Owners of commercial real estate who operate a business on their property can convert equity into cash by selling the property and leasing it back from an investor. Commercial real estate professionals call the transaction a “sale-leaseback.”
The benefits to the seller and the investor in this type of transaction often out way the drawbacks. The most obvious and attractive benefit to the seller is that it is way to raise capital without encumbering the property to any debt. The sale of the property converts equity into cash, while the lease gives the user control and use of the property. An investor gets an established tenant who is already in place and operating a business.
The transaction can provide an exit strategy for a property and business owner who wants to pull equity out of the property for any number of reasons: to generate residual income and to start moving toward retirement and the future sale of the business; to raise capital for children’s college funds, to pay for medial expenses, buy a second home or recreation vehicle; to raise capital to reinvest for expansion of the existing business or to invest in an other business or property.
Investors like these transactions because they get a predictable return on their investment through rents paid from a tenant with an established business. Since the new tenant (former owner) is used to managing the property, the investment may require minimal property management. And the investor gains tax advantages because the purchase starts a new depreciation tax allowance schedule for the property and may offer an interest deduction if financing is involved.
If the seller has the property free and clear of debt obligations there may not be many tax advantages to continued ownership of the property. Conversely a sale of the property may trigger capital gain tax consequences for the seller. If the gain is substantial the seller is well advised to consult with a knowledgeable tax attorney or accountant.
Depending on a sellers needs and objectives the options include: 1) pay the capital gain tax and use the balance any way they chose; 2) exchange into another property, using the IRC (Internal Revenue Code) 1031 tax deferral method; 3) or provide seller financing to the investor, which would generate an initial cash down payment and monthly cash flow with interest.
The 1031 Exchange option allows the seller to defer all capital gain taxes by “exchanging” equity (and debt) into another “investment” property. The IRC 1031 tax code must be followed carefully to qualify. If a seller chooses to pursue this method it is important to seek professional consultation and retain an experienced and reputable facilitator before initiating a transaction.
Seller financed transactions may be the best option if the seller has needs or plans for cash. By providing seller financing, the risk of default by the investor is minimized because of the control the seller has over the cash flow by becoming the new tenant. And the new lease may offset tax consequences by becoming a business expense that may be deducted from the business balance sheet. In contrast, conventional debt financing on real estate goes on the balance sheet as a primary liability.
The sale-leaseback transaction should be considered by anyone who owns real estate and operates a business on the property. Often the cash raised from the sale-leaseback is greater than the book value of the asset being sold. Seek out and contact a knowledgeable commercial real estate professional to analyze the cash flow options from the various perspectives to see how this type of transaction may get you closer to your financial goals and needs.