Selling a Business When You Own the Real Estate:Four Ways to Structure the Deal in California

For many California business owners, selling the business is only half of the transaction.

The owner may also own the building, warehouse, office, medical facility, restaurant property, industrial property, or other real estate from which the business operates. That creates an important question:

Should you:

1.   sell the business and the real estate together,

2.   sell them separately,

3.   keep the real estate and become the buyer’s landlord,

4.   or use some of the equity in the property to help finance the business sale?

There is no single right answer.

In fact, owning the real estate can give a seller considerably more flexibility than a business owner who merely leases the premises. Properly structured, the real estate can be sold for additional liquidity, retained to produce retirement income, or even used as a source of capital to help a qualified buyer complete the acquisition of the business.

The key is to stop thinking of the transaction simply as “selling my business.”

You actually. have two different assets and two different transactions:

1. the operating business; and

2. the real property occupied by that business.

How those two assets are handled can materially affect the purchase price, financing, taxes, cash flow, risk and, and whether the transaction can be completed at all.

Option One: Sell the Business and the Real Estate Together

The cleanest exit is often a simultaneous sale of both the operating business and the real property to the same buyer. At closing, the seller transfers the business assets or ownership interests and simultaneously transfers title to the real estate and in return receives cash or promise to pay overt time (financing).

For an owner who wants a complete exit, this approach has obvious advantages. The seller converts both assets to cash, eliminates future landlord responsibilities, and generally avoids having an ongoing financial relationship with the buyer after closing.

From the buyer’s perspective, owning the real estate can also be attractive. The buyer controls the location, is not exposed to future lease-renewal negotiations, and begins building equity in the property rather than paying rent to a third-party landlord.

Depending upon the transaction, borrower and lender, acquisition financing may also be structured to address both a change in ownership of the business and qualifying real estate. Because Small Business Administration (“SBA”) lending requirements change, the financing structure should be coordinated with the lender early rather than assumed after an agreement has been reached.

There Are Really Two Valuations

A common mistake is negotiating one large number without adequately distinguishing between the value of the operating business; and the fair market value of the real property.

The allocations matter. For federal tax purposes, the sale of an entire business for one overall price is generally not treated as the sale of a single asset. The consideration must generally be allocated among the underlying assets, with different tax treatment potentially applying to different asset classes.

The real estate likewise needs its own supportable valuation.

For example, a transaction might economically look like this:

Business value: $1,800,000

Real estate value: $2,200,000

Combined transaction value: $4,000,000

Even when negotiated together and closing simultaneously, these are not necessarily one economic asset. That distinction should be considered early rather than after the parties have already agreed upon a headline purchase price.

California Property-Tax Consequences

A California real-property sale will generally constitute a change in ownership or transfer for property-tax purposes unless an exclusion applies. For property that has been held for many years with a relatively low Proposition 13 assessed value, a reassessment associated with a change in ownership can result in a substantial increase in the property's tax burden to the buyer. The increased property-tax expense should be considered when analyzing the buyer's post-closing occupancy cost.

Option Two: Sell the Business and Real Estate Separately

The second possibility is to sell both assets, but not necessarily to the same person.

A buyer may be enthusiastic about acquiring the business but either unwilling or financially unable to purchase the real estate. That does not necessarily mean the business transaction must fail. Instead, the business could be sold to Business Buyer and the real estate sold to Real Estate Investor.

Business Buyer then becomes Real Estate Investor's tenant.

This can be particularly useful where the combined purchase price of the business and property is simply too large for the operating-business buyer to finance. Assume, for example:

Business value: $2 million

Property value: $3 million

A buyer who can finance a $2 million business acquisition may not have the liquidity or borrowing capacity necessary to complete a $5 million combined acquisition. Splitting the transaction can enlarge the buyer pool since a real estate investor may be interested in owning the real estate precisely because a successful operating business is the tenant.

The Lease Becomes a Critical Part of the Sale

When the business and property are separated, the lease becomes a central transaction document.

The business buyer needs enough lease term to justify purchasing the business and to satisfy its lender. The property owner wants dependable rent, an appropriate return, expense reimbursement, insurance protections and a creditworthy tenant.

While many of the standard commercial lease terms need to be negotiated as usual, there is an issue that can turn over like an iceberg and should be addressed in negotiations.  A future sale of the property can be a critical lease term because of the impact on property tax reassessment and that impact on Common Area Maintenance (“CAM”) costs. Under California's change-in-ownership rules, a transfer of the landlord's interest in leased taxable real property can constitute a change in ownership and cause the property to be reappraised, depending in part upon the remaining lease term.

