Episode 23: Key Concepts When Purchasing Commercial Real Estate

Michelle: Is it time for you to consider getting a commercial property for your business to operate from? There may come a time when you feel that you want to expand your business to a brick and mortar location. Or maybe you’re just tired of renting from someone else. Join us as we discuss some key facts to consider when purchasing commercial real estate. 

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Michelle: Hello, it’s Michelle and Shawn and this is Profit Points. And today we are going to talk about commercial real estate. So we get questions from clients a lot that have operating businesses and they’ve gotten to the point where they either need a brick and mortar location or they’ve been in a brick and mortar location. It’s not enough size for them or they’re looking to not rent anymore. Right. They’re tired of renting. They’re tired of paying their money out. It’s just kind of going out the window and not really seeing a huge benefit from that. So we have a lot of people that come to us and say, okay, well, I’m thinking about getting this commercial property or thinking about exploring commercial properties. What should I do? And it happens all the time, right? So one of the things we go through with them is how to initially get going on the purchase of this property. And then what are some of the benefits, right, that you can have by having a commercial property that you own. So let’s get into this, Shawn. Should someone purchase a commercial property in their own names, in the business name, in a different entity? What are your thoughts on that? 

Shawn: Yeah, yeah. Thanks. Generally what I would say is you should always purchase the real estate in a separate entity all its own, and it should be an entity not like an LLC, and not a corporation or an entity taxed as a corporation. 

Michelle: So that would be, let’s just be clear on that. So we say yes for LLC’s that are considered are either partnerships or disregarded entities. We say no to S corporations, even LLC’s that are potentially treated as an S- Corp for tax purposes. And we say no for corporations. Right. So yeah. Yeah, that’s where the yes and no come in. 

Shawn: Exactly. And you know, when we talk about this, you know, you want that real estate outside of the operating companies. So if you have, you know, a manufacturing company or any sort of operating company that is using the real estate for the operations, you don’t want to co-mingle the real estate and the operating business. A lot of that is for legal reasons, and that’s where your lawyer can explain what the benefits are for that. But they’re also tax reasons as well. So in the tax world, you’re wanting to keep that real estate in a separate entity. So you have flexibility for maybe gifting ownership to other people, to your kids. You don’t put it in a corporation because real estate is considered an asset that can increase in value over time, like stocks or bonds or they should anyway. 

Michelle: Well, right now we’ll see. 

Shawn: Right. Yeah. So you usually want to keep those outside of an operating entity. So because there’s tax rules around, you know, changing ownership and stuff like that could create a tax event without even selling the property. So you don’t want to get involved in something like that? 

Michelle: So one of the things that we tell people is if you’re considering buying commercial property, you should be doing or purchasing the property in that LLC to begin with. A lot of questions are, Oh, well, can I buy it in my own name and then transfer the property? And the answer is, Yeah, you can. But in a lot of instances, you’re going to incur transfer costs, additional transfer costs, I would say. Right. So you’re going to incur fees or taxes for transferring the asset initially. You know, when you first buy it and then you’re going to you could potentially incur those same transfer fees again if you transfer them into the LLC after the fact. So identifying the fact that you want to get this property into a different entity upfront, you want to do that in the beginning, you don’t want to do that after the fact. It is something that can be unraveled, but it’s better to do it the first time because then you are going to incur less in taxes and fees on the transfer of the real estate. 

Shawn: Yeah. Any time you’re trying to transfer the real estate, the title of the real estate from one name to another name in any way could incur additional fees and costs. So getting that title right in when you first purchased the real estate is a good idea. I recently had a conversation with a client who is considering purchasing real estate and it had a part commercial, part personal use that they were planning on. And at the end of the day, we thought that the commercial use was so minimal that we thought he should just purchase it in the name of his own name instead of the LLC because he was going to use it for personal purposes. So if that changes in the future, he understands that there could be a cost to that. But we didn’t feel like it was necessary upfront to do that. 

Michelle: So getting the property into an LLC has some benefits. And one of those benefits, by keeping the property in a different entity, is that your operating entity may, let’s say you have two owners on that operating entity and you have ownership percentages. It doesn’t have to be 50/50. It’s whatever, you know, was determined by the real estate if a separate LLC doesn’t have to be that same ownership. So you could have one person who has maybe more funding availability and wants to own more of the property or maybe just own the property 100% in this LLC, it doesn’t affect the operating entity. So you can have different ownership of the operating versus the commercial real estate depending on how you want that to play out. So a really good example is I have a law firm client that owns the law firm itself and it’s the operating entity it’s owned 60/20/20. Okay. So there’s three partners, 60% owner, majority owner, and then two, 20% owners. The real estate, though, however, was purchased and that LLC is owned a third each. So it’s a different structure, right? It’s a different entity structure and that’s something that they decided they wanted to have happen when they went to purchase the commercial property. 

Shawn: Right. Yeah. So again, you know, the flexibility of having it in a separate entity, you know, it’s there because you’re not bound by the same ownership as the operating entity. Yeah. And that’s a perfect example of what we were saying earlier. Yeah. Um, you know, and there’s, there’s all kinds of scenarios where that can happen. We talk about when you’re ready to sell the business, your operating business, do you want to keep the real estate and rent it out to the new owners of the business or whoever may end up moving into that property? Yeah. So having it in a separate entity, you don’t have to sell the real estate when you sell your business. You could just want to hold that on it or hold on to it as additional income in your retirement years or diversifying your portfolio of assets that you have. So it’s not all in the market. So yeah, having that in a separate entity also allows you for future planning with regard to the sale of your business. 

