Lease with option to purchase rental house

[Ranger]

New client has a rental. On June 1 2009 entered into a lease / option to buy with tenant. Tenant paid $10,000 for the option. The tenant was to make two more $10,000 payments, one June 1 2010 and one on June 1, 2011. The sale price was $105,000.

Tenant was to pay rent in the amount of $1,175. Then on May 31 2012 the option could be exercised. At the point, the original $10,000 would be considered a down payment and $1,175 monthly payments would be applied as installment payments at 6% for 120 months.

Tenant paid the original $10,000 and has paid all the monthly rental payments. However, since the two additional payments of $10,000 were not paid, the option was not exercised.

Prior tax preparer has reported all the monthly payments as rent on Schedule E for years 2009-2012.

Tenant has proposed to pay off the "balance" of the original sale price less the initial $10,000 paid and the monthly payments amortized at 6%. That would be about $64,000. The client wants to accept the offer just to get rid of the rental in a depressed market.

My question is how to account for this. The original cost was $94,000 with about $40,000 in accumulated depreciation. That would leave a gain of $10,000 as it stands.

I understand the IRS could reclassify it as a sale from the start. There are some factors in the clients favor since he continued to pay insurance, mortgage interest and property taxes. However the tenant paid for repairs and some improvements.

My first step is to a take quick look back to see what the potential tax liability might be. In the meantime your comments are welcome. Thanks!

[JohnH]

My initial reaction would be to let sleeping dogs lie. Report the transaction as it stands - a sale in the current year, with basis reduced in the amount of depreciation claimed during the rental period, etc.

The prior years are the responsibility of the client and the previous tax preparer. If you try to unwind the rental and amend prior years' returns, you are taking on responsibility you don't need to accept.

Even in an audit, I don't think IRS would likely reclassify the transaction because the net tax is about the same no matter how it's handled. The fact that the selling price was substantially renegotiated is pretty strong evidence that a valid sale never took place to begin with. They had an agreement of some sort, but once it was breached the seller also had the option to walk away and look for another buyer.

But you should advise the client that things are a bit fuzzy here, IRS might take a different view, and let them know that you are not accepting responsibility for anything that happened in the past. If they aren't comfortable with that, maybe they need to go back to the other preparer (or anybody other than you).

[kcjenkins]

I would not have a problem with showing it as a sale in 2013 given the facts presented.

[BulldogTom]

I agree with KC and John.

Tom

Hollister, CA

[DANRVAN]

Your client might have been better off to treat the transaction as a sale from the start, depending on income level and related capital gain rates the tax could have been greatly reduced.

In regards to the IRS, they are concerned about a business that is treating a purchase as a lease; specifically in situations where the term of the "lease" is shorter than depreciable life of the asset.

[Ranger]

Thank you for your comments.

Looking back, the client would have saved a couple of thousand dollars by calling it a sale. It appears the prior tax preparer knew enough about the tenant /buyer that the additional two payments of $10,000 likely would not be made.

If the transaction had been treated as a sale, the client would have a $4,000 tax liability if the contract was to be paid off as proposed in 2014. Otherwise, he will be looking at a minimal amount of tax on the $10,000 gain to be recognized on the reduced sale price of $64,000.

The current value is $87,000.

[JohnH]

These aren't related parties, are they?