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On commercial real estate: Overpay or pay the tax?

June 17, 2017

You’ve sold your commercial real estate. Proper steps have been taken to funnel the sale proceeds into a qualified intermediary as the first step to perfecting a tax-deferred exchange – a way to buy more commercial real estate and defer the tax obligation.

A careful review of buildings available for sale has given you a sense the market is over-heated. You are concerned you might overpay for a building — effectively paying more than the building will be worth in future years. After all, it’s a great time to sell but not a great time to buy.

So, is it better to overpay today and risk the building declining in value or simply pay the taxes – which could amount to 35 percent of your take.

One thing is certain. If you don’t buy commercial real estate and perfect your exchange, you WILL pay the taxes. Let’s use a hypothetical amount of $2 million as the sale price for the property sold. By the time you layer in federal, state, and Affordable Care Act taxes, your tax bill will approach $700,000.

The overpay is not as certain.

If you are considering replacing your $2 million sale with a $3 million buy and you overpay, your $3 million must decline to $2.3 million — a market adjustment of almost 25 percent –  for the offset to equal your certain tax liability.

We witnessed the market decline by over 25 percent in 2009-2010. But, now our values are back and have exceeded our previous 2007 highs by 30 percent. Plus, three things have changed since the lows of 2009-2010 – new construction hasn’t and will never match demand, thousands of square feet of industrial inventory have been scrapped in favor of multifamily development – thus a lower base, and 98 of every 100 buildings are occupied — the lowest vacancy in history.

One way to compensate for an overpay is with a long-term lease – a bridge greater than five years. Commercial real estate values tend to ebb and flow over seven to 10 years. I have a client who made a lease in 2008, at the market’s top. Through the term, market lease rates dipped. It’s now renewal time and the lease rates are back to the top.

Still not convinced? If you believe you are overpaying, would it make sense to overpay for a perfect building vs. over-paying for a building with challenges? My experience is good buildings stay leased.  A challenged building – even in good times – will have leasing issues.

Allen C. Buchanan is a principal and commercial real estate broker with Lee & Associates, Orange. He can be reached at 714.564.7104 or abuchanan@lee-associates.com. His website is allencbuchanan.com.

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