Author Topic: Long term option and arm's length doctrine  (Read 458 times)

Paul der Krake

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Long term option and arm's length doctrine
« on: August 13, 2016, 03:22:03 AM »
Let me preface this question by stating that this is purely hypothetical and more a thought exercise than anything else.

Suppose a married couple in their forties owns a large piece of land on which their primary home lies. They would like to pass the property down the family tree before dying, let's say 10 to 15 years before their life expectancy, so they can spend their old days in a Florida condo instead of dealing with a large property. The town around them is expanding like crazy, and while there are no guarantees in this world, everything points to the idea that this land will be a lot more valuable 30 years from now because of its location.

However, if they wait the 30 years before selling it to the son, the arm's length doctrine pretty much guarantees that they would have to sell it for something close to fair market value, or suffer the wrath of the Taxman. The son most likely will not have anywhere near the required monies to buy the property when the time comes.

Can the enterprising son sign a 30 year option on the property today, basically only paying a small insurance premium that could even be gifted back and stay below the gift laws? After all, nobody knows what the property will be worth 30 years from now, and there is no options market on this particular property.

For illustration purposes, let's say the numbers are as follows:
Current property value (2016): $500,000
Option price: $25,000 for a strike price of $750,000 in 2046

The married couple pays taxes on the $25,000 as income at their marginal tax rate of 25%, and gifts the remaining $18,750 back to the son, tax free. The effective option premium is a mere $6,250.

2046 rolls around and the fair market value of the property is now $5,000,000. The son exercises for the agreed $750,000. Does this pass the smell test? What can the taxman do to block the transaction?


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Re: Long term option and arm's length doctrine
« Reply #1 on: August 13, 2016, 07:22:12 AM »
It's a little unclear which taxman you're worried about: property transfer tax (which is usually minimal), state estate tax (wildly variable), or federal estate tax (~$11MM/couple exclusion).

I would talk to a hypothetical trust and/or local real estate attorney if the goal is to keep the property in the family. Or consider an LLC to hold the property. Or put the son on the title now as tenants in common, with the couple gifting the son additional equity over time [perhaps combined with a first year 5-year gift]. (I'm not any kind of expert in the area, but I doubt that modeling this as a pure options transaction is the best way to accomplish the [hypothetical] goal.)