While my lovely wife and I were cleaning out our closets, Marie Kondo-style, she asked if I needed to have some bespoke suits made, as I seem to have ‘outgrown’ my current ones. (I did not grow taller, unfortunately.) Custom-made goods of all kinds can be flattering, high-quality, lasting investments. In real estate investing, a rent-to-own arrangement can be the equivalent of a tailored suit when it comes to financial and tax planning.
A typical RTO has three elements: the sale of an option to purchase a property, a lease, and an installment sale of the property, which involves a series of deposit payments over the term of the agreement. As you can imagine, there are many dynamic parts, and the terms can get complicated. Tax treatments of such transactions are typically dictated by the legal aspects and the economic substance of the agreement.
Let’s examine some common RTO transaction components and see how they impact the seller/ landlord in terms of taxable income:
1. Sale of option to purchase
An option (in this case, a call option) typically refers to a contractual arrangement between a seller and a buyer where the seller provides a right, but not an obligation, to purchase a subject property at a predetermined price within a predetermined timeframe. The value of such an option is usually a function of various factors, including but not limited to the duration of the contract and the contractual purchase price of the subject property relative to the estimated fair market value of the property at the time when the option can be exercised.
Generally, non-refundable option premiums received from the seller in RTO transactions are treated as taxable income.
2. Rental payments
A typical RTO transaction involves the buyer renting from the seller for a predetermined period of time. Rental payments are taxable income for the seller/landlord.
3. Deposit payments
In addition to the rental payments, the seller typically requires deposit payments toward the purchase price of the property. Similar to many vendor-financing transactions, the intention is to allow buyers to have sufficient time to come up with the deposits.
For sellers, non-refundable deposits are generally treated as taxable income, but the seller may be able to defer the recognition of taxable income on refundable deposits.
4. Buyer exercises the option to purchase
When the buyer exercises the option to purchase the property at end of the lease term, the sale proceeds. Deposit payments received but not previously recognized as income are treated as taxable income to the seller.
The tailor in action
Let’s look at a sample scenario. Real estate investor Steve purchased a residential property in Ontario at the end of 2018 for $500,000. Steve expected the property value to increase to $550,000 by early 2021. He is also planning to retire that same year.
Steve is working on an RTO transaction (Plan A) with Roger, the tenant-buyer, at the beginning of 2019. Steve's tax advisor has also given him a few suggestions as illustrated in Plan B, laid out in the chart at TK. Both Plan A and Plan B would result in the same amount of cash inflow over the term of the RTO. Plan B, however, would generate $7,000 more in after-tax cash flow, which is about 10% more than Plan A. This is a result of the following:
Converting $5,000 of the option premium into the purchase price, thus deferring cash inflow and taxable income to a period when Steve will be subject to a lower tax rate.
Splitting $40,000 worth of non-refundable deposits into partially refundable and partially non-refundable segments. This allows Steve to defer tax on the refundable portion of deposits until the deposits are applied towards the purchase price in 2021.
As seen from the illustration, there are many factors that need to be taken into consideration in an RTO transaction. The sample is used to illustrate a number of these concept, but there are many other considerations, such as ownership structure, tenant credit risks, time value of money, market risk and hedging position. As such, investors should work closely with their tax advisors and lawyers to customize the structure, terms and conditions of an agreement to align with their investment plans. As always, tax optimization is a result of long-term planning and patience.
If rent-to-own is set to be your next bespoke suit, talking to your tax advisor is a good way to get your measurements taken.
Andrew Ku is a licensed public accountant who lives and works in Toronto. Contact him at [email protected]
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