OP's facts seem to me to be way more like a loan with the land bank holding title as security and restricting development until payment is made for specific lots.
Are you saying the Option Agreement should not be respected as such? It sounds like it and it sounds like Dennis would agree…
plus the risk of having to sell the land again to recover their investment.
But isn’t that part the nature of an option payment? (And I did note your use of the word “again,” implying the transaction should be cast as a sale). Doesn’t the Land Bank’s risk arise if the option isn’t exercised? And about that specific risk, what is it? It seems there’s a risk that the land value decreases. Whether or not that happens doesn’t really matter, it’s just a risk. The other part of this, as I see it, is that if the value stays flat, the Land Bank is precluded from selling the land to another buyer during the option period. If the value stays flat, that gets to your other point about compensatio for the Land Bank’s cost of money. And part of the overall holding period risk is that the Land Bank will incur holding costs, so perhaps part of the 12%-15% option fee is more or less a reimbursement for that. I can also see the Land Bank wondering about a possible sharp increase in value. Wouldn’t the option payment partially represent Land Bank’s desire to share in that appreciation to some degree? That is, it mitigates the risk that the Land Bank completely loses out on appreciation.
Like I said, there are much splitting of the hair that could be done here. But doesn’t it come down to this: Whether or not we have a valid option agreement? If we have that, then it shouldn’t matter if the agreement states the option payments won’t be credited at closing. They simply would be in practice. They would be added to the purchase price upon option excerise (or brought into income if the option lapses unexercised). If we have a valid option agreement, isn’t it implied that there is a real risk to the Land Bank?
It seems that if we have a valid option agreement, no hair splitting takes place. Even if part of the option fee is for the forbearance of money, it is not cast as such. Now if we have a sale, then we get into hair splitting. But it might be easy. Either the full option payment represents interest or we impute it somehow. In Koch, a hair splitting argument wasn’t raised by the IRS. The IRS just wanted to treat the full option payments as interest (at least this was one of their arguments).
Given that the “buyer” might not exercise the option, on what grounds could the form of the transaction be attacked based on a substance that feels like indebtedness? Would one factor be whehter or not the developer always exercises his options? To me, the fact that we have a special purpose Land Bank entity here means we should not be permitted to see what this particular developer has done with other Land Banks in the past. And it also seems that to level charge of a pre-arranged deal (i.e. a sale) because the developer always exercises his option would involve a whole lot of hindsight and/or a whole lot of prognosticating.