You happen to own the real estate (commercial condo unit, standalone building, house, etc.) that houses your dental practice. You want to sell the dental practice, BUT keep and rent out the space. Why? Maybe it’s too expensive for any buyer to buy. Perhaps you want an annuity (rental income) to help finance your retirement. Maybe you want to transfer the building to your family down the road. Maybe you built the building and you’re emotionally attached to the history of it all. One way or another, you’re NOT ready to sell the property. And you think your practice should be good enough to sell on its own. So what could go wrong with a practice sale? Well…. a LOT ACTUALLY!
Buyers Want The Real Estate
Buyers are sick and tired of dealing with landlords. Landlords have kept increasing the rent and bullying them with respect to parking matters, signage, not enough years left to actually sell (buyers need 12 years nowadays to get bank financing to buy), etc. And dentists looking to sell are always threatened by demolition clauses, relocation clauses, and simply NOT enough years left on the lease. Dentist tenants are always under the gun with respect to their leases and landlords. They’re on the hook personally sometimes – even when they SELL the practice, they may be forced to guarantee the rent for the buyer for a set period of time (sometimes indefinitely!). A demolition clause – for those who don’t know – is a tiny clause buried in a lease that allows the landlord to terminate their lease and kick the dentist out (with some form of minimum notice like 6-12 months) if the landlord ever wants to redevelop the building. Demolition and relocation and early termination right and terrible transfer clauses (where the dentist pays the landlord huge sums to get permission to transfer the lease) are all deal killers or price killers. Bottom line: buyers don’t want to rent if they can buy the property.
What About Giving a Buyer Dentist a Right of First Refusal?
Given that dentist tenants are always under threat from a landlord, they’re now at a point where if they know that you own your own real estate, then they will INSIST on buying it. And most of the time, a right of first refusal to buy the property at some point in the future is NOT GOOD ENOUGH for them. A right of first refusal is basically a property owner would include in a lease (it’s a term of the lease where the seller keeps the property and rents the space to the buyer). The right of first refusal says that if the landlord gets a third party offer to purchase the property, and the landlord wants to sell the property (and accept the offer), then they must FIRST present that offer to the dentist tenant. If the dentist tenant wants to match the offer, then the landlord must sell to the dentist tenant.
Basically, a right of first refusal gives the dentist tenant (the person who bought the practice but wasn’t able for whatever reason to buy the property at the same time) the ability to acquire the property when the landlord wishes to sell the property and gets an actual offer from a third party. But for many many dentist buyers, a right of first refusal ISN’T GOOD ENOUGH. Why? Because it doesn’t guarantee they’ll get the property. It’s a right to match an offer. But what if the offer is coming in too high and they can’t match? What if they landlord never wants to accept that third-party offer? So there’s no guarantee that the dentist tenant will actually get the property.
A right of first refusal is different from an OPTION that the buyer dentist would have to FORCE the landlord at some point in the future to sell the property. But such an option would not be looked upon favourably by a landlord. Why? Because landlords may not want to be forced to sell the property. So now we have a struggle between flexibility of selling the property (which the selling dentist/landlord wants) and the certainty of getting the property (which the buyer dentist wants). And it’s within this struggle that emotions run high and lawyers and accountants duke it out. But a lot of the time, it doesn’t get resolved easily and buyers and sellers walk away unhappy.
What About Giving a Dentist-Friendly Lease?
A selling dentist can offer a buying dentist a tenant-friendly lease. What does that mean? Low rent that increases slowly over time, very long term (e.g. 15-20 years), no demolition or relocation clauses, and a right of first refusal. But often times it’s just simply not enough for the buying dentist to want to take up. What we’ve seen is that dentists who keep their property GET PUNISHED for keeping their property. How?
Think about it like this: if a buyer is paying what they consider to be a lot of money for your practice, then they’re going to look for ways to get their money back. That comes in the form of cheap rent (less than fair market value). For example, we had a dentist who wanted to keep their property and rent it out for $120k (all in – inclusive of base rent, taxes, maintenance and insurance) every year. The dentist buyer was willing to pay top dollar for their dental practice, but insisted on paying only $80k in rent all in for 15 years straight! Ouch! And when you crunch the numbers – especially the tax numbers – you come to realize that the dentist seller is getting punished.
What About Tax Ramifications of Keeping the Real Estate?
A landlord corporation that keeps the real estate and earns rental income pays close to 50% tax on that income! OUCH! So if the total rent is $80k and after paying off all the taxes, maintenance and insurance, the landlord corporation’s base rental income is $60k, then the corporation is only left with $30k / year after taxes. And this $30k could be left in the corporation or dividended out to the shareholder(s) of that corporation (who would pay taxes at a personal level). That’s pretty low all things being equal.
Now, instead of keeping the $60k as profit and paying corporate taxes, the corporation could decide to pay out the $60k as a salary to the dentist as a “management fee”. This way, there’s no income left in the corporation for it to pay 50% tax on. But then the dentist would have to pay their personal marginal tax rate on that amount, which could range from 30%-53% tax (depending on the dentist’s total income and what their respective tax bracket is). Ouch!
