The veterinary profession is seeing record-setting revenues as the percentage of households owning small animals continues to grow. In addition, surging demand for quality veterinary care has pushed practice valuations to record highs. Corporate consolidators and private equity investors realize that now is an excellent time to purchase veterinary clinics and earn solid long-term returns on their investments in a recession-resistant industry. But what about the value of the veterinary real estate?
This article will focus on helping you make sound decisions about your hospital real estate so that you can maximize your long-term financial security.
First, if you are a practice owner who does not own your building, seriously look at purchasing the real estate. Interest rates remain near historic lows, and many lenders have extremely attractive financing options for veterinarians. With the proper financing in place and a commitment to pay off the debt in 10 years, you would be in a great position to maximize the building’s value and significantly add to your wealth regardless of whether you keep the property as an income asset or sell it as a capital asset and invest the proceeds.
If you are considering the sale of your veterinary practice, what are your options regarding the real estate? Consider these four.
1. Maintain ownership of the building as an income asset and sell it later.
This approach is common in many private sales and most corporate sales of a practice. First, buy the building, pay off the debt and retain ownership as an income asset through rent from the practice’s buyer. Then, cash in by selling the building a few decades later.
After you pay the debt on the building, the monthly rent checks flowing into a separate limited liability company can give you many advantages. If you are still working and do not need the additional cash flow to support your lifestyle, this option is a wonderful way to diversify your investments. If you sold your practice and are retired, the rent can provide meaningful income to support you and your family’s lifestyle for years.
Be sure to negotiate a long-term lease — 10 or 15 years — and a built-in cost-of-living escalator. When you finally sell the building, you likely will receive a nice capital infusion, adding to your long-term wealth and financial security.
You need to pay income tax on the rent, and even if you have a triple net lease, you will be responsible for certain capital improvements, such as to the building’s roof or parking lot. However, through planning and foresight, these expenses are easily managed.
2. Maintain ownership of the building as an income asset but sell it soon.
Many corporate and private buyers of veterinary practices do not want to own the real estate. However, if selling your building at or near the time of the hospital sale is important, fear not. What is possible and becoming commonplace for a practice owner is to sell the clinic to one buyer and, shortly after that, sell the real estate to someone else.
If you contemplate this approach, ask your accountant, attorney or real estate professional to help negotiate a long-term lease with the clinic buyer before you look to sell the building. This option offers an opportunity for tax planning by separating the gain on the practice sale in one year with the gain on the real estate sale in the following year. This plan could significantly lower your overall tax liability, depending on the state of capital gains taxes.
If the tenants are private practice owners, their ability as business owners is paramount in ensuring your continued rental income. If a corporate buyer purchases the practice, you will want a lease guarantee. The corporate guarantee, along with a long-term lease of 10 or more years and a built-in cost-of-living escalator, will increase the property’s value to an outside buyer of veterinary real estate.
3. Sell the building at the time of the practice sale and pay taxes on the sale.
As veterinary real estate sells for higher and higher prices, many owners maximize the valuation and cash in immediately. While paying taxes is rarely appealing, the capital gains rate is currently favorable from a historical perspective. Since we cannot forecast tax law changes, selling now and investing the proceeds might be attractive to you. Furthermore, you avoid future capital expenditures on the property.
4. Sell the building and defer capital gains taxes in a like-kind exchange under IRS Section 1031.
Section 1031 of the Internal Revenue Code allows for exchanging “like-kind” real estate. When done correctly, this approach enables you to defer capital gains taxes. In simple terms, the option means you could sell your commercial real estate building and reinvest the proceeds by purchasing other investment real estate. You could defer the tax obligation until you sell the newly acquired real estate.
If you were to die while owning the real estate, a “step up” in cost basis under current tax laws would occur on the inherited property. This means your heirs could sell it and not be obligated to pay taxes on the gains. Beware, however, government chatter about changing the tax code to eliminate the step up, so if tax avoidance is your primary motivator, you might be disappointed.
Keep in mind that several steps must be followed when executing a 1031 exchange. For example, an independent third party must hold the proceeds from the sale of a building, and the purchase of like-kind real estate must be made within a specific time frame. Failure to follow these steps means the IRS might disallow the 1031 exchange and demand the immediate payment of taxes. So, again, be certain to work with professional advisers experienced with 1031 exchanges. This advice is critical since you’ll likely be exchanging predictable rents from a piece of real estate you fully understand (the veterinary hospital’s physical plant) with the uncertainly of rental income from a possibly unfamiliar type of real estate.
So, what should you do? At the end of the day, what you do is like any major financial decision. The best course of action depends on your unique needs, wants and wishes. Veterinary real estate is a flexible asset. Used properly, it can enhance your financial well-being and your family’s, potentially for generations to come.
Be sure to consult with professionals experienced in such matters — from a certified public accountant or attorney to a commercial real estate appraiser or certified financial planner.
KNOW THE RULES
An IRS fact sheet available at bit.ly/3gvmBBS says this about like-kind exchanges:
“Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.”