A payment for an option to purchase property is not a taxable event to either party upon the grant of the option. See Virginia Iron Coal & Coke Co. v. Commissioner, 99 F.2d 919 (1938); Rev. Rul. 58-234; and Fed. Home Loan Mortg. Corp v. Commissioner, 125 T.C. 248 (2005). That is because it is unknown whether the option will ultimately be exercised. In general, as discussed in Virginia Iron Coal, the tax system generally operates on a yearly basis. However, in some circumstances, that is not possible, such as where an option payment is received in year 1 for an option to purchase property in year 2. It is unknown in year 1 whether the option will ultimately be exercised. Therefore, it is impossible to determine in year 1 how the payment should be treated. The transaction is treated as open until it is resolved.

If the option is ultimately exercised, the payment for the option is treated as part of the consideration for the sale of the property. The character of the gain is based on the character of the property being sold (e.g., a capital asset). The gain is taken into account in the year of sale rather than requiring the seller to amend its return for year 1 to include the payment in the year in which it was received.

If the option is never exercised and expires, the payment for the option is treated as ordinary income to the grantor of the option in the year in which the option lapses. The courts have determined it would be inefficient to keep prior years open to allow amendments to report unexercised options as income. They have determined the most efficient answer is to allow lapsed options to trigger taxable income to the option grantor in the year of lapse. For the purchaser of the option, the loss attributed to the failure to exercise the option is governed by Section 1234(a). It states loss is treated as the loss from the sale or exchange of the option on the day it expires and is of the character of the underlying property to which the option relates. The holding period for such loss is determined based on the holding period of the option. Reg. § 1.1234-1(a)(1). Thus, if the option is for the purchase of a capital asset and the holder held the option for over a year, the loss upon failure to exercise the option is long-term capital loss.

John G. Hodnette is an attorney with Johnston, Allison & Hord in Charlotte.

April 6, 2023/by TAX