There's no avoiding taxes, but investors can at least reduce the amount they have to pay by investing in commercial real estate. Understanding how commercial real estate taxes work, and knowing how to take advantage of the many real estate tax benefits available, can help investors lower their tax bill and keep more of their wealth.
How is commercial real estate income taxed?
Investors earn a return on their commercial real estate investment in two ways: the cash flow the property generates and in capital gains from appreciation. The way the profits on a commercial real estate investment are taxed depends on whether that profit is cash flow or capital gains.
The cash flow a property generates is the income an investor receives after covering expenses. This is taxed as ordinary income, so the tax rate is based on the investor's tax bracket. This is paid at both the federal and state level like any other business income.
In the most simple sense, capital gains are the difference between what you paid for something versus what you sell it for. For example, if you buy something for $100 and sell it for $50, you have a capital gain of $50. Of course, it's not quite that simple with real estate, since depreciation is involved. You can learn more in this article about how depreciation affects capital gains.
Capital gains are taxed separately from income, typically at a different rate. The main differences are that expenses can't be written off against capital gains, and the capital gains tax rate is lower than the income tax rate for most taxpayers.
Tax benefits of commercial real estate
One of the greatest advantages to investing in commercial real estate is the tax benefits that come along with it. Investors can take advantage of these benefits to reduce the amount they're required to pay in income tax, as well as capital gains tax.
Depreciation may be the greatest tax benefit in commercial real estate, because it's a non-cash expense. This means you get a substantial write-off each year but don't actually have to spend any money to get it.
The Internal Revenue Service (IRS) has determined that commercial real estate has a useful life of 39 years, so the value of a piece of commercial real estate is depreciated over that amount of time. This means each year, the commercial property owner is able to write off 1/39th of the value of their property as a depreciation deduction. Of course, the property can't continue to be depreciated once the 39 years is up.
Depreciation is written off against ordinary income, so the amount of taxes paid on the cash flow generated from the property is reduced each year.
However, there's a flip side to this. When it comes time to sell the property, there will likely be depreciation recapture. This means you'll have to pay tax on the amount you depreciated while you owned the property.
However, the tax rate for depreciation recapture is usually less than the income tax rate. This means the amount you save in taxes each year with the depreciation tax deduction will likely far outweigh the tax bill for recapture. You can learn more about how this works in this article on understanding depreciation recapture.
When a loan is used to purchase a commercial property, the investor is able to write off the amount of mortgage interest paid on the loan each year against their income. This can be a substantial write-off, especially in the first few years of the loan when the interest payments far outweigh the principal payments.
While depreciation and interest expense deductions help lower the income tax burden, they can't be written off against capital gains. However, real estate investors can defer capital gains when they sell their commercial property and reinvest the proceeds into another property. They can do this through a 1031 exchange, with the help of a qualified intermediary. The catch is that the commercial real estate investor can't cash out of the profit from the sale.
The advantage is that they can use their capital gain to invest in a property that produces more income. Since they're not paying taxes on the gain, they have more money to invest.
Commercial real estate owners can continue to exchange up to larger properties through future 1031 exchanges without having to pay capital gains tax along the way.
Lower tax burden for beneficiaries
Of course, a 1031 exchange only allows you to defer your capital gains tax, not completely avoid it. This means that once you finally sell a property, your tax will be based on the cost basis of the original property. However, your heirs can take advantage of another great tax benefit if you plan to pass your commercial real estate down to them in your will.
Your beneficiaries will get what's called a "step-up" in cost basis. This means that when they sell the property, they will only pay capital gains based on the property value when they inherited it.
The Millionacres bottom line on commercial real estate tax benefits
Commercial real estate investors can use these tax benefits to grow massive real estate portfolios and build generational wealth. However, the smart ones know to use a knowledgeable tax professional to help them do it. There are a lot of rules that go along with taking advantage of these tax breaks, and making any mistakes can be extremely costly.