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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2005

For small businesses, real estate can define the bottom line

Perhaps the most-striking feature about the money homeowners make from their houses is how little of it is intentional. For many home- owners, a mortgage payment simply has been a substitute for a monthly rent payment. But over time, loan balances went down, values went up and suddenly, homeowners had a half-million in equity sitting on the table.

Although a similar opportunity exists for small businesses, fewer entrepreneurs take that leap. They might think that running a business is challenging enough — why add the headache of owning additional property?

This view might be true for some small-business owners, but buying real estate to house your business — as opposed to renting — can have a material impact on your return from the business, as well as on your overall wealth.

Case study

To see this concept in action, consider the performance of a hypothetical automotive-products retailer, The Speed Shop, before and after a real-estate purchase.

For years, The Speed Shop provided a nice living for its owner. Renting space in a suburb of a major metropolitan area, the business — a Subchapter S corporation — consistently generated $750,000 in sales. It distributed net profits of 5 percent, or about $37,500, after paying a $60,000 annual salary to its owner. The business was stable, so the owner typically took the net profits out of the business as a cash payment.

One day, the owner received a call informing him that Speed Shop’s building owner died. The executor of the estate wanted to know if the business-owner would want to purchase the building for $750,000. The Speed Shop owner had invested his bonuses wisely in the past 10 years, so there was no question that he had the cash to make a 40-percent down payment of $300,000.

The question became whether purchasing the building would have a positive or negative effect on The Speed Shop’s owner. Assume the owner bought the building personally and rented it to his business. Let’s see how far ahead he might be after 10 years, as opposed to if he continued to rent.

If the $450,000 balance was financed with a 6.25 percent ARM, the monthly principal and interest payment would be $2,770, if amortized on a 30-year basis. Adding the annual taxes of $7,200 increases the monthly payment to $3,370. This is less than the monthly rent of $6,500 that the company paid, so the transaction would be off to a good start.

But let’s be conservative and assume that The Speed Shop’s owner spends $37,500 annually on maintenance and operating expenses for the building. This amount is the annual difference between the old rental payments and the new mortgage and tax payments.

Depreciation and principal

Now we need to make two adjustments to account for depreciation and principal contributions.

Let’s take principal first. The mortgage payments of $2,770 per month that total $33,240 per year include about $5,300 in principal payments in the first year. These principal payments cannot be expensed.

On the other side, there’s depreciation to consider. With net of land, which cannot depreciate, the value of the building is $675,000 — $750,000 minus an assignment to the value of the land at about $75,000, or 10 percent of the total property value. The useful life prescribed by the Internal Revenue Service for nonresidential, commercial real estate is 39 years. Therefore, the annual depreciation expense for the property is $17,308, which is the $675,000 basis divided by the 39-year useful life.

The income statement for the first year will look like this:

As the landlord, the business-owner feels none of this net loss. It’s delivered in large measure by the non-cash depreciation expense. On the downside, he also doesn’t feel the increase in equity of $5,300 because the mortgage payment does not change, despite the lower mortgage balance.

Regardless, what’s important is the business-owner’s ability to take this loss and net it against the profits he receives from his retail business that will ultimately have a material impact on his wealth.

As for the $37,500 in profit: Thanks to the loss on the building, the business-owner will pay taxes on just $25,552 ($37,500 profit minus $11,948 loss from real estate). In a 35-percent bracket, this means he avoided taxes of $4,182.

The Speed Shop’s net margin would have to increase to 5.86 percent to leave its owner with the same amount of cash after taxes. This represents an astounding 17.2 percent, or $6,450, increase in net-realized profits to the owner.

It’s important to keep in mind, however, that the feds, as a general rule, do not like to see passive income (e.g., income from a real-estate investment) offsetting active income (e.g., income from running a retail operation). There are rules that govern limits to the offsets that are more than certain amounts. And you might not be able to sway the Internal Revenue Service that your ownership and management of the building are active.

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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