My son has recently entered into a lease/option to buy his condo for
12 months. Half the rental income is to be credited towards the purchase. Is the full amount of the rent reported on Schedule E with HOA dues and property tax, etc. as deductions? Can the half that is being credited toward the purchase be deducted in the current year? Or is the purchase price adjusted at the time of sale? If the condo sale goes through next year, is the capital loss on the sale considered a business loss that is deductible or still a personal loss on the sale of a home that is not? He has received first month, last month, and a nonrefundable "security deposit" of $1000. Is the security deposit reportable in 2011 or 2012. Anything else he should consider related to tax on rental/ sale of the condo?
I'd say that $1,000/month is rent. If the sale goes through, the purchase price is $94,000.
Reasoning: suppose the lease said "Rent is $1,000/month. If you pay the rent on time for a year, you then have the option to buy for $94,000." That would be effectively the same as the "half the rent is credited to the purchase price" description, so ought to be treated the same by the tax code ("form over substance" violation otherwise).
That does not sound correct to me. Buying a 100k house with 6% down is different from buying a 94k house with 0% down, at least to lenders. And property tax is based on the appraised value of 100k, not 94k.
To me this looks like $500 is going into rent, and $500 into a separate account for down payment. If the buyer backs out of the deal, I suppose they lose their down payment and the owner would report this as income. If the buyer goes with buying the property, then just use the down payment money as part of the down payment. The account might have to be an escrow account to avoid complicated things like gift tax considerations and such.
If you don't intend to return the security deposit, record it as income in the year you receive it.
Still unanswered is the question to you whether your son is the buyer or the seller. It was not clear in either of your comments, and the answer to that question is critical in determining a proper response.
What would the fair market rent be without the "half goes to the purchase price" option? If it would be $1000/month, then I still go with my interpretation. If it would be less, then the renter/buyer is paying for that option, so the purchase price is above $94,000 (and perhaps $100,000 even if fair market rent is, say, $900).
The $500 will not be returned in any case. Now, is it rental income or capital gains (or decrease in capital loss)? That isn't known until Year 2, when the sale takes place (or doesn't).
How long did he own it? How was it used for all that time? If it was a residence converted to a rental, what was the fair market value at the time of conversion?
Son owned condo for 5 years. On September 1 he signed lease/ option to SELL agreement -- He receives rent for one year. Rent in the area for this type unit would be aprox $1200 to 1400 per month. He is receiving $1500. Next year on September 1 - if the renter buys the condo, at a price they have already agreed up, buyer will receive credit of 1/2 of each months rent towards purchase of the unit.
Price paid 5 years ago was $180,000. Agreed sales price according to the contract will be $130,000 in September 2012.
If he had sold outright now, he would have a $50,000 personal -- nondeductible loss on the condo.
The lease option was initiated by the prospective buyer, a totally unrelated person, who is going through a divorce and is not able to purchase anything until the divorce is final -- or at least the money aspects of it are determined.
If I remember correctly, if the unit had been converted strictly to a rental unit - and rented for a period of time and then sold at the $130,000 -- the loss would have been a business loss and therefore eligible to be claimed as a capital loss subject to usual rules of offsetting other types of capital gain, and Carried forward as long as it took to use up the $3000/ year that can be claimed.
Does entering the lease option at this time prevent him from claiming the loss? I would say no - rental income was collected and reported for the full year - the sale will not be complete until September
Son is the seller. That is why I was discussing reporting the rental income and expenses -- and whether the condo converts from personal to business for capital gains purposes when the house is sold in one year.
I believe that when a personal residence is converted to a rental and then later sold then you can report a loss on the sale. Obviously you can't on a personal residence.
The question is whether entering the contract to sell at the same time as the rental agreement negates the conversion of the personal residence to business for capital gains purposes.
No, it doesn't. However, the capital loss is based off the lower of basis and fair market value at the time of conversion, and the sale is for the latter, so there's no loss.
You cannot convert a personal loss to a business loss.
I'm not so sure about my previous answer of saying half is rent and half is down payment. Maybe the right thing for your son to do is to call it an installment payment. He sells the house for 130k, receives
1.5k a month for 12 months, and the remainder in full which the buyer does through a bank loan.
What was FMV when you started rental? If if was $120,000 you will have a capital gain of at $10k. You will also have to recapture depreciation, so your gain will be $10k plus one year's depreciation.
FYI, there is also a rule limiting the 500k capital gain exclusion when you convert your house from rental to personal, or personal to rental to personal.
For clarity - most states use an ASSESSED value which can, and frequently does, vary from the appraised value. And the appraised value may or may not be what is actually paid for the property. For example, in Kent County Delaware, in order to the Casinos approved back in the 1980s the state agreed to set real estate tax ASSESSMENTS at "60% of the 1987 cost of construction". Since the politicos argued that the casinos would be taxed to provide relief to residents they were forced to put up or shut up, if you will.
We paid just over $205K for our home when we built it, it was appraised at $330K but the tax assessment is just over $100K - our real estate taxes on
3.3 acres with a 2,400 sq.ft. house is less than $1,000 annually, including the local school tax.
I do agree that a $100K home with 6% down is way different with the lenders than a $94K home with no down.
Hence my question about what happens to the part that goes towards the purchase if the buy fails to happen.
