Whatever the kind of property used, the user has the option of purchasing or leasing. Should you buy the house you live in, or lease it from someone else? With few exceptions, there would be an overwhelming response to “own it”. The benefits weigh heavily toward ownership. With business property, the answer sometimes may be a lease instead.
Real estate investors who enter into a long-term lease instead of buying property decide with implications that can affect both financial and tax positions. The important difference between a long-term lease from a straight purchase (outright or with a loan) is borrowing (renting) the property itself for financial benefit.
Sometimes the choice of owning is not available and the property can only be leased not purchased. During a period when money is not available except at very high rates, leases may be the only consideration. Another time when only leases are practical could be with the best possible location in a large city, where institutional owners hold the land on a long-term basis.
Here are examples of some property users who must make this decision:
- Some real estate users have a prime objective of maximum cash flow now, in commercial or residential income properties. They will be interested in securing capital, and investing for maximum return.
- Any store chain, fast food outlet, or other franchise operations must use real estate in the operation. Should their money be used to purchase property for their locations or be retained for working capital and expansion?
- An owner wanting the highest leveraged position, with the greatest interest in securing the largest gain possible from the property. This owner could avoid tax liability on current income from the property.
With a new business, the owner of that enterprise has the choice of buying or leasing the business location. In the beginning, this choice has little meaning to most. The owner most often will lease a business location, preserving capital for the operation of the business. Capital is always critical in early operations and is seldom in enough supply to purchase real estate.
A Later Choice
The choice of buying or leasing remains as an alternative even later. After some years and much success, the owner may wish to expand, change locations, or just have a business location that is “tailored” to the specific needs of his operation.
So, the business owner buys a property with a small down payment. He borrows and builds a building, which is perfect for present and future needs of the business. In addition to the best location, other benefits might help to make the decision to purchase the property. These are:
- Like a home, the owner has the security of owning the property, and the peace of mind of knowing that no one will evict the business at some later time.
- The new improvement (building) on the property is a depreciable asset and so provides the added benefit of tax shelter for current income from the business.
- The interest paid on the loan is a business deduction. The difference, the amount paid to principal, builds equity in the property.
- The ownership of the real estate gives the owner stability and added stature in the community, increasing his financial strength.
Now, in addition to security and self-image, the owner has all of the elements of a good “leveraged” investment: Low down, large loan, and depreciation of the improvements. The cost may have been fairly small. After a minimum down payment, the payments on the loan may not have been too different from the previous monthly lease payments.
The Next Buyer
Still later, the picture changes again. After using the property for ten or fifteen years, this owner might be approached by a broker with a buyer for a good property to own as a passive investment. The investor prefers a commercial building with a good tenant and a long-term lease. The broker suggested a purchase of an existing business property from the present owner who might then lease back the property.
The big change for the business owner happened over the years. Because of inflation in those years of ownership and the annual reduction of the mortgage with the loan payments, he has built enormous equity in the property. The original down payment has now grown to a huge equity – maybe hundreds of thousands or millions of dollars!
The New Benefits
The purchase of the property was an excellent move for the business owner when it was done. Now, with time, his position has changed. When discussing this with his Real Estate Investment Counselor and CPA, the following list of benefits for the sale of the property, then a leaseback, were developed.
1. The hundreds of thousands of dollars (or millions) of capital tied up in the real estate ownership would be released for expansion of the business, operating capital, investments, personal use, or retirement.
2. The business owner’s balance sheet could improve. The amount of the current real estate loans would not show as a liability and the cash would increase the asset side.
3. The seller still has the use of the original building, built to the specific needs of his business, but now it will be with a long-term lease.
4. The rent paid on the building after the transaction is deductible as a business expense, just as it was when the business first started.
5. If the proceeds of the sale are invested, the annual return may equal the rental payments on the lease, in effect making the rent on the property free of out-of-pocket expense.
6. The cash will be received by the seller without any loan approvals and does not have to be paid back.
7. After the sale, if the business owner reserves the right to sublet the real estate, he may be very flexible on future plans to sell the business or continue to operate it.
These benefits were all to the liking of the business owner. The only drawback was the tax to be paid on the gain in value. After his CPA computed the actual amount, the tax was minimal compared to the benefits, so the sale, then leaseback was completed.
The sale-leaseback often accomplishes more for the seller than getting money by borrowing on the property. The seller is entitled to deduct the entire rental payment as a business expense. On a loan, only the interest can be deducted.
So, the sale-leaseback, in effect, makes the cost of the land depreciable. With a mortgage, the mortgagor can neither depreciate the land nor can the portion of the loan payment that amortizes the land (loan reduction) be deducted. Since the rent payments are similar to principal and interest payments on a loan, this means that all of the monthly payment (rent) is put on a tax-deductible basis. This may more than compensate for the loss of the depreciation deduction, which was only on the improvements. We recommend consulting with your CPA and/or tax attorney for any changes in the tax laws.