Tax Implications of Installment Land Contract vs. Lease Option/Purchase? - Posted by tb

Posted by JPiper on November 26, 1999 at 24:54:53:

Funny how a “whine” often drowneds out opportunity. I don’t suppose it occurred to you to sell a few notes to pay the tax. Or perhaps sell a few partials. Or perhaps borrow against some of the notes to obtain funds to pay the tax. Sheesh.


Tax Implications of Installment Land Contract vs. Lease Option/Purchase? - Posted by tb

Posted by tb on November 24, 1999 at 17:49:58:

Hello and thanks to everyone who is taking the time to read this post.

I was wondering if anyone knew the exact tax implications of selling on an Installment Land Contract versus a Lease Option or Lease Purchase Agreement?

From the information that I have gathered (minimal), the IRS considers an Installment Land Contract sale the same as a straight sale. Does this mean that taxes on the entire sale price would be due in that tax year? If so, how do you report the installment payments in years/months to come? Isn`t this a bit like double jeopardy?

I also understand that the option payment is only taxable as reportable income once the buyer has decided to fulfill his/her side of the agreement or defaults. How would the monthly payments be reported and what forms are necessary?

I understand that this is a rather long post with need for informed answers, but I just don`t want to get into a situation where I come up short on cash come tax time.

Thanks a Million! tb

Tax Implications may vary - Posted by Dave T

Posted by Dave T on November 24, 1999 at 22:43:58:

DISCLAIMER: I am not a tax professional. The following is simply my interpretation of the tax rules and is not tax advice. Please consult a competent tax professional before acting upon any information contained in this post.

There is not a specific answer to your question for all situations. Instead the answer depends upon the use and character of the property the taxpayer is selling.

First case – the property is investment property: When the taxpayer sells property and some or all of the payments for sale are to be paid in the future (as in a seller financed mortgage, or a contract for deed), the transaction is called an installment sale. A taxpayer using an installment sale is allowed to have a pro-rata portion of the total gain taxed as each installment is actually received. If the taxpayer uses a lease option arrangement to facilitate the sale, the sale is not recognized until the option is exercised. If the seller then finances the sale, the installment method can be used. Gains from an installment sale are reported on Form 6252.

Second case – the property is “dealer realty” (that is, property held primarily for sale to customers instead of for investment use): When the taxpayer sells dealer realty, all of the profit on the transaction is recognized and taxable in the year of the sale. It does not matter whether the seller finances the sale on a contract for deed or provides seller financing – all of the profit on the sale is taxed in the year of sale. If the taxpayer uses a lease option arrangement to facilitate the sale, the sale is not recognized until the option is exercised, but when exercised, all of the profit is taxable in the year of sale. Installment payments consist of both principal and interest. For this class of property, only the interest is reported as income since you already paid tax on the entire profit (or principal portion of the installment sale payment). Therefore no double taxation. Property expressly bought to rehab and sell for profit, or flip for profit, is dealer realty and not investment property.

In answer to your question about option payments: If the option is exercised, the option money is included in the sale price of the property sold. If the option lapses, the option money is ordinary income in the year the option expires.

Beware of IRS recharacterization - Posted by Joe Beginner

Posted by Joe Beginner on November 24, 1999 at 18:57:08:

I’m a newbie, but I’ve read that the IRS can recharacterize a L/O as a land contract on installment. The authority is the tax code which we all know is an easy read. Right? You may want to read John T Reed on this matter; I’m sure there are others you can read, too. From what I’ve learned, lease options are difficult to write, ther’re many pitfalls, and we sould use a lawyer.

Re: Tax Implications may vary - Posted by kim k

Posted by kim k on November 24, 1999 at 23:54:21:

If a “dealer” has to pay taxes on the entire installment sales price in the tax year of the sale, what happens if the buyer later defaults and the entire purchase price is never realized?

Lease/Option Tax Pitfall - Posted by Dave T

Posted by Dave T on November 24, 1999 at 23:02:39:

Forgot to mention in my first post:

When you use a lease option to sell you property, be careful about the option term.

Scenario: You give the buyer a thirty-year option with annual option payments and/or rent credits that effectively reduce the purchase price to zero at the end of the term.

