Category: Accounting Periods & Methods; Sales & Exchanges; Real Estate
Subject: Timing of Income Recognition
Title: Lease with Option to Purchase
IRC Sections: 1001, 1234
Filename: 1388.html
Date Produced: 04/98

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer is the lessor of real property. The lease provides the lessee an option to purchase the property. The lessor as grantor of the purchase option is compensated for the option.

Issue
The issue is the character and timing of income recognition with respect to the option money (the option premium) received by the lessor/grantor.

Answers
Option money is taxed to the grantor on the earlier of exercise or lapse of the option. In other words, option money received prior to exercise or lapse of the option is not taxed until such exercise or lapse. If the purchase option is exercised, the option premium is treated as part of the sale or exchange of the real property. The character of any gain or loss is the same as the character of the gain or loss from sale of the property subject to the option. If the option is not exercised, the option premium is ordinary income to the grantor of the option at the time of lapse.

Discussion
If a lease contains an option to purchase the property subject to the lease, the threshold issue is whether the lease and the option will be respected for tax purposes. I have not reviewed any of the lease-option agreements in question. For purposes of this memo I have been directed to assume that any lease-option will be respected as such for tax purposes and will not be recharacterized by the IRS or the courts as a disguised sale or a disguised transaction of any other sort.

You have cited Virginia Iron Coal and Coke Co. v. Comr., 99 F 2d 919 (4th Cir., 1938), cert. denied 307 U.S. 630 (1938) as standing for the proposition that the grantor of an option defers taxation of the option premium until such time as the option is exercised or the option lapses under its terms. After extensive research, I conclude that the holding of this case remains valid.

I also considered whether there could be a separate, special rule pertaining to lease-options as opposed to mere options alone. I found no evidence in the authoritative literature to indicate that a lease-option is treated in a manner inherently different from a mere option alone. I conclude there is no such rule.

You have suggested that the various tax acts passed in 1996 and 1997 may have changed the results described above. I see no evidence of that. I conclude that these tax law changes did not disturb the treatment of lease-option arrangements on real property as described above.

As to the character of income recognized by the grantor, Section 1234 and the regulations thereunder control insofar as the treatment on lapse of the option is concerned. Regulation Section 1.1234-1(b) explicitly provides that income recognized by the grantor on lapse of the option is ordinary income to the grantor.