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In This Issue:
(When ideas in tax and other legal areas in this publication seem to fit your situation, it is recommended that you discuss them with your professional advisor before taking action.)
Tax Savings With Installment Sales:
Installment reporting of real estate (and certain other) sales is a relief provision for sellers who agree to take payment in installments because the buyer cannot make full payment in cash (Code Section 453). As long as one payment is received in the year following the sale (and even if no cash at all is paid in the year of sale), the seller can recognize gain only as payments are received.
Even when a purchaser is prepared to pay all cash, a seller may prefer to use the installment method if even the remotest possibility of a long term capital gains tax rate seems possible (which is now the case—being an election year in 2000). However, a seller may be better off not using the installment method if he has unused capital losses that can offset the gain in the year of the sale.
Reporting Installment Sale Gain
Reporting installment sale gain is based on this formula:
Gross profit x payments received = gain recognized in the current year.
The gross profit is the contract price minus the seller’s basis (and minus any selling expense).
The contract price is usually the sale price minus any liabilities assumed by the buyer, such as the existing mortgage.
Payments received include any cash received (other than interest) and the fair market value of any other property received. However, it does not include the purchase money note given in the transaction.
Here is an example:
John and Mary sell a commercial building for $100,000, payable $60,000 cash over an existing mortgage of $40,000. A cash payment of $10,000 is to be made at closing and $10,000 is to be paid each year for the next five years at 8% interest. The seller’s basis in the property is $70,000.
- The gross profit (gain) is $30,000 ($100,000
minus $70,000 basis).
- The contract price is $60,000 ($100,000 minus
$40,000).
- The payment each year is $10,000 (excluding
interest).
- The gross profit divided by the contract price
equals 50.
- The gain recognized each year is $5,000 (50% of
the $10,000 payment).
- Total gain recognized is $30,000 ($5,000 x 6
years.)
Installment Sales With Refinance?
The installment sale, as we said, lets the seller delay paying taxes until cash is received from the buyer. What if the seller wants to both delay taxes and receive cash as soon as possible? Can the seller mortgage the property just prior to the sale, or refinance an existing mortgage, and then have the purchaser assume the debt? The Treasury Regulations say no.
The IRS classifies debt assumed by the purchaser in an installment sale as qualifying debt or non-qualifying debt. (Temp. Reg. 15a 453-1 (b)(2).) Qualifying debt is a mortgage or other debt incurred when in connection with the seller’s buying, holding or operating the property. This type of debt is not deemed cash received as of the time of the sale to a third party. All other debt is non-qualifying debt; if an installment sale occurs, the seller is deemed to have received cash at the closing equal to such debt.
Non-qualifying debt includes:Installment Sales With Refinance?
The installment sale, as we said, lets the seller delay paying taxes until cash is received from the buyer. What if the seller wants to both delay taxes and receive cash as soon as possible? Can the seller mortgage the property just prior to the sale, or refinance an existing mortgage, and then have the purchaser assume the debt? The Treasury Regulations say no.
The IRS classifies debt assumed by the purchaser in an installment sale as qualifying debt or non-qualifying debt. (Temp. Reg. 15a 453-1 (b)(2).) Qualifying debt is a mortgage or other debt incurred when in connection with the seller’s buying, holding or operating the property. This type of debt is not deemed cash received as of the time of the sale to a third party. All other debt is non-qualifying debt; if an installment sale occurs, the seller is deemed to have received cash at the closing equal to such debt.
Non-qualifying debt includes:
- Debt incurred in anticipation of the property’s
sale
- Any obligation of the seller incurred incident to
the sale (e.g., a real estate commission)
- Any obligation unrelated to the seller’s
buying, holding, or operating the property (for example, the
buyer agrees to pay the seller’s medical bills)
Note: How is it determined if debt was incurred in anticipation of selling the property? Time certainly is an important element. Let your tax advisor give advice on this if an installment sale is planned.
Installment Sale – The Double Sale
One way that a seller might try to obtain the maximum cash and a tax benefit from an installment sale is to arrange back-to-back sales. First, an installment sale at a price equal to current market value is made to a “related party” of the seller. Since payments will be made in future years, no gain is recognized until that time.
Then the related party makes a cash sale at the same price to the outside party who is the true buyer. No gain is recognized on the sale because the related party’s basis is equal to the selling price. The seller and the related party together receive all cash for the property while deferring tax to future years.
The tax code (Section 453(e)) limits this gambit by providing that the cash received on the second sale is deemed payment to the original seller in the case of certain related parties (essentially, a family member or a more than 50% controlled entity). However, even with respect to these parties, a second sale more than two years after the initial sale is not subject to the limitation. (See your tax advisor as other exceptions may also apply.)
Diversify Investments With Industrial
Properties
Many real estate investors have always limited their investments in apartment properties and office buildings. They have not considered industrial properties because it is an unfamiliar area of real estate (for them). Warehouse and distribution (W&D) properties are of interest because their standard layout suits a wide range of users, in contrast to specialized manufacturing facilities. Industrial properties look good for the following reasons:
- The market for industrial property is doing well,
with vacancy rates nationwide near those for apartments and
other commercial buildings.
- The economic recovery has boosted demand for
industrial (particularly W&D) space.
- There is a shift in the location and nature of
demand, caused by changing technology and trade patterns, that
will present investment opportunities.
- Institutional investors who have portfolios that
are light in industrial assets are acquiring W&D
properties for diversification.
