Rev. Rul. 82-52: Tax Treatment of Option Payments
For property option grantors, the tax treatment of the initial payment is deferred. Its character as capital gain or ordinary income depends on future events.
It is a common scenario in business and real estate for a property owner to receive a nonrefundable payment from a potential buyer. In exchange for this payment, the owner grants the buyer the exclusive right, or option, to purchase the property at a set price within a specified timeframe. While the receipt of cash might seem like a taxable event, the tax treatment is not that simple. The tax implications for the property owner who granted the option are entirely dependent on the future actions of the option holder.
The initial tax handling of this payment is determined by a long-standing principle that defers recognition of the funds. This approach acknowledges that the final character of the money is uncertain at the time it is received. Whether the payment will ultimately be treated as part of a property sale or as standalone income cannot be known until the option period concludes.
Initial Tax Treatment of the Option Payment
When a property owner, the grantor, receives a payment for an option to purchase property, the tax treatment at that moment is one of deferral. The grantor does not report any income or gain upon receiving the funds. This is because the ultimate nature of the payment is still undetermined. It is not yet known if the payment will become part of the proceeds from a sale or if it will be retained as a result of a lapsed option.
This deferral is governed by the “open transaction doctrine,” a concept that applies when the consideration for a transaction cannot be definitively valued or characterized in the year it is received. In the case of a property option, the payment’s character hinges on whether the option is exercised, and the tax consequences are postponed until the uncertainty is resolved.
Tax Outcome if the Option is Exercised
If the holder of the option decides to move forward and purchase the property, the tax treatment for the grantor becomes clear. The initial nonrefundable payment is rolled into the overall sale transaction. This payment is added to the final purchase price to calculate the total “amount realized” from the sale. The amount realized is reduced by the grantor’s adjusted basis in the property.
The adjusted basis is the original cost of the property, plus the cost of any capital improvements, less any depreciation taken. The result of this calculation is the capital gain or loss on the sale. The character of this gain or loss depends on how long the grantor owned the property.
If the property was held for more than one year, the gain or loss is long-term, which often benefits from preferential tax rates. If the holding period was one year or less, the gain or loss is short-term and is taxed at the grantor’s ordinary income tax rates. The gain is reported in the year the sale is finalized.
For example, a grantor receives a $50,000 payment for an option to purchase a commercial building. The buyer later exercises the option, paying the agreed-upon $950,000 sale price. The grantor’s amount realized is $1,000,000. If the grantor’s adjusted basis in the building was $600,000, the total capital gain would be $400,000.
Tax Outcome if the Option Lapses
When the option period expires and the holder chooses not to purchase the property, the tax consequences for the grantor are distinctly different. The grantor retains the initial option payment, and the entire amount is recognized as ordinary income. This income is not treated as a capital gain.
The grantor must report the income in the tax year that the option officially expires or is terminated. This treatment reflects the underlying principle that the payment is compensation for the period the property was held off the market.
Consider an example where a property owner receives a $75,000 payment in 2023 for a two-year option on a parcel of land. The potential buyer does not exercise the option, and it expires in 2025. The property owner must report the full $75,000 as ordinary income on their 2025 tax return.
How to Report Option Transactions
The method for reporting the financial outcome of an option depends on whether the option was exercised or if it lapsed. If the option is exercised and results in the sale of the property, the transaction is reported as a sale of a capital asset. For business property, this is detailed on IRS Form 4797, Sales of Business Property.
The gross sales price reported should include both the final sale price and the initial option payment. The resulting capital gain or loss is then transferred to Schedule D, Capital Gains and Losses.
If the option expires unexercised, the forfeited payment is reported as ordinary income. This amount is entered on Schedule 1 of Form 1040, Additional Income and Adjustments to Income, on the line for “Other income” with a description such as “Forfeited option payment.”