Updated October 21, 2020:

A commercial lease agreement with an option to purchase, also known as a lease option, is a form of commercial real estate contract in which the tenant and the property owner agree that there is an option for the tenant to buy said property at the end of a stipulated rental period. The agreement usually specifies the period within which the tenant has an opportunity to purchase the rented property. The parties agree on the following:

  • Sale price and the contract period.
  • The amount of the monthly rent to be credited toward the eventual purchase.
  • Who will be responsible for day-to-day property maintenance issues.

Purchase Price

Depending on the circumstances, the legal agreement or contract may or may not include a set price. When it does, however, the price might be a value agreed upon or the value appraised at the time of purchase. During lease option contracts, the intention of the parties plays a significant role. In several court rulings, the judges have always relied on the parties' intentions in determining whether a lease option transaction can be treated as a sale rather than relying on the economic tests.

The lease option is usually upheld if, at the point of entering the deal, the parties believed that the rent charged reflected fair market rates and the option price took into consideration the future value estimate. Two elaborate factors manifest a tenant's acquisition of equity interest in a property. The first is that the sum of the option price and the rent payments must approximate the property's fair market value. Secondly, there must be evidence of rent payment in excess of the current property's fair market rental value.

Tax Implications When the Lease Option Is Treated as a Sale

There are two significant tax implications whenever a lease option is treated as a sale:

  • The nature of rent payment and option payment during the lease period are changed.
  • The timing of the property's ownership transfer is changed.

Tax Consequences on Tenant-Buyer

  • No tenant is allowed to deduct his rental payments as such.
  • Given the depreciable improvements' presumed purchase price allocated, the tenant is allowed to deduct such depreciation.
  • Income tax deduction of a fraction of the rental payments the tenant makes. This deduction is calculated under the imputed interest rules.

Tax Consequences on the Landlord as a Seller

The following are the lease-option tax consequences on the landlord as a seller:

  • The option payment is considered a down-payment.
  • The rental payments made to the landlord in the lease option are considered to be part of the selling price.
  • The re-characterized rental payments result either in ordinary loss or ordinary long-term gain.
  • The rental income, also known as ordinary income, results in sale proceeds, also known as a capital gain.
  • Since the landlord is presumed to have disposed of the property, he is not allowed to deduct any depreciation or rental expenses allowance.

Benefits of Lease Option to Tenants

As a tenant with a lease option, there are numerous benefits that you get once you enter into a commercial lease agreement with your landlord. First, the property will require repairs from time to time. In such cases, you may strike some creative deals and, subsequently, apply the value of the work against the purchase price. Secondly, the lease option gives you time to save up a down payment without losing the property. Thirdly, your lease agreement is valid as long as it is agreeable to the landlord and, as such, you don't have to move out of the property. Finally, the lease option allows you to resolve your credit problems to qualify for a traditional mortgage.

Benefits of Lease Option to the Landlord

Lease option presents significant benefits to any landlord. These advantages are as follows:

  • Since the tenant hopes to own the property someday, he will take good care of it
  • The landlord receives a non-refundable lease option fee from the tenant-buyer, whether or not the tenant ends up exercising the option.
  • Considering that a portion of the tenant's payments goes to the eventual purchase, the landlord receives higher monthly payments from the tenant-buyer.
  • The tenant-buyer takes full responsibility for repair and maintenance.
  • Should the tenant be able to exercise the option, thus purchasing the property, the sales contract will already be in place, and the sales fee would be lower.

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