The Taxman Cometh

A Few Smart Ways to Moderate or Defer Taxes When Selling

 By Michael McCune

The good news is with interest rates low and the culmination of years of hard work, the values of most self-storage facilities are at an all-time high. Thus, we continually receive inquiries from owners that want to sell to retire, cash out, or just accommodate some other personal requirement.  An early topic in almost all of these calls is “I don’t want to pay the taxes” or “the government will get all the money”.  In some cases, the talk of taxes is just an excuse not to sell, but for many other owners, this concern is a legitimate frustration at how complicated the tax laws are.  While we will not argue that the laws are not complex or that taxes are fun to pay, there are some ways to mitigate their impact on a sale that may well let an owner enjoy the majority of the “fruits of his labor” and hold the taxman to a modest participation.  In this edition of the Market Monitor, we will explore the issue of taxation on the sale of a self-storage facility.  However, a few words of caution before we start.  First, I am not an accountant.  I suggest that you talk with a qualified tax advisor.  Second, these comments are very general and are subject to nuances in the law that could impact the application to your situation.  Lastly, I have had a couple of my tax advisors look this over and they have said, “It’s ok –as far as it goes—and to reread the first caution!”

With all of that in mind, let’s talk about how taxes generally impact a potential facility sale and how the taxes may be deferred and/or reduced.  I have outlined a hypothetical sale transaction that we can use as an example as we explore the various alternatives.

No “Bells and Whistles” Tax Treatment

Assuming that you just want to sell this property, pay the taxes and head out for Arizona, here is the calculation of the taxes that you would pay to Uncle Sam.  This does not include state and local taxes, and there are many variations you need to check into with your accountant.

Obviously, there are many assumptions that are made in our simple calculation, but at a minimum, this format will give you an idea of the general magnitude and method of calculation of the tax.  Now we can take a look at deferring some of the tax.

Tax Free Exchanges (1031 Exchanges)  

Everyone has heard of 1031 Exchanges, but how do they work and what can they do to help a seller with his taxes on a sale.  This is a special provision in the tax code that allows a seller to not pay any tax at the time of sale if the seller reinvests in another “like kind’’ property within the time frames allowed by the law.  Obviously, this can work to a seller’s advantage in the right circumstance.  Let’s take a look at our example again and assume that our buyer is willing to reinvest in another property.  Usually sellers look for a property with a solid income such as a retail property with a very strong credit tenant on a long-term lease.  A property with a major drug store chain lease is a classic example.  The return on such a lease, depending on credit, might start out with an 8.5% lease rate, have some modest rent “bumps”, and have over 15 years left on the lease.  If we assume that the seller in our example bought such a lease with the proceeds of the sale of his self-storage facility, we can see the impact on the net income after reinvestment as opposed using after tax dollars invested in a government bond.

Clearly, the impact can be very positive for a seller.  The exchange can be used for properties that are different prices than the one you are selling and by reducing the tax benefit; you can reserve some cash out of the sale. In some circumstances the taxes on the gain may be avoided altogether by a step up basis after death. While there are complexities to be considered, this little example may give sellers some incentive to explore the advantages of a tax-free exchange.

The Tax Consequences of Financing the Sale

Many sellers today are considering financing part of the sale of their facility by taking a note and deed of trust on the property.  In general (there are important exceptions), the tax treatment for this type of transaction is that taxable income is only recognized as the seller receives the principal.  This means that the down payment would be taxed at the time of the sale and the principal associated with each payment as it occurs would be taxed.  Since the principal of the loan payment is much less at the beginning of the loan, it means that the taxable portion of the payment would likewise be less in the beginning.  This means that a very significant amount of the tax is deferred for over the life of the loan.  Because of this deferral, the Net Present Value (time value of money) of the tax payments you will make on the sale are actually much smaller than if you paid the taxes at the time of the sale.  In essence, you are borrowing the tax on the sale from the government and earning interest on it until the loan is paid off.  I have done the calculations and the Net Present Value (@ 10%) of the tax payment actually made on principal payments received on a 25-year loan at 7.5% interest is about 25% of the amount that would have been due at the time of the sale.  In the right circumstances, “carrying the paper” can be very advantageous from a tax standpoint, particularly if you still believe in the property.

The Taxman Can Be Deferred, If Not Denied

These are just two of the more useful and routine ways that taxes on a sale can be moderated or deferred.  Your tax advisor and your Argus Broker, using their respective expertise, can help you find the right formula to meet your objectives and to make the process understandable.