Real Estate Rights Transactions: Lease Cancellations, Real Estate Options, Easements, and Covenants
The transfer or modification of real estate rights, which may include modification of leases or the granting of real estate options or easements and covenants, may be a taxable event.
Payments by a tenant to a landlord to cancel or modify a lease are considered rental income to the landlord. Payments received by a tenant for the cancellation of a business lease that was held longer than 1 year is treated as a §1231 transaction, which is subject to complex capital gains/loss rules. If a landlord pays the tenant to cancel or modify a lease for a personal residence or apartment, then the payment is a capital asset, which is a capital gain; however, losses are not deductible.
Real Estate Options
A real estate option gives the holder the right, but not the obligation, to purchase real estate at a stipulated price within a certain time. If an option for real estate is sold, then its tax treatment depends on the underlying property. Profits on the sale of options are generally considered capital gains and are, thus, subject to the capital gains rules, but if the sale of the underlying real estate would be considered ordinary income, then the gain or loss on an option on that real estate would also be considered ordinary income or loss. However, losses can only be deducted on business or investment property — losses on personal property are not deductible.
If the underlying asset is considered §1231 property, which is business or investment property that has been held longer than 1 year, then the gain or loss must be netted with other §1231 transactions to determine the capital gain or ordinary loss.
If the option lapses, then the option grantor treats the option income as ordinary income, regardless of the characterization of the underlying property. If the option is exercised, then the tax basis of the property is adjusted to include the payment of the option premium:
Adjusted Basis of Property = Option Premium + Property Sale Price
An easement is a granting of some property rights to another party to use a parcel of land in a particular way, such as when a farmer sells an easement for electrical lines and towers on his property. If an easement is considered to affect the entire property, then the adjusted basis of the entire property is simply reduced by the amount of the payment for the easement. However, in most cases, the easement will be considered to have affected only part of the property, so only that part of the property's adjusted basis must be reduced by the payment and if the payment exceeds the basis of that parcel, then the excess is treated as capital gain.
Example: Taxation of Easements
If a farmer has 100 acres of land with an adjusted basis of $10,000 and he receives $8000 for an easement that covers 20 acres, then taxable income will be recognized as:
- Adjusted Basis per Acre = $10,000 / 100 = $100
$8,000 for Easement – Tax Basis for the Affected Parcel of Land = $8,000 – (20 × $100) = $8,000 – $2,000 = $6,000 Capital Gain
A real estate covenant is a written agreement between 2 or more parties where the successors to the real estate agree to use or not to use the real estate in a particular way. The covenant is usually written into deeds, mortgages, leases, and contracts for deeds. Covenants are restrictive, such as requiring that the real estate be used for a specific purpose, such as for residential dwellings; or to enforce architectural or design standards, to limit the density of any future development, or to prohibit certain practices, such as selling alcoholic beverages on the premises. Because restrictive covenants generally decrease the value of the real estate, income is earned by releasing a restrictive covenant and is treated as a capital gain if the property was held as an investment.
- A contribution to a government for a scenic easement in perpetuity is considered a charitable contribution rather than a sale.
- If the easement is appropriated by condemnation, then tax can be deferred by investing in replacement property.
- The payment for the release of a restrictive covenant is considered a capital gain to the recipient if the property was held for investment.