Net Lease Deals Can Minimize Impact Of Tax Reform Act

Net Lease Deals Can Minimize Impact of Tax Reform Act
by Jeff Wilder

Reprinted from Advanstar's Hotel & Motel Management Magazine

Deal-making life under the 1986 Tax Reform Act has now officially begun. With the new law, real estate is viewed less favorably, capital gains are out and lower taxes on income are in.

So how will all these rule changes affect our hotel transactions?

Undoubtedly, net leasing and real-estate exchanges will gain much favor as deal-making tools.

I'll examine real-estate exchanges in the Feb. 23 issue of H&MM. In this column, we'll cover leasing.

Let's look at a hypothetical hotel deal: Ms. Owner is considering selling her hotel, which is valued at $3 million. Her depreciable basis is $1 million, so the taxable gain on the sale is $2 million. The 28 percent federal rate will yield a $560,000 tax ($2 million times 28 percent). Since most states have their own tax bites, she'll probably be looking at a $700,000 total tax bill.

All told, the deal would net Ms. Owner $2,300,000.

Now, if she has no mortgage and were to receive cash in the deal, she'd take the money down to the corner bank or broker and invest it in a financial instrument. It'd probably yield about 7 1/2 percent - or $172,500 yearly cash flow.

That's the end result of selling a $3 million hotel!

It hardly makes any sense to make this deal. After all, the hotel is worth $3 million because its net profit approximates $400,000. Who would elect to trade in a partially sheltered $400,000 for a fully taxable $172,500? Not many people I know.

Meanwhile, Mr. Buyer is looking for a business opportunity. He's checked with many of his private investors to see if they'd capitalize his next hotel acquisition, but they're reluctant: "Hotels are a little too risky these days," they say. Besides, they add, they've got lots of useless excess shelter and lots of passive losses - "and we don't need any more, thank you."

Less Reason to Sell Or Buy

This sets up an interesting dichotomy: Sellers have less incentive to sell because of higher tax rates and lower after-tax equity yields. Operators have less cash and, as a result, a relatively weaker bargaining position. Therefore, prices firm up and far fewer properties get sold.

Ms. Owner decides not to sell. After all, she reasons, capital gains will be back in a few years - that will be the time to sell. Furthermore, she feels comfortable that the property has good potential.

She opts to give out a long-term lease. She asks $300,000 in minimum rent plus a negotiated percent of the futures. After rent cost, the business will have a $100,000 cash-flow.

In order to assure that the operator will have both feet in the deal, she's asking one year's rent as security. Figuring that one year's rent plus closing costs and operating capital will be in the $500,000 range, Ms. Owner decides that, given the potential for current and future income, it's a reasonable risk.

Back to Mr. Buyer, who's begun looking for another kind of deal. He calls his broker, who has recently listed and structured Ms. Owner's lease deal. Mr. Buyer likes it; all he needs to do is put up $500,000 for the right to earn $100,000 out of the box - an honest-to-goodness 20 percent return on equity.

Investor Advantages

Calling his investors, Mr. Buyer reminds them that under the new tax laws, their investment in an operating lease that generates cash will yield very attractive passive gains. This is exactly what they need to apply against the passive losses they're not able to use.

A $500,000 investment to earn $100,000 per year! Every one of them jumps into the deal.

And for Ms. Owner, the lease arrangement will pay off when she does decide to sell. In a few years, tax laws will change again. Mr. Buyer, the tenant, will be the logical person to sell to and, with a few years as operator under his belt, may well be inclined to pay a fuller price than if he were going in fresh.