There goes the whole “let me keep this to earn an annual income” argument for keeping the real estate. It’s just not a good return given the tax situation – especially given that the buyer dentist won’t typically want to buy fair market rent (because they want to get their money back).
Well what if a dentist seller INSISTS on the buyer paying a certain amount of rent and increasing that rent periodically just like a normal landlord? Won’t be that good enough? Especially if their practice is attractive enough? I’d like to say that that would be a great way to look at it, but reality is different: buyers will put pressure on the seller to sell the real estate. It’s turning into a buyer’s market, interest rates are high, the tax situation is not great for keeping the real estate, and buyers are happy to wait it out while you struggle to sell the practice. You will punish you in the long under these circumstances by keeping the real estate.
What About Bank Financing?
Nowadays, banks are giving 70%-100% loans, amortized (that need to be repaid by the buyer) over 25 years for the purchase of real estate. The amount that banks are willing to finance depends on the property and the buyer and overall market conditions (e.g. interest rates, property values, projections, etc.). That could be a great deal for a buyer since they’d typically have to repay a loan over 12 years for the practice. By stretching out the payments on the real estate, they can offer more for the property because the payments are lower. The banks are also happy because they register a mortgage on property, which is a safe bet type of collateral. So again: this creates pressure on the buyers to buy the property.
What about Taxes on the Sale of the Property?
If the property is owned by a corporation and a number of tests are met, the shareholders of that corporation MAY qualify for lifetime capital gains exemption. That means that each shareholder could save up to $250k if they are allowed to maximize their use of their roughly $1-million capital gains exemption. Typically the sale of shares of a real estate holding corporation WILL NOT qualify for capital gains exemption treatment. BUT if the corporation is being sold ALONG with the practice – and again, a number of tests need to met – then there’s a possibility that the shareholders would be able to trigger their capital gains exemption.
Picture this: the selling dentist uses up all of their capital gains exemption on the sale of the practice (e.g. practice sells for $ 1 million and dentist saves ~$250k in capital gains taxes). And the dentist’s spouse owns the shares of the real estate and sells it simultaneously with the practice (e.g. the real estate sells for $ 1 million and the spouse saves $250k in capital gains taxes). That means that, altogether, no capital gains taxes were paid and the dentist’s family gets $ 2 million where they would have otherwise only received $ 1.5 million. That’s a $500k savings of real money. And that money is paid personally into their bank accounts! Wowza! Again, you’ll need to satisfy various lifetime capital gains exemption tests (that we talk about in this blog a lot – use the search bar above and type in “capital gains” and you’ll see some of those tests). But we’re talking about huge savings.
Also keep in mind that there’s currently a window of opportunity to take advantage of the lifetime capital gains exemption when you sell the practice AND possibly the property. Why? Because the liberals and the NDP have ruined dentists’ lives in the past on tax matters – remember when they essentially stopped dentists from income splitting with their kids with the Tax On Split Income rules back in 2017/2018? Terrible. And they’ve been talking about watering down the lifetime capital gains exemption rules as well – to basically make it less beneficial in some way to the dentist so they pay more taxes. Bottom line: right now you can pay no capital gains taxes (and save ~$250k) on a ~$1-million of capital gains exemption and then pay around 25% taxes on the rest of the purchase price when selling a practice. That’s the cheapest and best way to put money in your pocket. When you compare it to receiving a salary (e.g.30-53% tax rate) or dividends (47% tax rate), selling shares of a corporation and qualifying for the capital gains exemption is your best bet to KEEP the most $$$.
Maximize Value by Selling the Real Estate and Practice
One thing that the buyers and sellers may ACTUALLY agree upon to make everyone happy is to reallocate the purchase prices of the practice and the property. How could this play out? Well, imagine that a selling dentist’s practice is only worth $800k on the open market. And they have real estate owned by their spouse that’s worth $ 1.2 million. Since the capital gains exemption maxes out at $ 1 million, the ideal thing for the selling dentist and their spouse to do is to agree to shift $200k from the purchase price of the real estate over to the practice. So it’s now $ 1 million for each. This would save the dentist selling the practice $50k more and it would prevent the spouse from paying $50k more in capital gains taxes on the sale of the real estate (again, assuming everyone qualifies for the capital gains exemption).
Would the buyer be OK to shift $200k over from the real estate to the practice to help the selling dentist out? There’s a good chance. Why? Because the selling dentist would be more open to selling them the real estate if they could also save that extra $50k! So it all gets negotiated and everyone is doing everyone a favour in the process.
If you own the property and are thinking about selling just the practice, please be sure to educate yourself so you can make an informed decision. There are important things at play that you may not be aware of – including what buyers want, how they get financing, how the sale is taxed, etc. We often suggest, in order to keep things moving quickly in a sale, that sellers be open to the possibility of selling the real estate. They’d need a real estate appraisal from a reputable (we know them) member of the Appraisal Institute of Canada. And they’d need to do a separate share sale transaction for the corporation that owns the real estate. There may be a need to do a corporate reorganization to plan things out YEARS in advance to take advantage, so you’re encouraged to speak with us early.