How is Option Consideration listed on Financials? - Posted by Steve

Real Estate Investing
#1

Posted by JohnBoy on December 04, 2000 at 14:00:01:

I don’t know about you, but when I lease option a property my “intent” isn’t to SELL the property. My “intent” is to LEASE the property which exactly what I did. I may have given an option to the tenant to buy the property, but in my “opinion” that doesn’t mean my “intent” is to SELL. My “intent” is to get it LEASED in a hurry for MAXIMUM rental income by offering an “incentive” of giving an “option”, that’s it! An “option” isn’t a SALE and doesn’t “obligate” anyone to BUY. It merely gives them the “option” to buy and whether the tenant’s “intent” is to buy or not has nothing to do with my “intent”, which is to LEASE the property. The ONLY thing that I SOLD in this case would be the “option” which I was PAID for by the tenant paying me consideration which would be claimed when the tenant exercises the option or the option expires.

In my “opinion” the option doesn’t prove “intent” to SELL, it proves “intent” to LEASE by offering the tenant the RIGHT to buy, not the OBLIGATION to buy at some future date.

Whether the IRS has any rulings pertaining to this I wouldn’t know, but proving what one’s “intent” was in my opinion leaves a lot of argument to dispute it.

#2

How is Option Consideration listed on Financials? - Posted by Steve

Posted by Steve on December 03, 2000 at 08:08:44:

Is option consideration reported as an asset or liability on one’s financial statement? That is since it is not considered income until the option is excersized.
Thanks,
Steve

#3

Not listed at all - Posted by Bronchick

Posted by Bronchick on December 04, 2000 at 10:31:00:

It is neither an asset or a liability; it is the equivalent of an earnest money deposit. I report it when the option is exercised or expires. You can report it now as ordinary income if you like. If you wait until the option is exercised, it becomes part of the purchase price as long term capital gain (assuming you held the property the appropriate time period).

As a practical matter, I spend it now!

#4

Our way - Posted by Merle

Posted by Merle on December 03, 2000 at 13:50:27:

We prefer to show all monies received on a house as income at the time received … including the option consideration. Once you receive it, it will inevitably become income at some point.

Not sure that there are any advantages either way.

Merle

#5

Re: Option Consideration on Financials? - Posted by JPiper

Posted by JPiper on December 03, 2000 at 08:20:32:

I show it as a current liability. If it expired you would debit your liability account and credit your income account. If it is exercised I show it as part of the sales proceeds.

JPiper

#6

Re: Not listed at all - Posted by JPiper

Posted by JPiper on December 04, 2000 at 11:57:47:

Hi Bill:

The “inner accountant” in me disagrees with a part of your post. I agree that it is the equivalent of an earnest money deposit. In my financial statements earnest money deposits are shown as liabilities.

How on earth would you “not list it at all”? If the cash goes into the bank account, then it has to be “listed” as something.

Cash coming into your bank account would need to be reflected in some manner. You’re not operating out of a shoe box are you? LOL.

JPiper

#7

Re: Our way - Posted by JPiper

Posted by JPiper on December 03, 2000 at 20:23:59:

I would say there are some possible advantages to deferring taxation on option consideration.

The difference comes if the option is exercised. In that event my opinion would be that the option proceeds become an adjustment to your cost basis. This might be important for example if you had held the property for over 12 months…and therefore the option consideration (because it was an adjustment to your cost basis), would be accorded capital gain treatment (a more favorable rate).

A further advantage might be that if you 1031 your deal, the option consideration might be included in that transaction, meaning a deferral of tax.

Naturally you should (and I know you will) run all this by your tax advisor. It may be that there are different interpretations of the above.

JPiper

#8

Re: Not listed at all - Posted by William Bronchick

Posted by William Bronchick on December 04, 2000 at 13:00:52:

It’s not listed on my balance sheet because it isn’t anything. It certainly not a liability because whether the tenant exercises or defaults, I get the money. It is like escrow money to a title company - it isn’t aything to them for tax purposes.

#9

Re: Our way - Posted by Merle

Posted by Merle on December 03, 2000 at 22:27:52:

Excellent point!!

We’ve paid very little income tax since starting this business. We’ve never done a 1031 transaction, either. In fact, as I think about it, I realize that our business is quite simple compared to what I read about here.

The main point I wanted to make in the earlier post was that of consulting your tax advisor. Making the money is quite easy … controlling the spending determines your net gain. That includes your tax payments.

Thanks, Jim, for pointing to the bigger picture.

Merle

#10

Unearned Revenue - Posted by JPiper

Posted by JPiper on December 04, 2000 at 14:10:59:

I would put this in the category of an “unearned revenue”. You have received “payment” for an option, but the payment is not “earned” until the option either expires or is exercised.

From an accounting point of view an “unearned revenue” type of account IS a liability account on the balance sheet. This liability is extinguished WHEN the option is exercised or expires thereby REALIZING the income in one fashion or another. The liability is transferred from the liability account TO the appropriate revenue account at that time.

