What are Strategies for Business Exit Planning When the Business Owns Real Estate?

Posted May 10, 2023


Growing a business typically takes a ton of time, energy, and equity.

Regardless of where your clients are in the growth cycle of their enterprises, it’s important they have well-defined exit strategies in place. These strategies can be used as a roadmap to help guide them through crucial business decisions, as well as provide an end-goal target for all of their efforts.

If your clients run businesses that own commercial real estate, their exit strategy will likely be a bit more complicated. Real estate offers a host of tax advantages for property owners, and clients will have to decide whether they want to sell these assets along with their business or keep operating them as income-generating properties.

Let’s take a look at two strategies for exiting a business that includes commercial real estate among its primary assets.

Tax Implications of Selling an Investment Property

Exiting an investment property is much different from exiting a business because of the many tax considerations that come with divesting commercial real estate investments – especially when those assets have recognized significant asset appreciation since their acquisition.

Capital gains taxes from the sale of appreciated assets should be foremost among your clients’ concerns. Long-term capital gains taxes on assets held longer than one year are either 0, 15, or 20 percent, depending on your client’s taxable income and tax filing status.

The tax burden from a straight sale of an investment property can significantly eat into your client’s equity position. If your client’s basis in an investment property is $500,000, and the asset sells for $1 million, the sale would trigger a capital gains tax of $100,000 at the 20 percent capital gains tax rate.

There are a few exit strategies your clients can consider, and each comes with very different tax and financial implications.

Selling Real Estate With a Business and Completing a 1031 Exchange

If your clients want to exit their real estate holdings along with their businesses, they can shelter their exposure to taxation by completing a 1031 exchange.

Landlords who divest investment properties can defer 100 percent of capital gains taxes by rolling over all sale proceeds into a like-kind replacement property. There are four different kinds of exchanges, but the delayed exchange is the most common. In this type of 1031 exchange, the investor completes the sale of an investment property, identifies a like-kind replacement within 45 days, and closes on it within 180 days.

This exit strategy means your client will still have ongoing landlord and management duties, though. Depending on how the commercial lease is structured, your client may be responsible for building repairs and maintenance, tenant lease and rental rate negotiations, property marketing, and more.

Your clients will retain a great deal of control over their investment asset, but at the same time, managing a commercial property requires ongoing commitments of both capital and time. There’s a way to divest real estate owned by businesses that doesn’t require any additional capital or sweat equity investments from your clients.

Exiting Actively Managed Investment Real Estate for Passive Real Estate Investments

If your clients want to wash their hands of any further involvement in real estate owned by their businesses, they can sell real property assets and complete 1031 exchanges into passive real estate investments such as Delaware Statutory Trusts (DSTs).

Your clients can sell their actively managed properties and exchange them into fractional shares of a DST to defer any realized capital gains and accumulated depreciation recapture taxes. Since the Internal Revenue Service views beneficial interests in a DST as direct property ownership, DSTs are eligible for 1031 exchange tax sheltering both upfront and upon exit. DSTs offer no direct involvement in the properties held under trust, yet your clients can still enjoy the potential benefits associated with direct property ownership in investment real estate. DSTs typically have a holding period between seven and 10 years, though, making them highly illiquid investments.

Investors who purchase shares of a real estate investment trust (REIT) may receive annual returns and dividend-based income from the REIT without the headaches associated with direct property ownership. However, since shares of stock aren’t considered like-kind to real property, this passive investment option isn’t eligible for 1031 exchange treatment. Your clients would have to cash out of any actively owned properties before purchasing shares of a REIT. Although REITs are liquid investments, their performance is tied to movements in public equities markets. Crowdfunding is another option for passive real estate investments, but like REITs these investments aren’t eligible for 1031 exchanges and provide few tax advantages.

Putting it all Together

Businesses that include commercial real estate or investment properties among their primary assets have special considerations for their exit strategies.

Clients may choose to keep their real property assets in order to enjoy the tax advantages that come with direct property ownership. Clients who wish or need to divest those assets may be able to complete 1031 exchanges to defer capital gains taxes on appreciated real estate. Another option for clients who no longer want to actively manage their investment properties is to exchange into shares of Delaware Statutory Trusts.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.

Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

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