How Real Estate Affects the Bottom Line for Small Businesses
Perhaps the most striking feature about the money made by homeowners from their house was how little of it was intentional. For many, their mortgage payment was simply a substitute for their monthly rent payment. But over time, loan balances went down, values went up, and suddenly there’s a half a million in equity sitting on the table.
Although a similar opportunity exists for small businesses, fewer entrepreneurs take that leap. Running a business is challenging enough; why add the headache of owning additional property? While this may be true, buying real estate to house your business, as opposed to renting, can have a significant material impact on your return from the business and on your overall wealth.
To see this concept in action, consider the performance our hypothetical retailer: the Speed Shop. They sell automotive products. We will evaluate their business both before and after the purchase of real estate:
For years, the Speed Shop provided a nice living for its owner. Located in the suburb of a major metropolitan area, the business, a subchapter S corporation, consistently generated $750,000 in sales and distributed net profits of 5%, or about $37,500 after the payment of a $60,000 salary to the owner. Since the business was stable, the owner typically took the net profits out of the business in the form of a cash payment.
Suddenly, the owner receives a call one day. The building owner has died. The executor of the estate would like to know if our business owner would be interested in buying the building for $750,000. Because the owner had invested his bonuses wisely over the past 10 years, there was no question he had the cash to make a 40% down payment of $300,000.
The important question became this: would the purchase of the building have a positive or negative effect on the financials of the Speed Shop’s owner? Let’s assume the owner buys the building personally, and rents it to the business. How far out ahead might he come after 10 years, versus continuing to rent?
If the $450,000 balance was financed with a 6.25% adjustable rate mortgage, the monthly principal and interest payment would be $2,770, if amortized on a 30-year basis. Including 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 currently pays, so the transaction is 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 $37,500 equals the annual difference between the old rental payments and the new mortgage and tax payments.
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 (which total $33,240 annually) contain about $5,300 in principal payments in the first year. These principal payments cannot be expensed.
On the other hand, there’s depreciation to consider. Net of land, which cannot be depreciated, the value of the building is $675,000 (which is $750,000, less an assignment to the value of the land at about $75,000, or 10% of the total value of the property). The useful life prescribed by the IRS for non-residential, 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 Speed Shop’s income statement for the first year would look like this:
Income $78,000 Expenses Mortgage Payments Net of Principal -$27,940
Taxes -$ 7,200 Operating Expenses -$37,500 Depreciation -$17,308 Total Expenses $89,948 Net Loss $11,948
The landlord feels none of this net loss, because it is delivered in large measure by the non-cash depreciation expense. On the down side, however, he also doesn’t really feel the increase in equity of $5,300, because despite the lower mortgage balance, the mortgage payment does not change.
Regardless, what’s important is the ability of the landlord to take this loss and net it against the profits he receives from his retail business. This is what will ultimately have a material impact on his wealth.
Remember the 5% (or $37,500) in distributed net profits? Thanks to the loss on the building, the owner will pay taxes on just $25,553 ($37,500 profit minus $11,948 loss from real estate). In a 35% tax bracket, this means avoided taxes of $4,181.
Let’s put it another way: the Speed Shop’s net margin would have to increase to 5.86% to leave its owner with the same amount of cash after taxes. This represents an astounding 17.2% (0.86%/5.00%) increase in net realized profits to the owner.
It is important to keep in mind, however, that the Feds as a general rule do not like to see passive income (i.e., income from a real estate investment) offsetting active income (i.e., income from running a retail operation). There are rules that govern limits to the offsets over certain amounts. And if you try to convince the Internal Revenue Service that your ownership and management of the building is active, you may very well be unable to get them to see your point of view.
Now let’s project 10 years into the future and assume that rather than selling the business, our owner simply shuts it down and sells the building. Let’s also assume that after the first year, he replaced the 6.25% adjustable rate mortgage with 9.87% permanent financing. How did he do? At the end of ten years, he owes the bank $410,000. However, because real estate values went up by an average of 7% per year, he is able to sell the building for $1.47 million. After paying off the mortgage, the Speed Shop’s owner is 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 claimed for so many years finally catches up with him; it lowers the cost of the building, and in-turn increases the capital gains tax owed. In this case, the $17,308 in annual depreciation reduces the owner’s cost basis by $173,080 over ten years. Said differently, the owner must now pay taxes on this so-called “unrecaptured” depreciation at a rate of 25%. The balance of the gain will be taxed at the recently enacted, long-term capital gains rate of 15%.
However, this must be weighed against the avoided taxes of $4,181 in the first year, and $9,800 in years two through ten (as a result of a mortgage with a higher interest rate). But more importantly, it must also be weighed against the $634,692 ($1.06 million in proceeds, minus $125,308 in capital gains taxes, minus $300,000 initial investment) earned on the real estate investment after the payment of all long-term capital gains taxes.
The average after-tax gain of $63,469 per year ($634,692/10 years) is the equivalent of $97,644 pre-tax income in a 35% tax bracket. Adding this to the owner’s salary and profit distribution of $97,500 means that diverting the cash flow (which normally went into rent) toward ownership of real estate has effectively DOUBLED his income. It is as if he made the business twice as big, but he never added a single square foot to the operation. Yes, it’s safe to say that adding real estate into one’s business equation can have a very material effect on one’s wealth.