California's Board of Equalization specifically identifies a transfer of a lessor's interest subject to a lease having less than 35 years remaining, including written renewal options, as a change-in-ownership event.

A buyer may initially underwrite the acquisition based upon the property's existing tax bill. If the property is sold a year or two later and reassessed at a substantially higher value, the tenant's occupancy expense can increase dramatically - even though the tenant did not purchase the real estate and received no economic benefit from the property's appreciation.  For a property that has been held for many years under a relatively low Proposition 13 assessed value, the resulting increase in property taxes can be substantial. This matters greatly to a business buyer when the lease requires the tenant to reimburse the landlord for property taxes as part of CAM costs/charges, triple-net expenses, or other operating-expense pass-throughs.

Consider a simplified example:

Assume the property owned by one owner form many years currently has an assessed value of: $1,000,000 with a current market value of: $4,000,000.

The business buyer acquires the operating company and signs a lease under which property taxes are passed through to the tenant as part of CAM or triple-net expenses. If the seller retains the building and then sells it two years later in a transaction that results in reassessment, the tenant may find itself responsible for property taxes calculated using an assessed value far closer to $4 million rather than the historical $1 million assessment.

The buyer's rent may not have changed. But the buyer's effective occupancy cost certainly has.

That additional expense comes directly out of the operating business's cash flow.

The Buyer's Exposure to a Future Sale Should Be Negotiated

For that reason, a business buyer should consider the seller's anticipated ownership period for the real estate to be an important part of the negotiations.

If the seller says: “I intend to keep the building for at least five years.” that may have significant economic value to the buyer if the property's current assessed value is substantially below its market value. Rather than relying solely upon an informal statement of intention by the real estate owner, however, the parties should consider whether a sale or other reassessment-triggering disposition of the property within a specified number of years should become a negotiated lease term. Depending upon the circumstances, the buyer may seek provisions addressing issues such as:

• whether the landlord may sell the property during an initial period of the lease;

• advance notice of a proposed property sale;

• a right of first refusal or right of first offer in favor of the business owner;

• limitations on the amount of reassessment-related property-tax increases that may be passed through to the tenant; perhaps a clause limiting yearly CAM increases no more than 5%;

• exclusion of some or all tax increases resulting from a voluntary transfer by the landlord;

• a temporary phase-in of reassessment-related increases;

• rent adjustment rights if the property is reassessed following a sale;

• termination or other remedies if occupancy costs exceed an agreed threshold; and

• appropriate protections concerning a successor landlord.

The proper provision will depend upon the transaction, bargaining strength of the parties, lender requirements, market rent, lease term and anticipated ownership horizon for the real estate. The important point is that this issue should be analyzed before the business buyer commits to the acquisition price, not a year or two later when the landlord announces that the building has been sold.

Reassessment Risk Can Affect the Value of the Business

A business buyer ordinarily evaluates an acquisition based upon expected future cash flow. Occupancy costs are part of that calculation. If the lease permits an unlimited property-tax pass-through and there is a reasonable possibility that the real estate will be sold shortly after closing, the buyer should model the potential post-sale property taxes rather than relying solely upon the landlord's historical tax bill. Otherwise, the buyer can acquire a business based upon one level of normalized cash flow and discover shortly after closing that reassessment of the property has materially increased CAM or triple-net expenses which can affect: debt-service coverage; the buyer's return on investment; working-capital requirements; acquisition-loan underwriting; the value of the business; and ultimately, the buyer's ability to perform under both the acquisition financing and the lease.

For these reasons, the seller's anticipated disposition of the real estate during the first several years following the business sale should be discussed and memorialized during the business-sale negotiations.

Rent Itself Affects Business Value

The lease economics can affect the value of the business in another important way. If the rent is materially above market, the business may generate less normalized cash flow and therefore command a lower business value. Conversely, if rent has historically been artificially low because the business owner also owns the real estate, a prospective buyer's financial analysis should generally account for the market occupancy expense the business will actually incur after the sale. A business generating $500,000 of apparent cash flow while paying no rent to its owner is not necessarily a $500,000 cash-flow business once a market-rate lease is imposed.

The objective is to make sure the buyer understands not only what the rent is on the day of closing, but what the total occupancy cost could realistically become during the buyer's ownership of the business.

Option Three: Sell the Business and Keep the Real Estate

For many sellers, this is the most intriguing alternative. Instead of selling both assets, the owner sells the operating business but retains the real property and leases it to the buyer. The former business owner becomes the buyer's landlord. This can transform one illiquid operating asset into two different components:

Liquidity from the sale of the business + continuing rental income from the real estate.

For an owner planning retirement, this combination can be compelling.

