Scenario: Restaurant Owner Buys the Building

This page describes a composite hypothetical. It is not a real client or a real result. Numbers are simplified assumptions.

The Scenario in Brief

A restaurant owner has leased a space for years and now has the chance to buy the building. The owner wonders about the tax consequences of buying, whether to hold the building personally or in a separate entity, and whether a cost segregation study would be worth considering. The owner asks an advisor to walk through the issues.

Assumptions Used

• Purchase price: 1,800,000 dollars.
• Land allocation: 30 percent, or 540,000 dollars, leaving 1,260,000 dollars of depreciable basis.
• Recovery period for the building: 39 years.
• A hypothetical study assumes 25 percent of depreciable basis, or 315,000 dollars, is shorter-life property, including kitchen-related fixtures, specialty electrical and plumbing serving equipment, and paved parking.
• The building will be held in a separate limited liability company that leases the space to the restaurant's operating company.
• The owner materially participates in the restaurant.

Questions the Advisor Would Ask

The advisor would ask how the property will be financed, whether the lender has requirements about the holding entity, and whether the restaurant lease will be at a market rent. Rent between related parties needs support, because it is a deduction for the restaurant and income for the property owner. The advisor would also ask whether the owner plans to sell the restaurant later and how the building fits into that plan.

Worked Arithmetic: Rent and Depreciation

Suppose market rent for the space is supported at 132,000 dollars per year. The property company's income and expenses might look like this:

With a study and 100 percent bonus depreciation on 315,000 dollars, the first-year depreciation would rise sharply, likely creating a tax loss at the property company in the first year, while the restaurant continues to deduct rent. The figures are simplified and ignore partial-year effects.

Passive Loss Questions

Rental of property to a business in which the owner materially participates receives special treatment under the passive activity rules. Income from such a rental is generally recharacterized as nonpassive, which affects how income and losses interact. The advisor would explain that net rental income to the property company would be nonpassive, while losses from the rental are treated differently and can still be subject to limits. The rules are technical, and the advisor would review how they apply.

How It Might Play Out

The owner might decide to hold the building in a separate entity for liability and estate planning reasons, and to obtain a study if the projected first-year deduction is meaningful compared with the cost. The advisor would also discuss how the building and the restaurant would be sold if the owner exits, since buyers of restaurants often prefer to lease space, and the property could be kept or sold separately.

Risks and Limits

• Rent must be reasonable and documented in a written lease.
• A cost segregation study creates recapture on components if the property is sold.
• Lender requirements can constrain the ownership structure.
• Ownership of the building can concentrate risk in a single business location.

What This Scenario Teaches

The scenario shows how a purchase decision touches several areas at once: depreciation, entity choice, related-party rent, and exit planning. It also shows that a study is one option among several tools, and that its value depends on the projected income of the property company and the owner's other income. The investment decision should stand on its own economics.

Questions to Bring to Your Advisor

1. What rent is supportable for my space?
2. How should I hold the building?
3. Would a study be worthwhile given projected income?
4. How would the building fit into a future sale of the restaurant?

Lease Terms Worth Documenting

The lease between the property company and the operating company should state the rent, the term, who pays taxes, insurance, and maintenance, and what happens if the restaurant is sold. Keep evidence of how the rent was set, such as broker opinions or comparable leases for similar space in the area. Pay the rent on time and record it in both sets of books. If the rent is adjusted later, document the reason and the effective date.

Scenario Variations Worth Considering

Suppose the rent were set lower than the market. The operating company would have higher profit and the property company lower income, which might not be respected if it appears to be arbitrary. Suppose instead the restaurant owner planned to sell the operating business soon. The buyer might want a long-term lease, which could make the property more valuable as a stand-alone investment. Each variation changes the discussion, which is why an advisor examines the facts before suggesting a structure.

Educational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.