by: Mike Rosenberg, CPA, Retired Partner
Options can be used in real estate transactions to accomplish a number of important tax and financial objectives, including deferring the recognition of income without deferring the receipt of cash. In situations where the potential for future appreciation of a property is speculative, options may provide a benefit in structuring intra-family sales of property as an integral part of an estate plan.
The basic distinction between an option and a contract to purchase property is that an option gives a person a right to purchase property at a fixed price within a specified period of time, but imposes no obligation to do so. A purchase contract, on the other hand, is a mutual and reciprocal obligation to buy and sell the property. The income taxation of a privately structured option contract is similar to the taxation applicable to an option contract traded in organized securities markets. Consideration received from grant of an option is not taxed until the earlier of expiration or exercise of the option. If, for example, a property owner receives on December 1, 2013 a $500,000 option payment for granting a developer the right to acquire property for $10 million within nine months from the date of grant, the option payment is not taxable to the property owner in 2013 (assuming no further action is taken in 2013), but will be taxable in 2014 either when the option is exercised or is allowed to lapse. In the interim, the property owner has full use of the $500,000.
If the developer exercises the option and purchases the property for $10 million, the $500,000 option payment is treated as part of the sale price of the property; seller reports $10.5 million in sale proceeds, some or all of which may be taxed at favorable capital gain rates. The developer’s holding period for the property begins on the date the property is acquired, not the date the option was granted, and the tax basis of the property acquired includes the $500,000 option payment.
If the developer allows the option to lapse in 2014, the $500,000 option payment will be treated as ordinary income to the property owner. (This tax treatment is different than the lapse of options covering publicly traded stocks, securities or commodities, where gain due to lapse is taxed as short-term capital gain). The developer’s loss on expiration of the option is determined by the character the subject property would have had in the hands of the developer. Therefore, if the property would have been acquired for a condominium development, the loss on lapse of the option should be an ordinary loss since sales of the condominiums would have resulted in ordinary income from the sale of inventory.
In certain instances, options can be used to facilitate intra- family sales as part of an estate plan. In general, lifetime gifts (or intra-family sales) of appreciating real estate provides overall estate tax savings because the post-transfer appreciation in value of the property gifted (or sold) escapes the estate tax upon death. The picture gets a bit fuzzy when the property’s future appreciation potential is speculative and it may not be an ideal asset for a lifetime transfer.
A possible planning technique is for the senior family member to sell or gift an option to the younger generation (or a trust for its benefit) which gives them the right to purchase the property in the future at today’s value. The future purchase of the property can be structured either as a cash purchaser or a combination of cash and installment note. The transfer of the option to the younger generation will allow them to enjoy all the post-transfer appreciation in property value, while the downside risk is retained by the senior family member granting the option. The option will simply not be exercised if expected appreciation of the asset does not come to fruition. The key issue in structuring an intra-family option transaction is valuation of the option. Valuation issues inherent in transfers of non-traded property, such as real estate, are exacerbated when the property to be valued is an option to acquire the non-traded property. A qualified valuation expert should be consulted when structuring such a transaction.
Option transactions can take on different variations and permutations which provide the icing on the cake that facilitates consummating a transaction. Careful structuring of an option is important so that the option is not treated as a complete sale for tax purposes, with the option holder treated as owner from date of the execution of the option agreement.
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