When Is Real Estate Option Money Taxable?

This question came into to me sometime ago from a Realtor/Investor named Foz.  Foz, used the Rent to Own exit strategy for one of his real estate investments and he was smart enough to collect his real estate option fee upfront.

Now what?  Foz was concerned about his profit and his tax responsibilities associated with his smart and creative real estate investing. He contacted me for advice and below is the transcript:

Real Estate Investing Option Tax Question

Q: “When we do a rent to own and get that option money up front how do we report that? I just did my first deal. When I get money up front how should I report that in taxes? I have been told that I do not report that until the sale goes through or until the time expires. Do you have any info on this? One more question I had was I am about to sign a contract with a person and I want to sell it for 15,000, what is the process of doing this? By the way, my contract is assignable.”

A: Foz,

1. Yes, you are right. You are not taxed on option money until the option is exercised or expires. Consider it an interest free loan. What a deal huh?

2. Sounds like you do not have to do anything else except find a buyer for your contract. Give your attorney heads-up notices that you will be selling the contract and would he prepare an “assignment” form for you to use.

Q: Thanks Randy but my account is thinking something else here. He thinks that I need to put that money into an escrow account and I cannot touch it until the sale is final. What should I say to him or do you know what paperwork to use with a CPA?

A: Foz,

You need to get another accountant! He is wrong. Tell him to read the tax code before he gives out advice. He is embarrassing himself. He is referring to the code relating to 1031 exchanges where the seller cannot receive “boot” or cash at closing without being taxed on it. If the sale proceeds are held in escrow, they can be reinvesting in a like-kind exchange and no tax will be due.

The tax code that specifically relates to real estate option consideration is CLEAR. Tell him to look it up.

http://www.law.cornell.edu/uscode/text/26/subtitle-A/chapter-1/subchapter-P/part-IV