In an ideal commercial real estate investment scenario, an investor buys an investment property, holds it for some period of time, and then sells it for an amount more than they paid. In such a scenario, the investor is happy because they made a profit. But, that same profit is subject to capital gains taxes.
In this article, we are going to discuss capital gains taxes. We are going to describe what they are, why they matter, and how they are calculated. By the end, readers will have a more thorough understanding of capital gains taxes and will be able to incorporate this knowledge into their pre-investment due diligence process.
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What is a Gain?
In order to understand what capital gains taxes are, it is first necessary to understand what a gain is in the first place.
In the simplest terms, a gain – sometimes referred to as a gain on sale – is the difference between the sales price of a property and its cost basis. To illustrate what these two terms really mean, an example is helpful.
Suppose that an investor acquires a property with a purchase price of $5MM and their plan is to hold it for five years. In each of those five years, IRS accounting rules allow them to take $100,000 in depreciation deductions, which reduces the cost basis. So, at the end of the five years, the basis is $4.5MM. Now, suppose the investor is able to sell the property for $6MM. The difference between the cost basis of $4.5MM and the sales price of $6MM is a gain of $1.5MM
The exact amount of capital gains taxes is highly dependent upon how long the property was held.
Short vs. Long Term Capital Gains Taxes
Commercial real estate, along with other investment vehicles like stocks, bonds, arts, and collectibles, is a “capital asset,” which means that the government levies a tax on the profits upon the sale of the asset.
For assets held less than a year, the gain is classified as short term and is taxed as ordinary income. So, investors can expect to pay taxes at the rate of their normal income tax bracket.
For assets held more than a year, the gain is classified as long term and is taxed as such. Fortunately, the long term capital gains tax rate is less than the ordinary income. The exact rate paid is dependent upon a taxpayer’s income and filing status.
To illustrate the difference between short and long term capital gains, the following tables provide additional detail:
Ordinary Income Tax Brackets
|Filing Status||10% Tax Rate||12% Tax Rate||22% Tax Rate||24% Tax Rate||32% Tax Rate||35% Tax Rate||37% Tax Rate|
|Single||$0 – $10,275||$10,276- $41,775||$41,776 – $89,075||$89,076 – $170,050||$170,051 – $215,950||$215,951- $539,900||$539,900+|
|Head of household||$0 – $14,650||$14,651-$55,900||$55,901- $89,050||$89,051- $170,050||$170,051- $215,950||$215,951-$539,900||$539,900+|
|Married filing jointly||$0 – $20,550||$20,551-$83,550||$83,551- $178,150||$178,151-$340,100||$340,101- $431,900||$431,901- $647,850||$647,850+|
|Married filing separately||$0 – $10,275||$10,276- $41,775||$41,776- $89,075||$89,076- $170,050||$170,051- $215,950||$215,951- $323,925||$323,925+|
Long Term Capital Gains Tax Brackets
|Filing Status||Tax Rate of 0%||Tax Rate of 15%||Tax Rate of 20%|
|Single||$0 – $41,675||$41,675 – $459,750||Over $459,750|
|Head of household||$0 – $55,800||$55,800 – $488,500||Over $488,500|
|Married filing jointly and surviving spouse||$0 – $83,350||$83,350 – $517,200||Over $517,200|
|Married filing separately||$0 – $41,675||$41,675 – $258,600||Over $258,600|
So, from the two tables above, it can be seen that even the highest long term capital gains tax rate is 20%, which is significantly less than the ordinary income tax rate for high earners. This is one of the major benefits of investing in commercial rental property
Factors to Consider When Planning For Capital Gains Taxes
So, based on the information provided by these two tables, it is clear that the key factor in tax planning for a commercial property is how long commercial real estate investors plan to hold the property. Based on the lower long term capital gains rate, there is a strong incentive to hold the property for at least one year.
But, Look Out For Depreciation Recapture
Commercial real estate is a physical asset whose condition degrades over time. For example, HVAC systems break down. Carpets get worn out and tiles crack. To account for this type of wear and tear, the IRS allows commercial real estate investors to expense a portion of their asset’s value annually in a process known as depreciation. Each year, the amount of depreciation taken reduces the real estate investment property‘s cost basis. Over a multi-year holding period, depreciation accumulates to be a larger number.
