How to avoid a L/O looking like a sale?
Ok, you L/O to your buyer..... lets say term is 42 months.... basically at the end of the term of the lease you want to sign the tile over to them.
However, if you do that cant it appear as a sale .........
What would be the best way to handle this so that its not deemed a sale till the end of the lease or something like that
Great question!
Your problem here is a tax question. If the strike price of the option (i.e., the amount to exercise and purchase the property) is negligible or very small, the IRS will consider it a "deep in the money" option and will treat the option as a sale on the date the L/O was signed. In that case the L/O is treated as an installment sale and you would have to report gain each year. The problem is that if you were depreciating the property and claiming the rent as income, it may be difficult to go back and amend your tax return if the statute of limitations has expired (generally 3 years). Therefore, you can't even claim the lower capital gains tax on the installment sale since the transaction is now outside the statute of limitations.
I would recommend that the L/O is structured so that there is more than a 20% amount for the strike price at the end of the term of the lease. That way you will be within the IRS guidelines for capital versus operating leases. The other suggestion would be to have a provision in your L/O stating the tenant is not treated as the owner for tax purposes until the option is exercised. While that provision is not binding on the IRS, it does show the intent of the parties which would look favorable to a court if you would ever have to litigate the issue. The other thing would be to ensure that the term of the lease is not greater than the life of the improvements. If you are dealing with commercial or residential property, you want a term less than 30 years and if you are dealing with mobile homes, probably a term less than 7 years.
Hope that helps,
Taxjunkie