Turning Business Equity Into Retirement Income

Imagine an owner who sells a business for $2.5 million but retains a debt-free property worth $3 million. Rather than receiving another $3 million by selling the building, the seller keeps the property and enters into a long-term lease with the buyer. The seller may then receive monthly rental income while continuing to own an appreciating, or potentially appreciating, real-estate asset. That creates a very different financial profile than liquidating everything at closing.

Instead of: Business sale proceeds + property sale proceeds, the owner has:

Business sale proceeds + retained real estate + continuing rental income.

For some sellers, that recurring rental income and continued ownership of the property may be strategically preferable to receiving all of the property's equity at closing.

Of course, there is a tradeoff. The seller remains exposed to:

• real-estate market conditions;

• property expenses;

• mortgage obligations, if any;

• tenant credit risk;

• vacancy risk;

• maintenance issues; and

• the financial health of the business occupying the property.

These risks should be evaluated as deliberately as the benefits.

Keeping a Window Into the Business

There is another reason some sellers like this structure. The seller knows the property and they know the business. Because the business remains their tenant, they retain a legitimate economic interest in whether the occupant succeeds. This can give the former owner more visibility of the health of the business he has sold (and may have provided seller financing) than simply selling the business and walking away.

A properly negotiated commercial lease might provide appropriate rights concerning matters such as:

• inspection of the premises;

• insurance compliance;

• maintenance obligations;

• prohibited uses;

• alterations;

• financial information relevant to tenant creditworthiness;

• notices of specified material events; and

• defaults that may threaten continued occupancy.

For an owner who has spent decades building a business, retaining the real estate can provide both an income stream and a continuing window into the financial health of the tenant occupying the property.

Option Four: Use the Real Estate to Help Finance the Business Buyer

Sometimes a business is very sellable, the buyer is qualified and the transaction makes economic sense - but there is a financing gap.  This may be overcome if the seller may own substantial equity in the business real estate. That equity can potentially become part of the solution.

Refinancing the Property Before Closing

Consider the following simplified example.

The seller owns:

Business value: $2,000,000

Real estate value: $3,000,000

Existing property debt: $500,000

The seller therefore has approximately $2.5 million of gross real-estate equity before transaction costs and other considerations. Suppose a qualified buyer wants the business but can assemble only $1.5 million of the acquisition funding. There is a $500,000 gap.

One possible structure would be for the seller to refinance the real property, draw $500,000 from the property's equity and then use that liquidity to facilitate a seller-carried portion of the business acquisition.

Step 1: The seller refinances the real property.

Step 2: The seller receives cash from the refinance.

Step 3: The buyer obtains senior acquisition financing and contributes the required buyer equity.

Step 4: The seller finances an agreed portion of the business purchase price through a promissory note or other negotiated seller-financing arrangement.

Step 5: The buyer acquires the business.

Step 6: The seller keeps the real estate and receives rent from the buyer.

Step 7: The seller also receives principal and interest payments on the seller-financed portion of the acquisition.

The result can create several economic components benefiting the Seller: there can be cash received at closing; monthly rental income; principal and interest on the seller-financing obligation; and continued ownership of the real property.

Why Would a Seller Do This?

At first, the idea can sound counterintuitive. Why would a seller borrow against his or her own real estate and then help finance the person buying the business? Because the seller is not necessarily giving money away. The seller is converting otherwise illiquid real-estate equity into transaction capital. If that capital is the difference between closing and not closing, the strategy may unlock the value of the business while allowing the seller to retain ownership of the underlying property.

Economically, the seller has converted part of the equity sitting inside the real estate into another asset - a receivable from the business buyer, while retaining ownership of the property subject to the refinancing.

Whether that trade is attractive depends heavily upon the situation of the Buyer and Seller.

The Seller Creates Risk by Underwriting the Buyer

Seller financing should never be viewed merely as a device to get the deal closed. Once the seller carries part of the purchase price, the seller has become a lender. That means the seller should ask essentially the same question any prudent lender would ask:

If the property previously had little or no debt, refinancing it introduces a new fixed obligation. The rental income and the seller's overall financial position should be capable of supporting that obligation even if the business buyer encounters difficulties. In other words: Do not borrow against a secure real-estate asset merely to convert that equity into a poorly documented or inadequately underwritten business loan. The two sides of the transaction need to be evaluated together.

Coordinate the Lease and the Seller Note

When the seller retains the real estate and carries acquisition financing, the seller may wear three hats: they are the former business owner, they are the Landlord and also the Lender.  These relationships should be deliberately coordinated. The transaction documents should consider what happens when:

• the buyer pays rent but defaults on the acquisition note;

• the buyer pays the note but stops paying rent;

• the senior acquisition lender forecloses;

• the business is resold;

• the lease is assigned;

• the buyer becomes insolvent;

• the buyer abandons the premises; or

• another lender takes control of the business.