When a property is sold, the total of the accumulated depreciation is “recaptured“ and taxed. This may come as a surprise to investors, so this tax liability must be planned for when modeling investment returns. To illustrate how this works, let’s revisit the example from above.
In the example, the investor took $100M per year in depreciation for five years, for a total of $500,000. Upon sale, this amount of money is recaptured and taxed at the ordinary income tax rate, in addition to the long term capital gains taxes that are assessed.
To learn more about depreciation recapture and how to reduce its impact on profits, check out our blog post on the topic.
Deferring Capital Gains Taxes
Another major advantage to investing in commercial real estate is that, if a gain is achieved upon sale, there are ways to defer the tax bill on it. There are two in particular that investors should take note of.
A 1031 Exchange, sometimes called a like-kind exchange, is a type of real estate transaction that allows investors to defer capital gains taxes as long as they reinvest the proceeds from their sale into another property that is considered to be “like kind (the replacement property).”
In order to complete this transaction, there are a number of rules that investors must abide by, but the key point is that this is an incredible incentive that, if used correctly, can allow investors to grow their portfolio tax-deferred over time.
To learn more about 1031 Exchanges, there are a number of posts on our blog that can be read.
Opportunity Zones Program
Commercial real estate investors should also know about the IRS’s Opportunity Zone program.
The concept behind the opportunity zones program is to help investment capital flow into areas needing an economic boost by granting preferential tax treatment on eligible investments. With an opportunity zone investment, investors could reinvest their property sale proceeds into ”qualified opportunity zones” and receive major tax benefits for doing so. If the investment is held for five years, taxpayers could receive a 10% reduction in their capital gains taxes. If it is held for seven years, investors could receive a 15% reduction. And, this is the key tax benefit, if the investment is held for ten years or more, capital gains taxes are eliminated entirely.
Again, this is a powerful tax incentive for investors that can save investors a significant amount of money on their tax return over time.
To learn more about the opportunity zones program and how it saves you money on your capital gains taxes, check out our blog post on the topic.
When It Makes Sense To Pay Capital Gains Taxes
Deferring taxes over a long period of time may be a significant tax benefit for property owners. But, there are occasions when it may make sense to just go ahead and pay taxes on the gain.
If the investor(s) need the sale proceeds for another non-commercial real estate use – like a medical bill or college tuition – in the short term, it likely makes sense to just pay the taxes.
Getting The Right Advice
Everything in this article that precedes this section is written in the most general terms possible. The truth is that calculating tax bills, taxable income, and tax liability can be incredibly complicated – especially for commercial real estate investors with large portfolios.
For this reason, it is always a best practice to work with a certified public accountant (CPA) or tax professional who is familiar with all aspects of the internal revenue code, tax law, and what qualifies as acceptable tax deductions. These individuals can both help investors plan for ways to reduce their capital gains tax bill and keep them out of trouble for unacceptable tax treatment.
If, after reading this article, there are any questions about how to calculate capital gains tax liability, or how to defer capital gains tax, the best place to go for advice is to a CPA or tax lawyer.
Summary of Capital Gains Taxes
When planning an exit strategy from a property, there are many factors investors need to consider. Among the largest is understanding the impact of capital gains taxes upon a profitable sale.
Capital gains taxes must be paid on the “gain” in a sale. The gain is calculated as the difference between a property’s cost basis and its sales price.
If a property is held for less than one year, gains are taxed as ordinary income, which is the short term capital gains tax rate.
If a property is held for more than one year, gains are subject to the long term capital gains tax rate, which varies based on a taxpayer’s income and filing status.
If investors take depreciation on their property, they should be aware that it is likely that it will be “recaptured” upon sale, which means that there will be a tax bill (in addition to capital gains taxes) on accumulated depreciation taken over the holding period.
There are a number of ways that investors can defer capital gains taxes, but two of the most prominent are reinvest sale proceeds in a 1031 Exchange or in a qualified opportunity zone.
When planning for capital gains taxes, it is always a best practice to work with a CPA or tax advisor to ensure everything is done correctly.
Interested In Learning More?
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If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.