Nothing in the categorization of this unearned revenue account as a liability for your accounting purposes infers that this is a liability to the tenant. Completely different concepts. One is an accounting concept, the other a legal concept.

Assuming you show the cash coming in for option consideration, it needs an offsetting entry in the double-entry accounting system. Obviously that means that when cash comes in, an offsetting entry must be entered in either the income statement or the balance sheet. Otherwise your financial statements are not going to reconcile.

By the way, I would think that cash coming into a title company bank account would also need an offsetting entry…a liability account.

JPiper

#11

Re: Our way - Posted by Alan-Baltimore

Posted by Alan-Baltimore on December 04, 2000 at 10:59:27:

Merle,
How is it that you are paying little or no taxes?

I know that you’re not able to post specifics about your system and that any answers you give should be checked by an accountant, but could you give a general idea of how you’re able to sell your houses for profits of $15,000 or more and not get hit with either capital gains or income taxes? If all you do is lease/options where are your deductions coming from? My accountant has told me that in your system the only deductions would be for preparing the house to rent, advertising and management expenses. These would seem to be negligible according to everything I’ve read about your operation.

Any tax-saving tips would be greatly appreciated.

#12

Re: Unearned Revenue - Posted by Roy

Posted by Roy on December 05, 2000 at 06:36:03:

The Cash is listed as asset, Balance sheet
The liability is listed as unearned income Balance sheet!
At (sale) closing the unearned income entry is closed to the Income column and added to the income you get at closing.
Asset (asset being the property which was listed whem aquired, Right, along with the liabilities), is charged the deposit of unearned income decreasing the property asset value on the books.
Income entry,
I’m not, nor intend to be a accountant, I’m just talking.

#13

Re: Unearned Revenue - Posted by KennS

Posted by KennS on December 04, 2000 at 23:16:48:

JPiper,

This way of entering it in to G/L seems them most logical to me.
I like the account title of “Unearned Revenue” and I was wondering if you would share with me your chart of accounts list.
If you would be so kind, you can email it to me or you can send it to my toll-free fax. Just drop me an note.
I am in the process of setting up a new C-Corp (Nevada) for my investment and property management company. I wish to start with a clean chart of accounts.

-Kenn

#14

Re: Our way - Posted by JohnBoy

Posted by JohnBoy on December 04, 2000 at 11:15:24:

What about deducting the interest on all the mortgages and depreciation on all the homes? Then there’s all those business meetings at the golf course everyday! LOL

#15

Re: Our way-Taxes - Posted by Alan-Baltimore

Posted by Alan-Baltimore on December 04, 2000 at 11:48:55:

JohnBoy,
I thought that if you did a decent number of lease/options that the IRS was going to tag you as a dealer and consider your houses “inventory.” This means that you can deduct the interest as a business expense, but you don’t get the depreciation allowance and that your profits are treated as ordinary income (if you’re doing business as LLC, S corp, or in your personal name) or as corporate profits in a C corp. In other words, you can’t claim the more favorable capital gains rate.

Am I wrong in this (I hope so) or are you just playing the odds that the IRS won’t get around to calling you a dealer rather than an investor.

Of course, I understand that it might be necessary to buy a new company car to check up on all your properties :slight_smile:

#16

Re: Our way-Taxes - Posted by JohnBoy

Posted by JohnBoy on December 04, 2000 at 12:46:22:

I’m no accountant, but what does the number of lease options have to do with anything? I thought being a dealer had to do with a certain number of properties bought and SOLD within a year? Under a L/O you are only RENTING until the option is exercised, IF, it ever gets exercised. Until that happens it’s just a rental, isn’t it?

Even if you had 10 options exercised within the same year, doesn’t it depend on WHICH homes were SOLD that year? Meaning, the homes that the options were exercised that year were held already for two - three years. Not the same property that was purchased, lease optioned and the option was exercised within the same year the property was purchased.

Since Merle does a larger number of these with x number of homes being sold within each year perhaps he can explain better on how they treat these?

#17

Re: Our way-Taxes - Posted by Alan-Baltimore

Posted by Alan-Baltimore on December 04, 2000 at 13:09:50:

JohnBoy,

I thought that the IRS standard was the “intent” that you had when you purchased the property–kind of like the intent of a dimpled chad, I guess :slight_smile:

If you bought the property to sell (even using lease/option) then the property was no longer an investment just another item in your inventory waiting for the ultimate sale to go through (even if it’s postponed or delayed for a number of years via the lease). When you take the option consideration from your tenant/buyer, this would be evidence of intent that the property was for sale and not to rent. The number of properties has no bearing on the dealer status.

I’m meeting with my accountant later this week and I’ll bring this up to him for clarification

Maybe Merle or Piper would comment given the fact that they have done so many L/Os over the years.