The landlord's remedies, seller-lender's remedies and senior lender's rights can collide if the structure is not thought through in advance.

Seller financing can also interact with institutional or SBA acquisition financing. SBA policies applicable to change-of-ownership transactions, equity injection and seller financing should therefore be addressed with the acquisition lender early rather than after the parties have finalized their economic agreement. SBA's own materials continue to treat change-of-ownership transactions as a distinct underwriting category.

Seller Financing Can Have Tax Consequences Too

Seller financing can affect the timing and character of taxable income. Federal installment-sale rules generally concern transactions in which at least one payment is received after the year of sale, subject to important exceptions and asset-specific rules. When a business is sold, the IRS does not simply treat the entire company as one indivisible asset for purposes of an asset sale.

The purchase price generally must be allocated among the underlying business assets. Inventory, depreciable property, goodwill and other assets can receive different tax treatment, and some gain may not qualify for installment reporting. Buyer and seller also generally have reporting obligations concerning the agreed allocation. Interest received on seller financing is also treated separately from principal.

Consequently, sellers should model the tax consequences with their CPA or tax attorney before agreeing upon the purchase-price allocation, seller-financing terms and timing of payments.

Caution is Crucial When the Real Estate and Business Are Inside the Same Entity

Transaction planning becomes more complicated if the operating business and real property are owned by the same corporation, partnership or LLC. A seller should not assume that avoiding a conventional deed transfer necessarily means that California property-tax consequences have been avoided. California has separate change-in-control and change-in-ownership rules that can apply to transfers involving entities holding real property. The ownership structure should therefore be reviewed before deciding whether the transaction will be structured as:

• an asset sale;

• stock sale;

• membership-interest sale;

• real-estate sale; or

• some combination of transactions.

This is another reason transaction planning should begin before a letter of intent is signed.

The Best Structure Depends on What the Seller Wants After Closing

The right question is not simply: “What can I sell everything for?”  The better series of questions is:

            “Do I want to be completely finished after closing?” If so, selling the business and property together may be attractive.

          “Do I want substantial liquidity but also recurring retirement income?” If the answer is yes, selling the business and retaining the building may deserve serious consideration.

            “Is the combined business-and-property price limiting my buyer pool?” If the answer is yes, separating the transactions may make the business more financeable.

            “Am I comfortable becoming the buyer's landlord?” Be truthful with yourself and decide. Keeping the real estate creates continuing income, but it also creates continuing time and exposure to the tenant and the property.

            “Do I have substantial property equity and a good buyer who is short of acquisition capital?”  Each person has their own risk tolerance but a carefully structured refinance and seller-financing strategy may help bridge the gap.

            “Am I willing to take buyer credit risk?”  If the answer is no, then neither seller financing nor substantial dependence upon that buyer's rent may be appropriate.

A Business Sale Involving Real Estate Should Be Planned as One Transaction—Even When It Becomes Two

When an owner owns both the business and the real property, some of the most valuable planning occurs before the business is ever marketed.  The business valuation, real-estate valuation, market rent, property-tax exposure, financing structure, tax consequences and seller's retirement objectives should be considered together. Sometimes the best result is one buyer and one simultaneous closing. Sometimes it is one buyer for the business and another buyer for the real estate. Sometimes the business should be sold while the real estate is retained for long-term rental income. And sometimes the equity in the real estate can become the capital that helps make the business transaction possible.

Owning the real estate should not automatically be viewed as a complication.  It is another tool in the seller's toolbox. Properly structured, it can increase flexibility, broaden the pool of potential business buyers, generate continuing cash flow and provide a seller with alternatives that simply do not exist when the business operates from leased premises.

Just as importantly, when the business buyer contemplates becoming a tenant, the parties should not focus solely on today's rent. They should consider the long-term economics of the lease, including whether a subsequent sale of the property could result in reassessment and substantially higher property-tax or CAM obligations.

The important point is to determine the structure before the transaction determines it for you.

This article is intended for general informational purposes only and does not constitute legal, tax, lending, investment, tax or accounting advice. California business and real-estate transactions are highly fact-specific. Owners and buyers should consult their legal, tax, lending and financial professionals regarding their particular circumstances.

AI Disclosure:  This post was written with the assistance of an AI language model. The human author provided the topic and key points, verified the information, and performed all final editing. The AI (ChatGPT) helped expand on the details and refine the writing. The final content was reviewed and edited by a human to ensure accuracy and quality.