Jeff and Linda Foley are married and file a joint income tax return. Jeff is a lawyer and a partner in the firm of Foley & Looby, Attorneys at Law. Jeff is a 50% partner in the firm along with his partner, John Looby who is the other 50% partner. Foley & Looby (F&L) currently rent office space in a prestigious building and pay rent of $6,000 per month or $72,000 per year for their 4,000 square foot office. Thus, the firm pays $18 per square foot per year. As no equity is being generated by paying rent, Jeff and John are considering buying an office building. They have two buildings under consideration, as follows:
Building #1
• Building #1 is a relatively new building and has 10,000 square feet of space. The new building can be purchased for a total price of $1,000,000. F&L would only use 4,000 square feet of the space and have other businesses that would rent the other 6,000 square feet from F&L for $15 per square foot per year, a total of $90,000 per year. Maintenance costs would amount to approximately $10 per square foot per year. The building is in excellent condition and is ready to be moved into immediately and would require very few other outlays by F&L.
Building #2
• Building #2 is located in the downtown area in a certified historic district and would qualify as a certified historic structure. This building, nearly 80 years old, also has 10,000 square feet and, like Building #1, the other 6,000 square feet can be rented to other tenants at $15 per square foot per year, a total of $90,000 per year. However, Building #2 is not in as good condition as Building #1. The purchase price of the building would be $400,000, and Jeff and John estimate that approximately $600,000 would have to be invested in capital expenditures to make the building suitable for their business. After the significant capital expenditures, F&L estimates the maintenance costs to be similar to Building #1, or $10 per square foot per year.
Both buildings can be 100% financed at 8% annual interest rate for 15 years. The annual cash payment on the $1,000,000 mortgage would be $117,000. Assume both buildings will appreciate at a rate of 8% per year.
Jeff and John have come to you as their financial and tax advisor to help them make the decision as to which building to purchase. If the buildings are equally desirable from a non-financial and non-tax standpoint, what is the best decision for them? That is, should they stay where they are and rent, or purchase one of the two buildings? Assume both Jeff and John are in the top 35% marginal tax bracket.