exchange typically will not start until the property is transferred to the buyer by delivery of the deed at a closing. Nevertheless, there are some situations where the parties transfer all of the benefits and burdens to the tenant/buyer before the closing, and in these cases the IRS may apply the benefits and burdens test and decide that the transfer (for tax purposes) had occurred earlier. An example of this is a lease with option payments that are so large relative to the fair market value of the property that it is a virtual certainty that the buyer will exercise the option.
What about the option payments themselves? Generally, option payments are not taxable until the option is exercised or forfeited. If the owner is doing a §1031exchange and receiving option payments that are applicable to the purchase price, most tax advisors recommend that the owners have the qualified intermediary hold the option payments. Alternatively, the owner should consider sending the option payments to the closing or escrow agent prior to the closing so that the funds can be added to the exchange proceeds. If the owner chooses to retain the payments they will be taxable boot.
In some situations the option holder may decide not to exercise the option. The option may still have value, however, especially if the current market value of the property has appreciated above the fixed option price. Can the option be transferred by the option holder as part of a tax-deferred exchange? There is not much authority dealing with the tax treatment of options or other contract rights in a §1031exchange, but interestingly, in the case that established the validity of deferred exchanges, the taxpayer received only a contract right as his replacement property.
Other issues to consider are whether options are like kind only to other options or whether they can be considered like kind to a fee interest in real estate, and whether granting an option can make the relinquished property be treated as property held for sale rather than held for investment purposes.
In summary, when financing is difficult to obtain, an option, especially when combined with a lease, can help the transaction move forward. Always consult your tax professional prior to structuring an option transaction. First American Exchange is always available to help you set up your next 1031 exchange.