With any kind of investment, of course, there are always risks. The most significant is the potential for rapid functional or geographic obsolescence. Because of this, investors must carefully analyze factors such as location, construction, ceiling height, and the number and location of docks, as well as other factors.
A Good Demand
The real estate downturn did not affect industrial property as much as other properties because this property did not encourage speculative building; as much as 30% of the cost of W&D properties is in nondepreciable land, so they held limited appeal for tax-motivated investors. Foreign investors have largely avoided the W&D sector because it lacks the “trophy quality” that makes offices, hotels, and resorts attractive. As a result, warehouse development was driven more by demand than by capital seeking an outlet. Also the size of the properties discouraged many institutional investors who prefer to invest in larger properties than the typical $1 million to $10 million W&D property.
Demand for warehouse space was relatively strong during the past decade. Employment in warehouse-related sectors rose 3% annually between 1982 and 1992, while overall employment growth was at an annual rate of 2.6%.
Choosing The Investment
Choosing the right property may be a little more difficult. Certain factors may be driving the W&D market toward greater efficiency, changing how and where business will be done:
- Inventory control systems.
Computerization and new techniques such as bar coding
can insure faster and more reliable deliveries from shipper to
destination. Combined
with just-in-time systems, it reduces inventory and space
requirements.
- Automated space. Using robots in W&D facilities will grow over time,
encouraging more efficient use of space.
- Regulations.
With the trend toward deregulation during the past
decades, there has been a reduction in delivery costs by
trucks and planes, causing a shift away from rail and water.
This widens the possible locations for W&D
facilities and encourages the construction of fewer and larger
facilities. Since
trucks and planes speed deliveries, the amount of inventory
stored and the space needed can be reduced.
Investment in W&D facilities must be very
carefully thought out because of the conflicting needs for greater
demand for space while using existing space more efficiently.
Operating The Small Town Center
When you are looking at shopping centers, bigger is not necessarily better. While a well-run regional or super-regional shopping center can produce a good financial return, so can a successful small-market shopping center. In many cases, the small town center can turn out a better return. One of the benefits is the control that the owners can have by being “the only game in town.” This can help generate high returns.
Good Customers and Stable Tenants
In a small town center (10,000 to 100,000 people within a 5-mile radius), there is usually little tenant turnover. The tenants are attuned to shifts in the local economy and can be flexible when economic change occurs.
The stores in the small-town shopping centers have a stable business because they concentrate on basic necessities (food, clothing, dry cleaning services, etc.), thereby insulating themselves from economic downturn which can often spell disaster for merchants of luxury items. These centers can also benefit from the nature of the customers. They are loyal and want to help their neighbors, who are often the store owners. Further, the small-town shopping center is viewed as a community asset. It can be where community activity takes place—the July 4th parade forms there, band concerts are held there, holiday promotions are celebrated there. For investors, these community events bring additional traffic and sales.
The Successful Center
A small-town shopping center needs “hands-on” investors who carefully plan the investment. It should:
- Dominate the market. The key factors are consumer habits, surrounding businesses,
and accessibility. Consumers
must habitually look to the shopping center as the place to go
for their needs. The
surrounding businesses must complement the wares offered at
the shopping center. And
the center must be readily accessible via a good roadway
system with safe entrances off the highway.
The minimum size for market dominance usually is 75,000
square feet.
- Be in a stable market. Employment base and local industry should be strong and
diversified.
- Locate in an area with the right demographics.
Young families with growing children, who need and want
lots of products, are “right.”
Analyze the growth potential for the market.
- Have a good tenant mix.
There should be a strong anchor, anchor, usually a
department store or a nationally known grocery chain with at
least 10 years remaining on its lease.
The remaining store tenants should offer products or
services in special demand in this particular locale.
Sporting goods, for example, usually are popular in
small town shopping centers.
Expensive jewelry stores typically are not.
While stationery and greeting card stores generally
attract customers, sophisticated and costly gift shops do not.
Also successful are stores selling hardware, family
shoes, and books and records.
Re-Energizing The Center
After about ten years, a small-town shopping center may need something to re-vitalize it. Expanding the center with a national retailer might help invigorate the tenant mix. Enclosing an open mall can be a good renovation to attract new interest. Simply giving the shopping center a face-lift might insure its dominant role in the area.
Your Real Estate Investment
Knowing what you can do in some investment situations can be the difference between an annual profit or loss in your currently owned commercial property or the one you intend to acquire. How you acquire it can be important.
The professional commercial real estate broker is in the position to represent a client in real estate transactions by setting up sales, exchanges, leases, purchase and sales of options, and management of real estate. This real estate practitioner stays aware of current tax laws and court decisions in order to structure transactions, but does not give legal or tax advice (unless he/she is also an attorney or a certified public accountant). In any complex transaction that might result in changes in any owner’s legal or tax situation, the other members of the “consulting team” should be the owner’s attorney and/or tax advisor. We always recommend consulting with these professionals during the planning and closing of major real estate transactions. All can affect taxes and estate planning.
We are the heart of your professional team, creating the real estate transactions that will be needed to expand your estate. Let’s get together to evaluate your present portfolio of properties, or review your plans for future acquisition.
Starting with your present position and your goals for the future, we can set out moving directly toward achieving those goals.
Opportunities for investment are all around. You may need another small commercial building for an investment or a large apartment complex. We cover the entire real estate market. Call us for an appointment to discuss your objectives.
“This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting or other professional service. If legal advice is required, the services of a competent professional person should be sought.” – From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations. © 2000 All Rights Reserved. |