Michelle: Yeah, that’s a great point because you know, you may want to hold on to that to the real estate and rent it out to someone else. There’s a lot of great discussion around passive income and that may be the way that you go about building your own net worth to a greater degree. And if you know, real estate is pretty solid other than, you know, maybe some fluctuations here and there. But over time, you know, it’s a decent investment. So one of the things that we talk about with people who have operating entities and then purchase commercial real estate is renting the property to the operating entity. Let’s talk about that a little bit and what that looks like. 

Shawn: Yeah. So typically when you get into these arrangements where your operating business is in a real estate that you own, you know, you would create a rental agreement with your operating business. And, you know, we suggest actually having a real rental agreement drawn up with fair market value rent. So and then that company actually pays your rental company or that separate entity rent on a regular basis. It provides deductions for the operating business which could potentially save you taxes depending on how your operating entity is taxed. And then on the other side, you would have income for the rent, but you would have deductions related to depreciation of the property and any other related costs. 

Michelle: Real estate taxes or mortgage interest. If there’s a mortgage on the property, those exact things. You can also set up those rental agreements in various ways. There’s a lot of times where rental agreements will be set up with a triple net lease, which means really the operating company is going to pay nearly all the expenses that relate to the operation of the property. And then in that case, you know, all the expenses would fall on to the operating company with just maybe real estate taxes and mortgage interest on and depreciation on the commercial real estate property LLC. 

Shawn: Yeah, exactly. And you know, again we suggest having an attorney draw up the documents for all of these things, you know, to create this separate entity, to create these rental agreements. There may be even a loan from the operating company to the rental company in order to help fund the purchase of the property. So there might be some co-mingling or intercompany transactions that you have to make sure that there are agreements in place for all that stuff to pass IRS scrutiny for some of that stuff. 

Michelle: Yeah. And we even mentioned, you know, fair market value and we have people that have had these properties and they’re charging double or triple fair market value. And in many instances, let’s talk about what the IRS thinks about that, you know, and yeah. We’ve both been under or helped represent clients that have been in audit situations. And let’s talk about what the IRS has to say about all that. 

Shawn: Yeah. As I said before, you could save taxes by renting the property back to the operating company. And the IRS knows that, obviously, and doesn’t want you to overstate those tax savings, so they require you to set the rent at a fair market value. So the fair market value would be what would someone who was not related to you, a third party, what would they pay to rent that property? What’s the average rental space in that geographic area for that type of building? For that type of industry? What is all of that going for? And, you know, there’s some fluctuation in there and there’s some room to maneuver on that. But, you know, you want to kind of get a third party perspective on that as to what they would pay and then set the rent at that rate. 

Michelle: So I’ve had people that have done their own research, you know, got quotes for various spaces that maybe comparable comparable rental spaces and, you know, have basically used that and kept that in their file as what the rent would potentially be for, for the property and kind of had that in their perm file so that when and if they were ever examined by the IRS, if it was ever in question. If it is reasonable, I say in most cases the IRS is not going to fight it all that much. They have bigger fish to fry. But they would definitely examine if it looked odd, if it was very odd for either the space that was there or even at examination, if they dug into the agreement and it just didn’t make any sense why this number was being used, that’s when you kind of find yourself in trouble. 

Shawn: Yeah and also if you aren’t actually paying that rent, like is it just a book entry that you’re in? You’re not actually finishing that transaction by actually paying it, right? So yeah, you got to have some exchange of funds there to help that whole process. 

Michelle: And it can be very easy because you can set up, you know, a bank account that is in the same place that you have your operating company and do a rent sweep every month to pay rent makes it nice and easy for people. You don’t have to physically write a check. It doesn’t have to be a physical invoice as long as you’re following the agreement, you know, the agreement, the rental agreement. And it doesn’t need to be overly complicated, but that’s the kind of stuff that they look at as to whether or not this is like a legit type of rental for that space.

Shawn: Right, exactly. Yeah. So you know, getting all your ducks in order with all the paperwork and following through with actually making those transactions happen, whether it’s the rent, the loans, you know, all that stuff. 

Michelle: Right. Right. So anything else that people need to be considering when they’re getting commercial property? I mean, we talk today about some of the ways that you need to purchase the property. We talked about building net worth and how you could have potentially different ownership percentages in some of the benefits and then also maybe even some of the pitfalls as it relates to third party values and the IRS when it comes to renting it back to the owner operating company. 

Shawn: Yeah, just one final thing I think is, you know, be prepared to have your business financials ready if you need to get a mortgage, you’re going to need your personal financials, you’re going to need your business financials all put together to provide the lender. They’re going to ask for everything. Not just the business, because, you know, it’s an owner operated entity. So you’re going to have you’re going to have you know, you’re going to need down money. You’re going to need, you know, all the financial for the business and your personal to put together. 

Michelle: Yeah. Keep that organized. Speaking of which, if you are struggling with your business, finances and not sure where to go. You can take our master class and that is at ModernCPAonline.com/masterclass and you get a free 24 hour access pass to learn the three big financial mistakes new business owners make and what to do next. We encourage everyone to kind of take this master class. It will provide some basic foundations. If you like this content, please be sure to subscribe and hit the notification bell to get all of the latest releases. We thank you for joining us today on Profit Points. 

Shawn: Take care. 

Michelle: For more information on getting ready for tax time, visit ModernCPA.com/quiz to take the free 60 second quiz to find out if your business is ready for tax time. We also encourage you to subscribe to our channel so you don’t miss any future videos and leave a like and a comment below if you have any further questions.