State capital gains tax
In addition to federal capital gains tax rates, you may also be exposed to state capital gains tax. Aside from Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming, all other states impose a tax on capital gains. To learn the applicable rate in your jurisdiction, you should check in with your state’s tax authority.
In addition to federal and state taxes on capital gains, you may also be exposed to depreciation recapture tax. Depreciation recapture is tax is the tax known to "come back to bite you." If you may become liable for depreciation recapture tax upon disposition of your commercial property, you should contact your tax advisor prior to the sale to limit your exposure to recapture tax. In addition to depreciation recapture tax, you may also be liable for net investment income tax, which is a 3.8% tax on certain passive income. Let’s just say there may be a lot of taxation on those capital gains.
With all the potential exposure to various taxes, as an investor, learning how to preserve some of your capital gains is essential to your success.
Section 1031 tax-deferred exchange
One tax savings strategy that many investors utilize to defer capital gains until future years is Section 1031 like-kind exchanges. Section 1031 like-kind exchanges are used by commercial real estate investors who dispose of their real estate investment property and acquire another investment property of a like kind. Performing a Section 1031 exchange is a very intricate and detailed process; the steps can be found here. Since the process involves many technical steps, always work with an advisor when performing a Section 1031 like-kind exchange.
Another tool that may also be used to defer your capital gains tax if you have an eligible property located in a qualified opportunity zone, you can invest your capital gains into a qualified opportunity fund. At present, investors are allowed to defer their gains using a qualified opportunity fund until 2026, so there's still plenty of time to participate in the program. While there is still time, investing your capital gains into a qualified opportunity fund requires a substantial amount of technical skill, so you should always consult with an advisor before using any of the steps outlined here.
Millionacres bottom line
Deciding to invest in commercial real estate can be a lucrative endeavor. However, before deciding to make such a substantial investment, you should first consider your projected tax liability and explore the tools available that will limit your exposure to capital gains taxes. Working with your tax advisor is always key to your financial success.