Can you hold on to your real estate when you sell your practice? Certainly. However, in most situations, the buyer most likely will be able to afford BOTH the practice and real estate. There are two reasons for this. First, the practice will pay a fair market rent to whoever owns the real estate. In most cases, this is enough to cover the mortgage. Second, there are many commercial lenders who are very aggressive in our profession who make it possible, usually with small down payments to finance the entire deal.
Although practice real estate represents a good investment, because most veterinary hospitals are special use buildings, the number of potential tenants is very limited. From an investment perspective, it would make more sense to own rental property with a much wider appeal. Also, because it is usually limited in use, a veterinary hospital has less upside potential than other commercial properties. If the tenant veterinarian chooses to move out and build his own hospital nearby, the owner is faced with a major remodel for a new tenant – it is unlikely another veterinarian would rent this space knowing there is a brand new hospital just down the street.
The very best buyer for a veterinary hospital is the veterinarian who is buying the practice, but when the practice’s real estate is sold it can trigger substantial tax repercussions. Often 30% or more of the real estate sale’s net proceeds may be unwittingly lost to taxes. The 1031 Tax Deferred Exchange is a little utilized tax strategy for sellers of commercial real estate that can help with the tax issue.
The 1031 tax deferred treatment of capital gains is one of the best vehicles for preserving and building real estate wealth. This provision of the Internal Revenue Code allows property owner to exchange their property for other like-kind property without recognition of capital gains. The code makes it possible to transfer the financial gain that is realized from the sale of a commercial property into another commercial property without federal capital gains tax at the time of the sale.
How Does a 1031 Exchange Work?
Once an owner sells and closes on an investment property he or she wishes to qualify for a 1031 Exchange, he or she must identify a possible replacement for the relinquished property within 45 days. In choosing a replacement property the owner must follow one of the following three rules:
1) The “three-property” rule: The owner may identify up to three properties, regardless of value.
2) The “200 percent” rule: The owner may identify any number of replacement properties as long as the combined fair market value (FMV) of those properties does not exceed 200% of the FMV of all sold properties.
3) The “95 percent” rule: The owner may identify any number of properties no matter the aggregate FMV, as long as 95% of the value of those identified properties is acquired.
Finally, the owner must close on the identified replacement property(s) within precisely 180 days from the sale date of the original property.
What are the Requirements for Full Tax Deferral?
To fully defer all capital gain taxes, an exchanger must meet four requirements:
1) The investor must acquire property with the same or greater debt. If an exchanger does not acquire a replacement property with an equal or greater amount of debt, he or she is relieved of a debt obligation, and this is called a “mortgage boot”. The IRS considers this reduction in debt a benefit to the exchanger; therefore, it is taxable, unless it is offset by adding equivalent cash to the replacement property purchase.
2) The investor must reinvest all exchange proceeds. If an exchanger does not reinvest all exchange proceeds from the sale of the relinquished property, the balance received is considered “cash boot”, and the investor will have to pay capital gains taxes on that amount.
3) The investor must use a “qualified intermediary” (also known as a facilitator or accommodator) to hold the funds from the first sale until purchase of the new property is closed. the “qualified intermediary” (QI) is the person or entity who acts as the middle person in the exchange, providing the paperwork, oversight, escrow services, and expertise necessary to ensure that the transaction legally qualifies as an Exchange under Section 1031 of the Internal Revenue Code. Even though a 1031 Exchange is a complicated process, an Exchange using a good Qualified Intermediary can become a simple transaction and look surprisingly like a standard sale.
4) The new investment must be in “like-kind” property – a term that is, fortunately, very flexible. The IRS 1031 Exchange rules technically require the exchange of “like-kind” relinquished property for other “like-kind” replacement property. This does not mean, though, that exchanged properties must be of the exact same type (for example, bare land exchanged for bare land or an income property exchanged for another income property). The actual definition of “like-kind” is far more empowering in its flexibility. In truth, any real property held for investment or real property used in a trade or business can be exchanged for any other real property held for investment or real property used in a trade or business.
When utilizing a 1031 it is important to note that the new investment need not be penny for penny of the previous investment. For example, if you sell your property for $500,000 and buy a new property for $300,000, you will pay the full taxes on the $200,000 profit but have the reduced tax on $500,000.