How lease option deals affect income taxes

Unlike traditional rent or purchase agreements, lease option deals offer investors and tenants little in the way of obvious tax benefits. How do these agreements work tax-wise and what pitfalls should you avoid?

During the course of the lease, the tenant is still the tenant. Until he or she buys the property from the landlord – who applies the lease-option fee and the rent premium (or credit) toward the purchase – they cannot deduct monthly rent payments from his income taxes (unlike mortgage interest and property taxes).

Since many tenants never consummate the sale, they wind up forfeiting the option fee and the rent premium, both of which are nonrefundable. However, if you use a corporation to purchase a lease option – then sublease the home to yourself but don’t complete the sale – the corporation can take the option and rent premium money it paid to the landlord as a capital loss.

Landlords have an easier time earning tax benefits. If a landlord sells his personal residence using a lease-option, then they may exclude up to $250,000 of the gain on his income taxes (the Internal Revenue Service raises this limit to $500,000 for married owners). Note, however, that the IRS considers some investors as dealers, which significantly alters tax treatment.

Make sure that your lease-option deal is actually a lease-option deal and not a disguised sale. In other words, the price of the home should stay the same over the course of the lease. If the purchase prices decreases over a long period of time – and the tenant can purchase the home for a nominal amount at the end – that could spell tax trouble.

Finally, both landlord and tenant should work with local, reputable professionals with experience in lease-option tax treatment.