When we are dealing with a business owner that owns the real estate that the business occupies, we are often asked about the best way to treat this underlying real estate. Unless there is a particular circumstance that clearly dictates the decision, our response is almost always to be flexible and be prepared to keep or sell the real estate to maximize the marketability of the business. In most situations, it is more difficult to sell the business than the real estate and the business owner has some options to achieve the desired outcome.
For combined transactions of $5,000,000 or less, SBA financing is likely to be used. Most SBA lenders like real estate as collateral and will make more attractive loans if real estate is involved. Not only will the buyer receive a better interest rate, but the amortization of the loan may be extended from 10 years to 15 years or longer, depending on the relative values of the business and the real estate. The lower interest rate and the longer amortization result in lower monthly payments, which enables the buyer to pay more for the combined transaction.
In some situations, the Seller would prefer to keep the real estate as in investment, but we have encountered buyers who will not buy the business without the ability to also buy the real estate. This scenario may particularly occur for destination-driven businesses in premium locations. In this type of situation, the Seller of the real estate can make a Section 1031 election to defer the tax gains, if any, on the profit from the sale of the real estate. The Seller would then reinvest the proceeds in another parcel of investment real estate. There are detailed rules that must be followed in these types of tax deferred transactions and experienced professionals should be involved, but the benefits can be substantial.
For example, over 20 years ago, I sold my parents’ wholesale gift distributing business. They also owned an office warehouse building that had significant appreciation. I helped them sell the warehouse and reinvest in a farm. The transaction saved six figures in taxes, and resulted in a low maintenance income stream that subsidized their retirement. Upon their death, the farm will get a “stepped up basis” and the farm can be retained or sold with little or no taxable gain.
In other situations, the buyer may not want to buy the real estate. For example, Private Equity Groups often do not want to purchase real estate, as they believe they can generate higher returns for their investors by investing and creating value in operating businesses, rather than real estate. In this scenario, the real estate owner can either keep the real estate and rent it to the buyer or sell the real estate to an investor. If the Seller of the business is contemplating retaining the real estate, he or she should make sure that there is a formal lease in place at fair rental value with terms that would be acceptable when dealing with a third party lessee.
(originally published in February 2016 eNewsletter)