Is a Lease with an Option to Buy a Home Right for You?

As interest rates rise and economic uncertainty abounds, many people have decided to lease their homes rather than buy them outright. But some renters may have a road to home ownership—through a lease with the option to buy.

Such arrangements offer advantages to both renters (lessors) and landlords (lessees). Regardless of which side of the transaction you're on, you need to be aware of the potential tax consequences.

Nuts and Bolts

In addition to monthly rent, a lessee with an option to buy generally pays an upfront option fee and/or monthly option fees that will count toward the purchase price if the lessee exercises the option. At the end of the lease, the lessee can obtain a mortgage for the balance of the price or opt out, thereby forfeiting the option fees.

These arrangements give potential buyers who currently lack the funds for a down payment or the credit rating for an affordable mortgage a path to ownership. Lessees can check out a house and a neighborhood before committing. Plus, the buyout is usually specified in the lease. So, if the value of the home increases during the term of the lease, the lessee could benefit from a previously agreed-upon lower price.

There are upsides for lessors, too. They may be able to collect higher monthly payments and a higher price overall than from a traditional sale. The arrangements also expand the pool of potential buyers at a time it might be shrinking. Plus, lessees with an option to buy have a financial incentive to take care of the property.

Tax Treatment

Lease payments are treated as rental income for the lessor, taxed at the applicable ordinary income rate. If the lessee exercises the right to buy, any payments the lessor/seller receives after the date of sale are considered part of the purchase price.

When the lessee has paid option fees on top of rent throughout the lease term, the lessor shouldn't recognize those extra fees until the option is exercised or expires. At that point, they're recognized as either 1) capital gain (as part of the purchase price) if the option is exercised, or 2) ordinary income if the option lapses.

If the lessee exercises the option, option payments are included when calculating the tax basis for the property. This will reduce the tenant/buyer's capital gains liability (if any) if the property is later sold for a profit.

Note that the lessor also could have some tax consequences at the state or local level. For example, the lessor might lose a property tax homestead exemption and protections from rate increases that are reserved for owners who use their properties as their principal residences.

Traps for the Unaware

These tax treatments assume the IRS recognizes the arrangement as a lease, rather than a sale. That's not always the case. Certain characteristics may prompt the IRS to recharacterize the transaction as a sale, which comes with different tax treatments for the buyer and the seller.

Situations that might draw unwelcome IRS attention include:

• Contractual incentives make it very likely the "lessee" will exercise the option.
• The lease payments are significantly higher than fair market rent in the area. (That is, they more closely resemble mortgage payments than rent.)
• The lessee pays property taxes, insurance, maintenance and repair expenses.
• The purchase price is below fair market value.
• The aggregate lease and option payments approach the fair market value of the property.
• The lessee is required to make such substantial improvements to the property that the investment could be recouped only by purchasing it.
• The lease payments are credited against the option price.

The IRS will look at the totality of the circumstances, as well as the parties' intent. If the IRS deems the arrangement to be a sale, the lease and option payments are considered part of the purchase price. The IRS assumes that ownership transferred when the original agreement was executed—as opposed to at the end of the lease—so the seller isn't entitled to deductions for property taxes, insurance and other expenses.

If the property wasn't the seller's principal residence and the seller owned it at least one year before selling, the seller treats the income from the sale as long-term capital gains (or ordinary loss), which are taxed at lower rates than ordinary income. If the home was the seller's principal residence, the seller may qualify to exclude up to $250,000 of that gain from income ($500,000 if you're married and file a joint tax return).

The buyer can claim deductions for property taxes and similar expenses, as well as mortgage interest. The portion of the "lease payments" not considered interest is treated as part of the purchase price and used to compute the property's tax basis.

Proceed with Caution

A lease with an option to buy offers many potential advantages, especially in a rocky housing market. It's not without tax risk, however. Consult your SSB tax advisor to determine if the arrangement could pay off and help you avoid the potential tax traps when structuring the deal.