Option Payments and Other Cash Received Before Exchange
Not all pre-exchange cash receipts by the Seller from Buyer are boot nor treated as income in the year of receipt by the Seller.
Frequently, a taxpayer receives cash from a potential buyer either as consideration for an option to purchase the property at a later date or as an earnest money deposit. The taxpayer may receive these funds before a like-kind exchange of the subject property is being considered, or in anticipation of a like-kind exchange. A careful analysis of the tax effect of the payment is necessary at each stage of the transaction to ascertain when, and if, the payment is treated as income to the seller.
The general rule for option payments is that their receipt is not an income-recognition event until the option transaction is complete either by sale of the property or by expiration of the option. Similar rules apply to an earnest money deposit made in consideration of a purchase and sale agreement: The payment is not income to the seller until the transfer contemplated by the contract has been executed. IRC §1234.
EXAMPLE 1: A taxpayer and a buyer enter into an option agreement on 1/1/X1 for Whiteacre, a parcel of raw land in which the taxpayer has a basis of $90,000, which is being held for investment purposes. In consideration for the taxpayer's agreement to convey Whiteacre to buyer at any time on or before 12/31/X2, the buyer makes a nonrefundable payment of $10,000 to the taxpayer. Both the buyer and the taxpayer agree that the payment will be a credit against the purchase price if the buyer exercises the option before it expires. If so, the taxpayer does not recognize income on receipt of the option payment. IRC §1234.
These rules do not change when a taxpayer anticipates undertaking a like-kind exchange but has not yet conveyed the relinquished property to the buyer. Receipt of cash before a like-kind exchange neither results in income to the seller nor "taints" the cash as boot for IRC §1031 purposes. If the seller subsequently conveys both the option payment or earnest money proceeds to a qualified intermediary (QI) before or concurrent with the conveyance of the relinquished property, and the QI subsequently exchanges the relinquished property and the proceeds of the option payment or earnest money deposit for a replacement property that is conveyed to the taxpayer, then the cash will not be treated as cash boot received for §1031 purposes.
EXAMPLE 2: Assume the same facts as in Example 1, except that on 6/1/X2, the buyer exercises the option right to purchase Whiteacre for $100,000. In anticipation of the sale of the property to the buyer, the taxpayer enters into an exchange agreement with the QI meeting the requirements of Treas Reg §1.1031(k)-1(g) and concurrently transfers $10,000 to QI, who subsequently gives the buyer a $10,000 credit, and conveys Whiteacre to the buyer for $90,000 cash. The taxpayer later identifies replacement property and the QI purchases it on the taxpayer's behalf for $100,000 cash, using the $10,000 transferred to the QI by the taxpayer and the $90,000 paid by the buyer. Result: The taxpayer realizes gain of $10,000, but no gain is recognized. See IRS Letter Ruling 7952086.
Crucial to this analysis is the taxpayer's transfer of the option or deposit money to the QI before the exchange. If the taxpayer does not convey the option proceeds to the QI before the exchange, the cash option or earnest money payment would be treated as boot. If, in this example, the taxpayer did not transfer $10,000 to the QI, and instead purchased replacement property for $100,000 with $90,000 cash proceeds from sale of the relinquished property and $10,000 mortgage loan proceeds on the replacement property, the taxpayer would have cash boot of $10,000 in the exchange and, thus, have realized and recognized gain of $10,000.
A taxpayer who receives option payments from the buyer of the relinquished property and retains the payments following transfer of the property must treat the option payments as cash boot in the year of the exchange. See IRS Letter Ruling 9413024.