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Selling the property
Now project 10 years into the future and assume that rather than selling the business, the business-owner simply shuts it down and sells the building. Also assume that after the first year he replaced the 6.25 percent ARM with 9.87 percent permanent financing. How did he do? At the end of 10 years, he owed the bank $410,000. However, because real-estate values went up by an average of 7 percent per year, he sold the building for $1.47 million. After paying off the mortgage, The Speed Shop’s owner was left with $1.06 million.
True, he doesn’t get to pocket this. He must pay long-term capital-gains taxes. And all that depreciation he took for so many years comes home to roost, in lowering the cost of the building and in turn, increasing the capital- gains tax owed. In this case, the $17,308 in annual depreciation reduced the owner’s cost basis by $173,080 in 10 years. In other words, the owner must now pay taxes on this so-called “unrecaptured” depreciation at a rate of 25 percent. The balance of the gain will be taxed at the recently enacted long-term capital-gains rates of 15 percent.
This must be weighed against the avoided taxes of $4,181 in the first year and $9,800 in years two through 10, as a result of a mortgage with a higher interest rate. More importantly, it must also be weighed against the $634,692 ($1.06 million in proceeds minus $125,308 capital-gains taxes minus $300,000 initial investment) earned on the real-estate investment after payment of all long-term capital-gains taxes.
The average after-tax gain of $63,469 ($634,692 divided by 10 years) per year is the equivalent of $97,644 pre-tax income in a 35-percent bracket. Adding this to the owner’s salary and profit distribution of $97,500 means that he doubled his income by diverting the cash flow that would normally go into rent toward ownership of real estate. It’s as if he made the business twice as big without adding a single square foot to the operation.
Based on this example, it’s safe to say that adding real estate into the business equation can have a material effect on the wealth of principals in a small business. Take this case into consideration when weighing your options of owning vs. renting real estate for your business.
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