Q:

Subject:  Sale of residence

I am a tax preparer with a small office in MI and am wondering if you would give me your opinion on a transaction.  I have a client who leased a former residence to someone for up to five years, with an option to buy at any time during the lease period.  The buyer/tenant assumed all practical ownership responsibilities for maintenance, paid a higher than market rent during the 5 years so that a portion of the rent was applied to the option sale price and a portion of the “rent” was designated as property tax and insurance reimbursement.  The buyer was trying to work out of some personal tax liens and they took most of the five years to do so. My client did not want to sell on a land contract because it would be harder to evict the buyer if the personal tax issues could not be resolved and third party financing obtained. The sale was completed in 2007.

My client, the seller, received a 1099 for the 2007 closing and they would like to exclude the gain on sale, other than depreciation recapture.  Their contention is they really sold the property in 2001 when the lease/option started.  The lease payment was equal to a reasonable interest rate, plus tax and insurance escrow and the amount applied to the down payment amount.  While the title did not transfer in 2001, the client’s contention is there was basically a land contract sale in 2001, at which time they met the ownership and occupancy requirements. All payments received during the almost five year period have been reported as rent and the property was depreciated- perhaps not the right thing to do (in hind sight).

I have not found anything right on point so I am wondering if you would give me your thoughts on this.  Thanks for taking the time to read this and I look forward to reading your response

A:

I am assuming that your client didn’t report the sale of his primary residence, with the Section 121 tax free exclusion, on his 2001 1040, which is where it should have been shown if he wanted to claim it as such.  Trying to recategorize the sale from a normal lease-option (which it seems like to me) to a primary residence sale six years after the fact, when the statute of limitations bars any changes to his 2001 1040, is crazy and not something that would have any chance of standing up to the slightest bit of IRS scrutiny.

In addition, if he has been claiming depreciation since 2001, that also completely undermines his argument that he actually sold the property back then.  Having his cake and eating it too seems to fit that scenario.

I am also assuming that your client hadn’t been reporting any interest income from the buyer’s payments; another contradiction to the argument that there was a 2001 sale.

Based on your description, your client had a standard lease option with a 2007 sale of a rental property.  He could have obviously done a 1031 exchange into new rental property during 2007, but it is too late now to make that kind of change in the type of transaction he had.

If you’ve read much of my postings, you know that I have very little sympathy for people who are too short sighted and/or cheap to consult with a professional tax advisor before the consummation of a potentially taxable transaction and then cry about the consequences when their 1040 is prepared.  The proper time for your client to consult with you would have been before the 2007 closing of the sale.  You may have advised to set it up as a 1031 exchange or even as an installment sale if he could have afforded to carry back some of the sales price.  Now, it is too late to set those things up and he has a fully taxable sale of a rental property.

That’s how I see it.  I hope this helps.

Kerry Kerstetter