Real Estate Options

Most real estate investors believe that Real Estate Options are very complicated and difficult to understand, but this should not be the case.  Real Estate Options can be wonderful tools, given the right situation.

What is a Real Estate Option?

A Real Estate Option is a contract that specifies an agreement between two parties, for a future transaction, on an asset at a predetermined price.  Is it important to remember that a Real Estate Option is exactly that: An Option.  This means that the owner of the Real Estate Option does not have to exercise his or her option.  The owner of a Real Estate Option has the Option of either purchasing the property or letting the Option expire worthless (walking away from his or her Real Estate Option).

Why Use Real Estate Options?

Using Options in Real Estate can be very lucrative.  Real estate investors use options for a number of reasons, including:

• Avoiding short term capital gains
• Speculating
• Decreasing the amount short-term capital required
• Acquiring temporarily control of a property
• Maximizing the return on a specific real estate investment

When a real estate investment property is purchased and sold for a profit within one year of ownership, the IRS classifies this as a short term capital gain.  Short term capital gains taxes are taxed as ordinary income (up to 35%); however, long term capital gains taxes are taxed at 15%.  Some investors, depending on the situation, may want to sell a short-term option on the property rather than an immediate, outright sale of the property.  Below is an example of a situation where it would be wise to use a Real Estate Option, in order to avoid the higher short-term capital gains taxes:

1. Real Estate Guru purchases a real estate investment property on 1/1/2011 for $100,000
2. Wal-Mart opens next to Real Estate Guru’s property on 10/2/2011; the investment property is now worth $175,000
3. A Buyer approaches Real Estate Guru and offers $175,000 for the property
4. Real Estate Guru makes a lot of money, so he does not want to pay 35% in short-term capital gains taxes on the $75,000 profit
5. Real Estate Guru agrees to sell the Buyer a 3 month “European” option on the property for $10,000
6. On 1/2/2012, the Buyer exercises the European Option and the property title is transferred to the Buyer
7. Real Estate Guru now pays 15% long-term capital gains tax on the $65,000 profit from the sale of the property and 35% short-term capital gains tax on the $10,000 profit from the European Option.

In the above example, Real Estate Guru saved $13,000 in capital gains taxes by using a Real Estate Option.  Without use of the Real Estate Option, Real Estate Guru would have paid the following:

 

No Real Estate Option

Property Cost Basis	$100,000
Sale Price	$175,000
Short-term Capital Gains Profit	$75,000
Short-term Capital Gains Rate	35%
Total Capital Gains Taxes Due	$26,250

 

With a Real Estate Option

Property Cost Basis	$100,000
Option Price	$10,000
Sale Price	$165,000
Short-term Capital Gains Profit	$10,000
Short-term Capital Gains Rate	35%
Short-term Capital Gains Taxes Due	$3,500
Long-term Capital Gains Profit	$65,000
Long-term Capital Gains Rate	15%
Long-term Capital Gains Taxes Due	$9,750
Total Capital Gains Taxes Due	$13,250

The difference between an American option and a European option is the following:

• An American Real Estate Option can be exercised by the owner of the option at any time
• European Real Estate Options can only be exercised by the owner of the option at the date of expiration

In the above example, the reason why Real Estate Guru used the European Real Estate Option was because he did not want to pay short-term capital gains tax on the entire $75,000 profit.  By using the European Real Estate Option, Real Estate Guru ensured that the Buyer could not exercise his option prior to 1/2/2012 (1 year and 1 day after Real Estate Guru had originally purchased the investment property).  It is also important to keep in mind that the profit from the option itself is classified as short-term capital gains.  By using a Real Estate Option, Real Estate Guru showed his knowledge and expertise, while saving himself $13,000 in capital gains taxes ($26,250 – $13,250 = $13,000).

For more on the difference between short-term and long-term capital gains taxes, please read google Real Estate’s article: Short Term vs Long Term Capital Gains.

Real Estate Options: The Technical Stuff

This section of Real Estate Options is dedicated to legal verbiage and what should be included within a Real Estate Option Contract.  Feel free to skip over this…

A Real Estate Option is comprised of the following elements:

1. Optionee: Optionee is the name given to the party buying a Real Estate Option. Once the Real Estate Option is exercised, the optionee is now the buyer.
2. Optionor: Optionor is the name given to the party selling a Real Estate Option. Once a Real Estate Option is exercised, the optionor is now the seller. 
3. Real Estate Option: When an optionee buys a Real Estate Option, he or she buys an exclusive, unrestricted, and irrevocable option to purchase a specific property at a fixed, predetermined purchase price within a specific duration of time. 
4. Option Consideration: Option consideration is the amount of money paid by an optionee to buy a Real Estate Option from an optionor.
5. Option period: The option period is the specific period of time specified in the Real Estate Option agreement in which the option is in effect. 
6. Exercise of an Option: The exercising of a Real Estate Option occurs when the optionee notifies the optionor, in writing, that he or she will exercise his or her Real Estate Option and purchase the specific property. 
7. Expiration of an Option: A Real Estate Option expires when an optionee fails to exercise his or her Real Estate Option within the predetermined option period in the Real Estate Option agreement. 

Real Estate Options: Conclusion 

Using Real Estate Options can be profitable, fun, and exciting, but it can also be complicated, risky, and stressful.  Prior to purchasing or selling a Real Estate Option contract, make sure that you fully understand the financial impact of each possible scenario.  A Real Estate Option can be an all or nothing type of investment.  Remember: One in doubt, seek advice! 

If you would like to contact me about anything regarding Real Estate Options, just send an email to Constantine@googlerealestate.com.

Another informative article from google Real Estate.