The process of selling your veterinary real estate seems easy enough: call a broker, they’ll list your property, and you’ll wait for the offers to roll in. Especially with a long-term lease and a corporate tenant, selling your practice building is not a difficult thing to do. But what seems simple on the surface has many tough decisions and considerations underneath. Will the sale provide the best possible financial outcome for you and your family? Are you prepared to pay a considerable amount of taxes on the property sale? What are the questions you need to seriously think about when selling your veterinary practice’s real estate? Let’s dive into key considerations and your options.
At a high level, there are two fundamental questions regarding the potential sale of your real estate to start with:
1.Taxes: The sale of your veterinary practice building will result in a substantial current tax bill, meaning that 25 percent or more of your proceeds will go to the government. Taxes on the real estate sale are complex–while it is a capital gain (20 percent tax rate), other tax issues like depreciation recapture and the Obamacare surcharge will increase your payments to the government.
2. Alternative investment options: Receiving a large sum of cash after paying taxes requires that you have options to reinvest it. You or your investment advisor can find mutual funds or bonds to invest your cash. However, something to think about: do you have sufficient investments in these asset classes already? If you review your investment portfolio, asset allocation (how much you have in various asset classes – stocks, bonds, real estate, alternative investments, etc.) is important to consider here. You should have a thoughtful answer to this question before selling your real estate.
At this point, you may be thinking: what are my alternatives to selling holdings in the building or selling the building for cash? Having full knowledge of the options at your disposal will weigh into your decision. There are two main alternatives you can consider: a 1031 Exchange or contributing to a Real Estate Investment Trust (REIT).
1031 Exchange
IRS code (1031) describes this type of transaction, where you can defer any taxes due on a sold real estate property if you reinvest the proceeds into a different real estate asset within six months. The gain on the property sale will not be due until you eventually sell your newly purchased building.
Why would you do a 1031 Exchange? There are several reasons:
- If holding a single-tenant veterinary building is not diversified enough for your retirement asset portfolio
- If you think there is a risk of the buyer not renewing the lease
- If you have concerns that the area is deteriorating and impacting the future value of the building and its rental rates
- If you don’t want any responsibility as a landlord (most veterinary leases have some limited responsibilities) and you want to find a triple net lease
While 1031 Exchanges are common, they do contain some complex rules. We recommend working with an experienced real estate agent (and potentially an attorney) to help you navigate the rules of 1031 Exchanges and to make sure they’re done correctly.
Contribution to a Real Estate Investment Trust (REIT)
When veterinary practice owners take advantage of REITs, they can benefit from tax deferrals, asset diversification, and decent cash flows. A Real Estate Investment Trust (REIT) is an entity that buys and manages real estate and must distribute much (90 percent) of its cash flow to its owners. Some REITs are publicly-traded, while others are private. In general, REITs offer diversification with these trusts typically owning hundreds of properties with strong cash flows (especially because they must distribute those cash flows to owners), and you would become a small shareholder in the portfolio of many properties.
REITs can achieve tax deferrals for veterinary property owners when they do NOT sell the property to the REIT but rather ‘contribute’ the property in exchange for shares or ownership in the REIT (or the portfolio of properties that the REIT owns). By structuring the transaction as a contribution, rather than selling it outright, taxes can be deferred until you sell the shares in the REIT, which may be years down the road!
The benefit of pursuing this approach includes:
- Achieving diversification without paying taxes
- Maintaining current income (typically quarterly REIT distributions) from the real estate
- The REIT takes over any ‘management’ responsibilities for the property and becomes the landlord
REITs are a valuable path to pursue, but there are always risks. If you’re contributing your property to a REIT, be aware of the potential pitfalls:
- You should ensure the REIT managers are capable and run the business well.
- You should know the answer to the following hypothetical situation: let’s say you lose control of your property and the REIT is sold. If this happens, will your proceeds from the sale be ‘rollover shares’ into a new REIT, or will it be a taxable event where you lose any control of timing?
Currently, there are a handful of veterinary-specific REITs looking to add assets to their portfolios through this approach. While these REITs are not publicly-traded (which provides some additional risks), the potential of an eventual IPO or sale does provide some upside to the practice owner.