For many business owners, owning the property where they conduct business provides operational stability, financial diversification, and tax benefits for the owner. When it comes time to sell the business, a prospective buyer may want to purchase that real estate along with the business itself.

But some buyers might hesitate to acquire both assets at the same time, and some owners might choose instead to keep the real estate and lease it back to the business after it's sold.

This article discusses the benefits and risks of such a transaction, ways to mitigate those risks, and suggestions for structuring the lease.

Benefits, risks of retaining ownership 

Retaining the real estate and leasing it to the business offers a number of benefits for the owner. Rent provides a predictable passive income stream while the owner continues to benefit from any appreciation in the market value of the property. Deferring the sale of the real estate also defers realization of any capital gains and payment of Washington’s real estate excise tax. If the property still has remaining depreciable basis, the owner may continue claiming depreciation deductions to offset rental income.

Having the flexibility to acquire the business separately from the real estate may also be attractive to prospective buyers. A lower overall purchase price widens the pool of potential buyers, which may increase competition for the business. Prospective buyers may also value the flexibility to relocate after the initial term of the lease. Although this is a risk the property owner needs to consider, it may also be an opportunity. Sometimes the highest and best use of a commercial property is not the business that operated there for years or decades but some other operation more responsive to changing market conditions, which can mean higher rent for the owner. 

Finally, a lease agreement ensures that the interests of the buyer and seller are aligned for some period of time following closing. From the buyer’s perspective, a lease means that the seller continues to have “skin in the game,” which may encourage cooperation with respect to knowledge transfer, handoff of key client relationships, and other important transition items. 

For the seller, the lease represents an ongoing commercial relationship with the buyer and offers a certain degree of continued visibility into the operations of the business. Moreover, if the business transaction involves a seller note, a properly drafted lease provides the seller with additional security — a default under the note should trigger a default under the lease, allowing the seller to terminate the lease and find a new and more solvent tenant. 

Of course, retaining the real estate rather than selling it together with the business isn't without its downsides and risks. The purchase price would include only the business itself, resulting in reduced proceeds for the seller. As already mentioned, the business may leave or fold, creating a vacancy to be filled. The seller also becomes a landlord with all the challenges and risks inherent to the task. 

Mitigating the risks of becoming a landlord 

Some of these downsides are commercial decisions, likely to be driven by the seller’s financial and life circumstances. Competent advice from trusted business, tax, and real estate advisers is invaluable in weighing those decisions. However, many of the risks associated with becoming a landlord can be addressed in the lease itself. 

First, the property should be held in a limited liability company set up for the sole purpose of holding the property, sometimes called a single-purpose entity or SPE. An LLC protects property owners from personal liability arising out of the property or under the lease if the LLC is properly formed, capitalized, and maintained. So long as there is only one member in the LLC — or a husband and wife, as Washington is a community property state — the LLC is disregarded for federal income tax purposes but provides legal protection nonetheless. 

Second, a lease agreement should be drafted and executed between the SPE and the business entity. The buyer will generally want to negotiate a new lease as part of the business transaction. The seller should consider negotiating for a triple-net lease in which all maintenance, operating costs, insurance, and property taxes related to the property are paid by the buyer-tenant. The lease should include broad indemnification of the seller-landlord for liability relating to the operations of the buyer-tenant on the property. The buyer-tenant should also be required to obtain, at minimum, market-standard commercial general liability insurance and property insurance. 

The lease might also give the tenant the option to purchase the property at some point in the future for an agreed-upon purchase price. Such an option can be especially useful when the buyer of the business wants to purchase the property but prefers not to — or can’t — finance the acquisition of the business and real estate at the same time. The buyer gets the ability to defer the purchase of the property while the seller keeps an otherwise motivated buyer in the deal, negotiates a suitable purchase price for the property in advance, and collects rent in the meantime. However, the option should be carefully structured to avoid IRS recharacterization as a disguised sale or financing transaction, which could accelerate recognition of capital gains. 

The bottom line 

Retaining the real estate isn’t suitable for every transaction. However, it's a structure that every business owner should understand. When structured properly, it offers a variety of benefits to the selling business owner and gives the buyer operational and financial flexibility.