Owner-Occupied Commercial Real Estate for the Entrepreneur

Practical Advice on Profiting from Commercial Real Estate in the United States

Many entrepreneurs have proven that owning the real estate used by their closely held businesses can provide them the advantages of stable rents for their businesses and appreciation for themselves. Many other benefits accrue to the owner of single-tenant commercial real estate, including the ability to employ advantageous tax strategies, an income stream in perpetuity, asset diversification, and control of the propertys tenancy.

Case Study: M & G Consulting

M & G Consulting is an engineering firm located in Southern California. They have rented space in a business park for many years and each year they have observed that their rent has increased by at least the rate of inflation. Although their business is successful, they have come to realize that their landlord has made just as much profit in the form of rents and appreciation on the building as they have in their business. They vowed to take control of their situation and began the search for their own building.

Identifying the Building

First, M & G identified the building size and amenities that suited their needs. They planned for the growth they expected over the next 10 years. In addition, they planned for future technology needs in terms of communications facilities, the image they wished to portray to clients, the proximity and ease of access to transportation hubs, and not least importantly, the geographic area. Their specifications were shared with trusted employees, and modifications were made based on ideas generated in group discussions. The owners then began their search and quickly settled on a building in a business park about 10 miles from their current site.

Negotiating the Terms

M & G negotiated with the owner of the identified building regarding his price, terms, willingness to carry back secondary financing, and willingness to complete necessary repairs and tenant improvements. The owner was flexible because he had held the building unsold for some time. The buyer and seller settled on a set of mutually acceptable terms and signed a contract.

Structuring the Entity to Hold the Building

M & G soon discovered that they could hold title to the building in a variety of ways, each of which had its own advantages and downfalls in terms of liability and tax treatment. M & G discussed the legal implications with their attorney and the tax implications with their CPA of the following methods:

Limited Liability Company (LLC)

M & Gs attorney advised them that they could structure building ownership as an LLC, the major advantage being that it would be a legal entity separate from either M or G, and therefore limit personal liability from claims arising from the property. However, M & Gs accountant pointed out four disadvantages of an LLC holding the property:

1. The cost of establishing an LLC, largely attorney fees, is significantly greater than for some other forms of ownership.
2. If an LLC has two or more owners, they must file partnership federal and state tax returns, [1] which require most taxpayers to seek professional (i.e. costly) tax preparation assistance.
3. In some states (e.g. California), an LLC, including a single-member LLC, is required to file a tax return and pay an annual fee based on gross revenue the fee, which is $800 if the building makes no net income, can go as high as $11,790. [2]
4. Not only is the owner taxed on his or her portion of the net profits of the LLC, losses may have limited deductibility depending on the cash the owner has invested in the LLC.

Sole or Joint Ownership

M & Gs attorney advised them that the property could also be held under sole ownership (one owner), or as a tenancy in common or as joint tenants with right of survivorship (multiple owners). Under any of these structures, the attorney opined, unlimited liability falls on the owner of the building for any potential claims against the property. [3]

M & Gs accountant told them that the attractiveness of sole ownership or joint ownership versus an LLC is that it requires only one additional form on a personal tax return. Net rental income or loss on the property is taxed at ordinary income tax rates on the owners tax return. He also pointed out that these entrepreneurs can mitigate personal liability risks through the establishment of a comprehensive insurance policy. That said, the decision of which way to structure the entity holding the property should be based on the LLC fees and costs versus the cost of any extra insurance required because the property is held in the owners name.

Formal General Partnership

Essentially, a formal general partnership is a tenancy in common that is required to file a partnership tax return (usually form 1065), which is usually prepared by the partnerships accountant. Very often, establishing the partnership also requires an attorney to prepare the partnership agreement. M & Gs accountant strongly urged them to have a formal partnership agreement if they chose to enter into any form of partnership; in his experience, many problems are avoided if they are anticipated, which is what the partnership agreement formalizes.

The partnership is not required to pay income taxes and each partners share of net rental income or loss on the property is taxed at ordinary income tax rates on his or her tax return. The general partners have unlimited liability for the partnerships acts, and they will often opt to insure against loss from those activities.

Formal Limited Partnership

A formal limited partnership is another type of tenancy in common required to file a form 1065 partnership tax return. However, while the limited partners liability is generally restricted to the amount they contributed to the partnership, the general partners liability is unlimited. There must be at least one general partner and most often it will be a corporate entity established for that sole purpose. If so, that corporate owner must file a form 1120 tax return to report its share of the income from the property.

Again, establishing the partnership often requires the services of an attorney to prepare the partnership agreement. The partnership is not required to pay income taxes. Each partners share of net rental income or loss is taxed at ordinary income tax rates on his or her tax return.

C-Corporation (Regular Corporation)

It is rare that a property is owned by a corporation and leased out to others; doing so usually means losing tax advantages such as favorable capital gains treatment on the property at sale, the ability to deduct operating losses from the property, and the ability to take tax-sheltered cash from the property. In addition, any cash taken from the corporation would be double taxed (if taken as dividends) and subject to payroll taxes (if taken as management fees) neither scenario is tax efficient.

The only advantage of corporate ownership is the limitation of liability; however, this can also be achieved by holding the property in an LLC or a limited partnership.