How to Sell Your Business and Pay Zero Capital Gains Tax
Every year I meet a few owners who just sold a company for a few million dollars and are about to write the largest check of their lives to the IRS. Most of them heard about this idea too late. So here it is early.
The principle is simple. A business sale puts a large gain on your return in one tax year. A commercial building, bought in that same tax year with a cost segregation study and 100 percent bonus depreciation, puts a large deduction on the same return. When the deduction is usable against the gain, the gain shrinks or disappears, and you own a building that pays you rent.
Simple to say. Three things have to be true for it to work.
One: timing
The building has to be acquired and placed in service in the same tax year as the sale. If you close the business sale in November and buy the building in February, you have a gain in one year and a deduction in the next, and the deduction does nothing for the gain. Owners who are planning a sale should be looking at buildings six months before closing, not six months after.
Two: the deduction has to be big enough
This is where cost segregation and the new permanent 100 percent bonus depreciation do the work. I explained the mechanics in detail here. The short version: a cost segregation study moves 25 to 35 percent of a building's depreciable basis into five, seven and fifteen-year property, and all of that is deductible in year one.
So if you sold a business for a $3 million gain, you need a building with roughly $3 million of short-life property to zero it out. At 30 percent, that is a building with about $10 million of depreciable basis. With 60 percent leverage, that is about $4 million of equity. Which, not coincidentally, is about what you have after the sale.
You do not have to zero out the whole gain. Offsetting half of it is still the best tax outcome most sellers will ever see.
Three: the loss has to be usable
This is the rule that sinks most versions of this plan, and the one you will not hear from whoever is trying to sell you a building.
Rental real estate losses are passive by default. Passive losses offset passive income, and a gain on the sale of a business you ran is usually not passive income. So for the deduction to reach the gain, one of a few things has to be true. You or your spouse qualify as a real estate professional in the year of the sale: more than 750 hours and more than half your working time in real estate, with material participation in the building. Or the activity is structured so that the loss is not passive in the first place. Or you have other passive income the loss can land against.
A lot of owners can meet the real estate professional test in the sale year, because they are no longer running the business and have the hours. A spouse who takes it on full time can meet it. This is the part your CPA has to bless in writing before you close either transaction.
What it looks like with numbers
Owner sells a company in June for a $3 million gain. In September, she buys a $12 million multi-tenant flex building with $4.8 million of equity and a $7.2 million loan. Land is $1.8 million, depreciable basis $10.2 million. The cost segregation study moves 30 percent, or $3.06 million, into short-life property. She qualifies as a real estate professional for the year.
Federal result: the $3.06 million deduction offsets the $3 million gain. The federal capital gains tax on the sale, roughly $600,000 to $700,000 depending on bracket and the net investment income tax, goes to approximately zero. She owns a building throwing off income and she still has the remaining $7.1 million of basis depreciating over 39 years.
Minnesota result: Minnesota does not conform to bonus depreciation, so 80 percent of the deduction is added back on the state return and recovered over five years. She will still pay Minnesota tax on most of the gain in year one. The federal savings are real and large. The state savings come later.
Where it breaks
It breaks when the building is bought in the wrong year. It breaks when the owner cannot meet the real estate professional test and has no other passive income. It breaks when somebody models the Minnesota return as if it were the federal return. And it breaks when the building is a bad building, because a tax deduction does not fix a bad investment. The building has to make sense on its own. The tax outcome is the bonus.
How we fit
We buy, build, lease and manage multi-tenant office, flex, industrial and retail in the Minneapolis–Saint Paul suburbs, and we partner with investors on individual buildings through joint ventures and single-asset partnerships. For an owner coming off a business sale who wants to be a real estate professional, a joint venture on a building you help select and operate is often the cleanest structure, and we run the cost segregation study as a matter of course.
If a sale is in your future, the time to talk is before the letter of intent, not after the wire hits. Bring your CPA.
General information, not tax advice. Timing, passive activity rules, real estate professional status and Minnesota conformity all depend on your facts. Nothing here is an offer to sell securities.
Mike Sowers, CCIM founded Commercial Investors Group in 2005 and is the Managing Member of AlphaDiv Real Estate Fund. He is the author of the Amazon bestseller Commercial Real Estate Investing and host of the CREative Commercial Real Estate Show. mike@cre-fund.com