Property Biz Canada

Don’t take an offer price at face value

john clarkTo sell, to buy, or to sit on a property and consider some other way to maximize a return on the investment?

For the owners of any type of property intended to generate income, be it a commercial office tower, a strip mall or an apartment building, this is often the question. At any time an owner may find themselves fielding what may appear to be a compelling offer, but they must weigh it against the opportunities that exist to reinvest the proceeds and how much capital they will actually have at their disposal after they have covered the tax burden and the other costs associated with a real estate transaction.

Recently, Len Potechin, an independent real estate professional in Ottawa, received what he believed to be a good offer for the city’s iconic Elphin apartments at 370 Metcalfe St., which he has owned since the early ’70s. The property was, for him, an investment meant to generate income. But with the combination of capital gains tax and tax on recovery of depreciation, the net proceeds would have left him with an amount such that it would have been very difficult or impossible to replace the income from the building. As a result, he thanked the party for the offer but declined to accept it.

“If I sold that building today, and took what I would have (after covering the taxes) and tried to invest that money somewhere else, I would get half the income that I am getting out of it now,” Len said.

How exactly does that combination of capital gains tax and tax on recovery of depreciation factor into the due diligence process to decide if an offer truly is as good as it looks at first glance?

Let’s start with taxes on recovery of depreciation.

When you purchase a tax-deductible asset that is intended for use over several years, such as an apartment building, you can deduct a percentage of the asset’s value from your annual taxable income over the life of the asset. This has the obvious benefit to reduce your income tax owing. However, if you sell that asset for more than its current depreciated value, you will incur a tax burden as a result.

For example, say you purchase an apartment building for $10 million. Over the next five years, you take $2 million worth of depreciation deductions, which leaves you with a current value of $8 million. Then, you turn around and sell the property for $9 million. In the eyes of the tax man, you have just realized a gain of $1 million, which is taxable as part of your ordinary income. This is what’s called tax on recovery of depreciation.

Capital gains taxes can add to this, if you sell the property for more than the original purchase price. Say, for example, you sell that building, purchased for $10 million and depreciated to $8 million, for $11 million. You will have to pay recovery of depreciation taxes on $2 million (the difference between the original purchase price and the current depreciated value) and capital gains taxes on $1 million (the difference between the original purchase price and the sale price). Capital gains are taxed at 50 per cent, so $500,000 of that $1 million will be taxable as part of your ordinary income.

Now, you could defer the capital gain for up to five years with a vendor take-back mortgage, but this would not necessarily shift you into a lower tax bracket. In which case, your total tax owing would not be reduced, only spread out, but so too would your receipt of the proceeds from the sale.

But the tax burden is still only part of the puzzle. The other issue is, depending on your business strategy and investment goals, what can you do with the net proceeds that remain from the sale of the asset? Depending on the market, there simply may not be any other opportunities around that will provide you with the same or better income. The costs of the sale, and the related tax burden, may in fact erode your financial position and cause more harm than good. This is the conclusion that Len came to after crunching the numbers.

The alternative may be to look at how you can increase the revenue-generating capacity of the asset, through improvements and other investments. And consider this: if a buyer comes knocking with a lucrative offer, they obviously see an opportunity. Are they seeing something you are not by virtue of having an arms-length perspective? Instead of a sale, perhaps there is an opportunity for some kind of partnership.

About John Clark: With over 30 years of experience in the national real estate appraisal and valuation industry, John Clark (BA, AACI, P.App., FRICS, Chartered Valuation Surveyor) is a leading expert on real estate matters that impact the value of commercial, institutional, residential and other special use properties. He joined The Regional Group of Companies Inc. in 1988 and has served as Vice-President of Valuation and Consulting since 1990. He is a Fellow of the Appraisal Institute of Canada and served as its National President, 2001-2002.

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