In this extreme scenario, the IRS will deem that you have an installment sale in disguise. The IRS will re-characterize the transaction as an installment sale and then compute your taxes as they should have been computed in the first place. Penalties and interest on top of the tax liability just deepen the wound, particulary if you are forced to recognize the entire profit in the first year of the option term.

Re: Beware of . . . - Posted by Joe Kaiser

Posted by Joe Kaiser on November 26, 1999 at 02:11:25:

John T. Reed advise about lease options . . .since he’s yet to actually “do” a lease option deal. Too many “pitfalls” I guess.

Hey, to each his own and all that jazz, but really, you didn’t think his one hundred and one reasons not to do lease options bordered on the absurd?


It happens whenever it snows in Hawaii - Posted by Bronchick

Posted by Bronchick on November 25, 1999 at 10:15:46:

The IRS has never re-characterized a lease/option as a land contract where the terms clearly spelled out a lease with option and not a sale. There is one reported case in which the IRS re-characterized a lease/option as a sale on real estate and it involved a long term lease with a declining balance option price.

Reacquisition of property - Posted by Dave T

Posted by Dave T on November 25, 1999 at 17:17:24:

If the total of all payments received before reacquisition is greater than the total of the gain previously reported plus reacquisition costs, then there is a reportable gain. Refer to section 1038 of the tax code for more specific details.

Even though in a foreclosure the seller is reacquiring property he or she previously owned, the seller now has all the payments previously made by the defaulting buyer and the entire property back.

The tax code essentially converts all the previous payments into taxable gain. From the total of all previous payments received, subtract the gain previously reported and subtract any reacquisition costs. The result is the gain on repossession. Of course, this is only the general rule for calculating gain on repossession and there is another set of formulas that may limit the reportable gain on repossession.

If the answer to the math is a negative number, I am out of my depth. I suspect that the basis of the reacquired property is adjusted accordingly – though I do not know for sure.

A fine line . . . - Posted by tb

Posted by tb on November 24, 1999 at 23:23:17:


Thanks for both of your posts. Competent, complete and much appreciated.

It would seem to be that the distinction between “investment property” and “dealer realty” is a very fine line.

My guess would be that the IRS decides, in the end, just what side of that line you were on when you decided to sell your property. It must be very difficult to prove your “intentions” to the IRS and I have now come full circle in my search for the true meaning of “dealer realty”. Could it be that the sheer number of parcels or homes that sell each year be the red flag that makes you a “dealer”, or quite possibly the amount of passive income you happen to be receiving as a result of past and current sales; will we truly ever know?

As for me, I may just claim that I am a “dealer” right off of the bat, make my sales, and pay my fair share of taxes like a “good” American.

Thanks again for your insight.


Actually… - Posted by karp

Posted by karp on November 26, 1999 at 11:06:23:

It does snow in Hawaii and there is even an active ski slope…

Coincedentally, I was one of those idiots who wrote up a “crafty” lease option which really was an installment sale and got spanked HARD by the IRS…


Karl Hartley

Re: Reacquisition of property - Posted by kim k–AZ

Posted by kim k–AZ on November 25, 1999 at 21:37:27:

AAAhhh, the plot thickens. Thanks for your reply and concise info. HAPPY THANKSGIVING Dave, to you and yours.

Re: A fine line . . . - Posted by Brad Crouch

Posted by Brad Crouch on November 26, 1999 at 12:28:13:


Consider forming a Corporation or LLC to deal with the “Dealer” type properties. That way you don’t get personally stuck with the dealer status. Let a business entity be the dealer. Form a second corporation or LLC for any properties that you want to “hold” for the long term.

Your name may appear on some loan documents, but you might want to try keeping your name off “titles” and out of the public records. Bill Bronchick has some pretty good information on this subject.

If a deal is too skinney to support tax consequences, then the deal is not a deal for you. But with some pre-planning, you might be able to reduce the tax bite.

The alternative is to not earn any income because there will be income taxes due, if you do. Not acceptable!

Good luck,


Hold the phone . . . - Posted by Bronchick

Posted by Bronchick on November 25, 1999 at 10:24:54:

I would NOT pay the taxes up front, EVER! There is no clear rules in the Code about what is a “dealer,” just guidelines based on tax court cases. Why pay when you are not clearly a dealer?

