Tax

Real estate options and leases with purchase options can enhance your real estate investment profits. Here’s a concise guide to help you navigate the potential pitfalls and maximize your returns.

Stand-Alone Purchase Option

A stand-alone purchase option can be highly profitable. Here’s how it works:

• Immediate cash. You receive cash up front from a buyer wanting the option to purchase your property at a set price within a specific period.
• Outcome benefits. If the buyer exercises the option, you sell the property at a premium. If the option lapses, you keep the property and the option payment.

Lease with Option to Buy

This approach offers several financial advantages:

• Higher rent. Charge a premium rent, possibly applying a portion toward the option price.
• Up-front cash. Require an up-front option payment, which becomes your immediate cash.
• Property maintenance. Tenants are more likely to maintain the property well, often handling repairs themselves.
• Long-term tenants. Tenants planning to buy tend to take better care of the property.

Legal and Tax Considerations

Understanding the tax implications is vital:

• Option proceeds. If the buyer exercises the option, the up-front payment is part of the sale proceeds. If the option lapses, it’s ordinary income.
• Example. If Mary pays $10,000 for an option to buy your property for $300,000 within 15 months, she adds the option cost to her property basis if she buys. If she doesn’t buy, the option lapses, resulting in a long-term capital loss for Mary and ordinary income for you.

Avoiding Pitfalls

Options and leases can sometimes be deemed sales contracts by the IRS, especially if

• the option forces the tenant to buy due to high rents, or
• the lease conveys significant ownership benefits to the tenant.

Eight Rules of Thumb

To ensure your lease-with-purchase-option is compliant and beneficial, be sure to follow this advice:

1. No equity build-up. Don’t apply rent toward equity.
2. No automatic title transfer. Avoid clauses that transfer ownership after a specific number of payments.
3. Short-term rent proportion. When renting for a short period, ensure rents are not an inordinately large portion of the total price.
4. Fair market rents. Ensure rents are reasonable and not excessively high.
5. No interest equivalents. Avoid building interest equivalents into rents.
6. Proper investment. Maintain at least a 20 percent investment in the property.
7. Fair option prices. Set option exercise prices at or above fair market value.
8. Restrict improvements. Prohibit tenant improvements.

If you want to discuss real estate options, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 15, 2024

Early withdrawals from a traditional IRA before age 59 1/2 generally incur a 10 percent penalty tax on the taxable portion of the withdrawal. There are several exceptions to this rule that can help you avoid the penalty under specific circumstances. Below, I have outlined the key exceptions that may apply to your situation.

Substantially equal periodic payments. You can arrange for a series of substantially equal periodic payments. This method requires careful calculation and adherence to strict rules but allows penalty-free withdrawals.

Medical expenses. Withdrawals for medical expenses exceeding 7.5 percent of your adjusted gross income, or AGI, are exempt from the penalty.

Higher education expenses. You can use penalty-free withdrawals for qualified higher education expenses for you, your spouse, and your children.

First-time home purchase. You can withdraw up to $10,000 (lifetime limit) for qualified home acquisition costs without penalty.

Birth or adoption. You can withdraw up to $5,000 for expenses related to the birth or adoption of a child.

Emergency expenses. Starting January 1, 2024, you can withdraw up to $1,000 annually for emergency personal expenses without penalty.

Disaster recovery. Withdrawals for qualified disaster recovery expenses are exempt from the penalty, up to an aggregate limit of $22,000.

Disability. If you are disabled and cannot engage in substantial gainful activity, you can withdraw funds without penalty.

Long-term care. Beginning December 29, 2025, you can take penalty-free withdrawals for qualified long-term care expenses.

Terminal illness. Withdrawals due to terminal illness are exempt from the penalty.

Post-death withdrawals. Amounts withdrawn after the IRA owner’s death are not subject to the penalty.

Military reservists. Active-duty military reservists called to duty for at least 180 days can withdraw funds without penalty.

Health insurance premiums during unemployment. If you receive unemployment compensation for 12 consecutive weeks, you can withdraw funds to pay for health insurance premiums without penalty.

Domestic abuse victims. Starting January 1, 2024, you can take penalty-free withdrawals of up to $10,000 if you are a victim of domestic abuse.

IRS levies. Withdrawals to pay IRS levies on the IRA account are not subject to the penalty.

It’s important to note that SIMPLE IRAs incur a 25 percent penalty for early withdrawals within the first two years of participation. Additionally, Roth IRAs have different rules, allowing penalty-free access to contributions but potentially taxing and penalizing withdrawals of earnings.

If you want to discuss your IRA, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 8, 2024

One significant tax benefit of owning residential rental property or non-residential commercial or investment property is depreciation—a deduction you get without spending any additional money.

But regular depreciation for real property is slow. Residential rental property is depreciated over 27.5 years and non-residential property over 39 years, providing a relatively small deduction each year.

Fortunately, there is a way you can speed up your depreciation deductions—especially during the first year or years you own the property: cost segregation.

“Cost segregation” is the technical term for separately depreciating the elements of property that are not real property. These are elements other than land, buildings, and building components. They include

• improvements made to the land, such as landscaping, swimming pools, paved parking areas, and fences; and
• personal property items inside a building that are not building components—for example, refrigerators, stoves, dishwashers, and carpeting in residential rentals.

Using cost segregation does not increase a property owner’s total depreciation deductions, but it does accelerate them over the first few years because personal property has a five- or seven-year depreciation period and land improvements a 15-year period.

In addition, by using bonus depreciation and/or Section 179 expensing, owners can deduct all or most of the cost of personal property and land improvements the first year they own the property—providing a potentially enormous first-year deduction.

A cost segregation study must be conducted to identify which building elements are personal property and land improvements and then to determine their depreciable basis. Studies can be conducted by engineers or done more cheaply with other methods that the IRS views as less reliable.

Cost segregation may not be advisable for every property owner—for example, where it results in a loss that can’t be deducted due to the passive loss rules, or where the owner intends to sell the property within a few years and has to recapture as ordinary income the cost-segregated depreciation deductions.

The best time to perform a cost segregation study is the same year you buy, build, or remodel your real property. But you can wait until a future year—perhaps when you have enough rental or other passive income to use the speeded-up depreciation deductions.

If you want to discuss cost segregation, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• July 3, 2024