Is it Better to OVERPAY for Commercial Real Estate or Pay the Taxes?

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You've sold your commercial real estate. Proper steps have been taken to funnel the sale proceeds into a qualified intermediary as the first step to perfecting a tax deferred exchange - a way to buy more commercial real estate and defer the tax obligation. 

A careful review of buildings available for sale has given you the sense the market is over-heated. You are concerned you may overpay for a building - pay more than the building will be worth in future years - after all, its a great time to sell but not a great time to buy. 

So, is it better to overpay today and risk the building declining in value or simply pay the taxes - which as previously discussed could amount to 35% of your take. 

One thing is certain. If you don't buy commercial real estate and perfect your exchange - you WILL pay the taxes. Let's use a hypothetical amount of $2,000,000 as the sale price for the property you sold. By the time you layer in federal, state, and Affordable Care Act taxes, your tax bill will approach $700,000.

The overpay is not as certain.

If you are considering replacing your $2,000,000 sale with a $3,000,000 buy and you overpay, your $3,000,000 must decline to $2,300,000 - a market adjustment of almost 25% -  for the offset to equal your certain tax liability. We witnessed the market decline by over 25% in 2009-2010. But, now our values are back and have exceeded our previous 2007 highs by 30%. Plus, three things have changed since the lows of 2009-2010 – new construction hasn’t and will never match demand, thousands of square feet of industrial inventory have been scraped in favor of multifamily development – thus a lower base, and 98 of every 100 buildings are occupied - the lowest vacancy in history.
 One way to compensate for an overpay is with a long term lease – a bridge greater than five years. Commercial real estate values tend to ebb and flow over seven to ten years. I have a client who made a lease in 2008 - at the top. Through the term, market lease rates dipped. It's now renewal time and the lease rates are back to the top.  

Still not convinced? If you believe you are overpaying – would it make sense to overpay for a perfect building vs over paying for an building with challenges? My experience is good buildings stay leased.  A challenged building – even in good times – will have leasing issues.