Leasing property to a potential buyer serves a variety of purposes. The structure is most frequently used when a potential buyer, for whatever reason, does not have the funds available to purchase the property immediately. The advantage to the buyer is having additional time to obtain the purchase funds (or financing) while still having use of the property. For the owner, rental income is generated while a buyer and purchase price are locked in, provided the buyer can secure the needed funds or financing within a given period of time.
Often the owner has utilized the property for business use or investment and desires to defer the gain through a § 1031 exchange once the property is “transferred” to the buyer. Lease arrangements in an exchange transaction have the potential to raise questions about the timing of the actual transfer of the property, particularly if the owner is using a lease to delay the actual closing in order to extend the exchange deadlines for identification and purchase of replacement property. Accordingly, the owner will need to make sure the lease agreement with the lessee/buyer is a true lease and not a disguised transfer of the property.
The agreement should be prepared properly to preserve the ability to exchange and defer the gain once the property is actually sold. For example, owners should check local law to make sure rental payments do not create an equitable ownership in the property. The owner/lessor should retain some of the burdens of ownership, such as paying the taxes and insurance, even if the money comes from the buyer/lessee. If any of the money is applied toward a purchase option, the amount should be reasonable. Payment of a non-refundable option may be construed as a sale if the option payment is so large that a reasonable person would be expected to exercise the option.
If the legal and equitable title along with some of the burdens of ownership remain with the owner, then the exchange has not started, even though the buyer/lessee is in possession and enjoying the benefits of the property. The owner can likely take possession of the lease payments without the risk of being in actual or constructive receipt of “exchange funds.” If any portion of the lease payments is applicable to the purchase price, the owner may wish to include those funds in the exchange proceeds. The funds should be forwarded to the closing agent prior to the actual conveyance. After closing, those funds should become exchange funds. If the owner retains the funds, they will be taxable boot. Note that having lease payments applied to the purchase price may cause the transaction to be construed as a transfer rather than a true lease, especially if the amount applied is substantial.
Sellers thinking of leasing their property or selling to an existing lessee should consult their tax advisor to determine the best structure for their particular situation.