The following is an excerpt from the “Cash Cow” Course of ONE way to deal with the issue:

"The capital gains and installment sales rules apply for principal residences and properties held for ‘productive use.’ I.R.C. §1234. If you are actively buying and selling real estate on a regular basis, you may be considered a ‘dealer’ in real estate properties. A dealer is one who buys with the intent of reselling rather than for investment.

There is no magic formula for determining who is an investor and who is a dealer, but the IRS will balance a number of factors, (See, e.g., Winthrop, Ada Belle v. Tomlinson, 417 F.2d 905) such as:

? The purpose for which the property was purchased
? How long the property was held
? The amount of sales by the taxpayer in that year
? Amount of income from sales compared to taxpayer’s other income
? How many deals the taxpayer did in that year
? The amount of gain realized from the sale

If the IRS pegs you as a dealer, then you cannot use the installment sales method under I.R.C. §453. The installment sales will be disallowed and the entire “paper” profit is reported as ordinary income in the year of sale. The interest part of the payments will continue to be taxable in the year of receipt.

This re-characterization could be a large “hit” for the taxpayer. For example, suppose the taxpayer bought and sold ten properties on the following basis:

? Purchase: $90,000 purchase price, $20,000 down, $70,000 loan @ 8%
? Resale: $110,000 resale price, $10,000 down, $100,000 land contract @ 11%.

Thus, in each case the seller receives $10,000 in cash and $10,000 in “paper” profit. He also collects monthly net cash flow of about $440 per month. He pays taxes on the $10,000 cash and reports the balance as an installment sale. He also pays tax on the interest received each year. If the profit on the ten deals is re-characterized as ordinary income, the taxpayer now has $100,000 additional income subject to tax in the year of sale!

The following are some tips for handling the dealer issue:

? Keep One Year’s Cash Flow Reserve on Hand. Suppose that you buy and wrap 10 properties, with an average $10,000 “paper” profit and collecting an average $440/month cash flow as described above. The annual cash flow ($52,800) is enough to cover the hit if you are audited and denied installment sale treatment. Invest the first year’s income in liquid assets, such as stocks, bonds and mutual funds."

Re: Hold the phone . . . - Posted by JPiper

Posted by JPiper on November 26, 1999 at 01:23:50:

This sounds like a sucker bet to me!

Sounds like there?s going to be very little question as to whether you?re a dealer or not. Certainly if the investor has taken your good advice, incorporated because of the risk of dealer categorization, and has now done 10 deals in this corporation creating $120K cash profit, and $120K paper profit?..where?s the question? You?re a dealer. No question on that at all.

The success of your suggestion rests only on whether the IRS audits?.not on whether you are a dealer or not. If you lose this audit roulette, your risk is NOT just the payment of the tax due. It?s also the penalties and interest. Further, this audit may not be the next year?.so the interest and penalties may be for more than one year.

You?re really going to gamble with your cash flow in the stock market ?hoping? your stock market earnings will exceed the penalties and interest of a failed tax gambit? And if they don?t?

I?d pay the tax, hire some good tax advisors to set up tax strategies within my successful corporation. This one isn?t even a gray area.


why I DO NOT want dealership status - Posted by RRSmith

Posted by RRSmith on November 25, 1999 at 20:38:44:

The above posting by Bronchick is quite good, when I read JT Reeds three pages on dealership status, I wondered what all the excitement was about. Now in the next few years (hopefully) I will have enough volume to worry about this important tax issue. There are no clear rules to preserve your “non-dealer” status but there are some areas that are more gray than others.

I`m holding. - Posted by tb

Posted by tb on November 25, 1999 at 17:59:44:

Thanks always Bill for your wisdom and time.

In the beginning I thought that I had found the pot of gold at the end of the rainbow. Literally hundreds of low FMV, residentially zoned, unimproved parcels within an incredibly beautiful planned community selling for pennies on the dollar. Along with that, a huge market ready to gobble up these parcels on owner financing with low or no annual interest on the payments. All was good.

Then a colleague of mine familiar with the IRS`s definition of “dealer realty” deflated my dream. It seems that selling 100 to 200 parcels of land a year, even at the low FMV of $2,000.00, would instantly throw up red flags with the IRS who would proptly slap my company or myself with the dreaded “dealer” status.

An incredible niche lies before me, and yet I am afraid to enter thanks to the IRS. . . woe is me.

Thanks again for your time, it is much appreciated.