Small-business owners should consider any real estate owned by their business integral to the success of their personal financial plan. Real estate owned by a business can provide unique tax benefits and offer an inflation hedge. These benefits are different during one's working years and retirement years. They should be considered as part of a transition when one sells their business to retire.
While running a small business, owners must balance responsibilities to their employees, customers and families with building a strong financial future for themselves. Adding the headaches that come with owning property relative to renting may seem like an unnecessary burden. However, the unique benefits provided by real estate to business owners may be worth the hassle.
Financial benefits
Real estate has been shown to be an excellent inflation hedge. High inflation rates pose difficult problems for business owners who must balance passing on costs to customers with their own rising expenses. If one is to purchase the property occupied by their business on a fixed rate mortgage, then their real estate costs are mostly fixed — and immune to inflation. Although property insurance and property taxes will likely rise with inflation, this still provides a competitive advantage that provides clarity to business owners planning for their business and personal financial future.
Real estate ownership provides unique tax benefits to small business owners that should be discussed with an accountant. While many business owners are reluctant to tie up capital in a real estate purchase, this can be offset by using leverage and taking advantage of bonus depreciation. Banks are typically more willing to lend against real estate than an operating business. This allows one to use less capital for the purchase and possibly improve their monthly cash flow versus paying rent.
To take advantage of bonus depreciation, the business owner will need to have a cost segregation study done. Any parts of the property that the IRS considers having a useful life of less than 20 years may be deducted 100% in the first year. This allows the business owner to deduct the value of 100% of the bonus depreciated property against ordinary income, while the remaining property (excluding the value of the land) is depreciated over 39 years. When this property is sold it must be "recaptured," but only at a tax rate of 25%.
Real estate and retirement planning
When approaching retirement, the sale of the business and sale of the real estate should be considered separately. While it may make sense to sell both to the same buyer, selling them separately could better help the business owner reach their goals in retirement.
The business owner should attempt to maximize the value from the sale of both the business and real estate. In some cases, a buyer of the business may prefer to rent real estate. In this case, one could serve as landlord or find an investor who would like to purchase the property. Breaking the sale into two components allows each to be maximized.
Holding the real estate as an investment could provide an inflation hedge in retirement. Rents tend to increase with inflation, so holding the property to collect rents could help one adjust their retirement income upward with inflation. This strategy is not without risks and should be considered in conjunction with the business owner's overall financial plan.
Selling your business real estate
Business owners who sell their real estate should consider the potential tax consequences and plan accordingly. There are options to pay the taxes in the year of sale, spread them over time, or delay them indefinitely by exchanging into other real estate. Each option will have its own benefits and disadvantages that should be considered given your objectives.
An outright sale of the real estate when the business is sold would provide immediate cash that could be utilized elsewhere to prepare for retirement. However, this could involve paying taxes at a higher rate because the sale of the business and real estate in the same year could bump the owner into a higher tax bracket. Also, any depreciation must be "recaptured" at a rate of 25%.
Selling the real estate in an installment sale could allow the owner to spread the capital gains over time and earn interest at the same time. When one sells real estate and finances the purchase by taking a mortgage, they report the gains as they receive payment. This allows the gains to be recognized in future years when they may be in a lower tax bracket but comes with the risk that the purchaser is not able to make the payments.
A business owner should understand the risks and rewards of owning real estate as part of their business. This understanding allows them to make the best decisions that provide the highest chances for success.
Seth Mullikin, CFP, is the founder of Lattice Financial.
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