 Avoid
short-term gains on investment property
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 Dear
Tax Talk,
We purchased a townhouse as an investment property and rented it
to our daughter, with a signed rental agreement, in May of 2005.
To make a long story short, the rental agreement stated if they
were not able to make the rent payments, the property would be put
up for sale. I knew this would be the only way of getting them to
leave the property.
The townhouse was put up for sale Dec, 31, 2005 and they moved
out on Jan. 7, 2006. We have had several offers but these have fallen
through to date. The question that I have is this: If we sell the
townhouse now, is it subject to our 28 percent tax rate because
it is a short-term capital gain? If we hold the property and rent
it out with an option to buy until after our one-year anniversary
of ownership, what will be our long term capital gains if we don't
exchange the property as a 1031?
-- Jan
 Dear
Jan,
I guess you knew your daughter all too well. If you close on the
sale of the property prior to one year and one day, you'll realize
a short-term capital gain that will be taxed at the same rate as
your other ordinary income. You estimate this to be 28 percent.
If you wait for more than one year to close the sale, you'll cut
the tax almost in half, as the long-term capital gains rate in 2006
is 15 percent. As you suggested in your question, the best method
to accomplish the sale is to rent with a purchase option exercisable
after one year and one day.
The rental agreement should be clear that it is a
rental contract and not a sales contract to avoid shifting the economic
burdens and benefits of ownership prior to the exercise of the option.
That is, you don't want to enter into an agreement that shifts so
much of the responsibility for the property to the tenant that,
in essence, the tenant is considered to have purchased the property
and is only awaiting the legal transfer of the title.
This is unlikely to occur in a financed deal, as the lender wouldn't
lend until there was an actual transfer of title. Similar care should
be exercised in a cash deal. The terms of the contract can provide
for a set price and can even provide for rent credit, but stay clear
of items that make it look like a disguised sale. A good attorney
can help you with the purchase option to accomplish your goals.
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