There used to be a local guy who was notorious for selling the same house multiple times. He'd bump the rent by 50% and tell the renter that they'd get credit for half the rent paid over the 2 or 3 year lease period AND he'd carry the paper, under two conditions - they had to buy at the full fair market value at the time of the sale (they could NOT use the value of the house today - this was when real estate was increasing in value) AND they couldn't be late AT ALL on the return at any time during the period.
The trap was that most people interested in a lease to buy option were either unstable or unreliable financially. So most of them missed a rent payment at some point and those that didn't usually missed a mortgage payment - and either way he'd get the house back and start all over again.
snipped a LOT, but kept the most recent update from the OP
OK, now we have more info. Here's my take -
Until they sign a sales contract there is no sale. So renting the house for a year should qualify it for long term treatment. BUT it likely won't be capital in nature, AND there's more to this than a civilian realizes. Rather, converting it to trade or business use changes the nature of the gain or loss. When a rental property is sold it gets reported on Form 4797 and the gain, if any, gets divided between gain from recapture of depreciation, taxed at 25% under the current law, and gain from appreciation, which gets long term capital gain tax treatment.
When its sold at a loss the loss goes on Form 4797 AND is fully deductible in the year of the sale. There is no $3K annual cap on deducting the loss because the loss became ORDINARY in nature when the property became a rental.
BUT WAIT, there's more, you son may be caught in the Twilight Zone on this -
When the property was placed into service as a rental you have to determine the value for depreciation purposes. This can be tricky when property values are dropping - using your numbers, he paid $150K but its only worth $130K so the basis for depreciation STARTS at $130K then gets reduced further for the value of the land, which is NOT depreciable. That's assuming that the house IS worth $130K today. If the house is actually worth only $120K and the $130K sale price was intended to account for an increase in value of the next year you have to start with the $120K and reduce that for the value of the land - no matter how hard you try you will never wear out dirt, hence land is not depreciable.
For illustration purposes let's assume the house cost $150K when he bought it, it's worth $130K now and $30K of that attributable to land. Your son will get to depreciate the $100K value of the house over 27.5 years. So his Rental Schedule E will show depreciation of about $3600 for a full year. Your case is a bit more convoluted since the rental spans 2 calendar years, but I'm ignoring that. So at the end of year one your son's basis in the property will be $130,000 LESS $3600 in depreciation for an adjusted tax basis of $126,400. When they execute the contract of sale for $130K he will have a GAIN, not a loss, and that gain will be taxed at a flat 25% because it is all related to recapture of depreciation - unpleasant, but pure and simple (thus far).
The LOSS in value from what he paid - $150K - to the fair market value when rented - $130K - is personal in nature and is NOT deductible - sucks to be him .
There are also a whole bunch of wild cards that I've ignored - for example, if your son's AGI, without regard to his rental activity, is greater than $150K any losses associated with the operation of the rental property will NOT get deducted on his return. Rather they get suspended and carried forward until he completely disposes of the property. In the year of disposition he'll get to deduct all suspended losses from the rental and these will help offset any gains associated with the sale of the property.
We also haven't discussed what happens if the renter fails to buy and your son rents for another 2 years and property values come back so that he sells the house for $155K. NOW it really gets interesting since now there really is a gain. This gain will get split into THREE pieces - gain from recapture of depreciation, gain from appreciation - which gets allocated between business use and personal using a fraction determined by the rental use period over the last 5 years. If he rents it for 3 years then 60% of the gain is business gain and gets taxed at long term capital gain rates, the balance of the appreciation gain is personal and tax free as he can exclude up to $250K in gain from the sale of a principal residence as long as it was his HOME for 2 of the last 5 years. If he rents it for 3 years and ONE day, he is not entitled to exclude any of the gain as gain from the sale of a home.
And I haven't accounted for any of the settlement or associated expenses either.
AND we still haven't settled on the treatment of the 50% of rent payments if the buyer fails to buy. If your son keeps that money its rental income to him. In my opinion, which since you haven't paid for cannot be relied on because I won't stand behind it, your son needs to pick up ALL the rental payments as income to him, then at the sale he will put some money towards closing to help the buyer close. Whether that goes as part of the down payment or towards closing costs is another matter still.
On the other hand, if the WRITTEN agreement says that 50% of the rent paid will be refunded if there is no sale, then he does NOT report it as income because he must give it back at the end of the rental period.
NOTE I have not researched this, I'm shooting from the hip - do NOT rely on this as professional advice, because until I'm paid it ain't advice.
I just wanted to throw in a brief comment on this.
Without seeing the actual agreement, I say that what you've got is a rental situation (report all income that way) for income tax purposes unless or until a sale takes place. Then, if the property sells, there would be a credit or price adjustment for 50% of the rent paid as per the agreement. It probably doesn't matter to the seller how that is reflected on the closing statement (as a credit or a price adjustment) because either way it nets out. However, if shown as a credit, I would insist on an appropriate description, such as, "Credit for rent paid under option agreement."
In my opinion this transaction alone would not be sufficient to qualify the loss for ordinary treatment under 1231. There is no bright line test here...it turns on "facts and circumstances." But in my view it would take, like, a solid two years of rental with no strings attached (like an option to sell) to convincingly covert a former personal residence to business loss status under 1231. In any event, the loss (if any) would be based on the lower of cost or FMV at the time of conversion.
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