Investing in commercial real estate can certainly be a very profitable endeavor. However, it is important for investors to remember that they must factor in taxes when estimating their potential return. Fortunately, there are ways that the tax bill can be deferred.
In this article, we are going to describe seven ways to defer capital gains taxes on a profitable real estate investment. For each one, we will describe what it is and and highlight the pros and cons of utilizing that strategy. By the end, readers will have the information necessary to determine if one
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. We have a long track record of delivering profitable returns to investors so it may be important to be familiar with the tax deferral strategies described in this article. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
What is a Gain?
In order to understand capital gains tax deferral strategies, it is first necessary to understand what a gain is in the first place.
Simply, a gain on sale is the difference between a property’s cost basis and its sale price. So, for example, if an investor purchased a property for $1,000,000 and sold it ten years later for $2,000,000, the gain on sale is $1,000,000 (NOTE: This example is for illustrative purposes only. Calculating the actual gain on sale can be very complicated given things like depreciation deductions. It should be calculated by a CPA or tax advisor).
Under IRS rules, a gain on sale is taxable. The exact taxes due is dependent upon the length of time the property was held and the income tax bracket of the taxpayer. But, as a general rule, capital gains for properties held 12 months or less are taxed as regular income while properties held more than 12 months are taxed at the lower long term capital gains tax rate (~25% at the time of this writing). The exact calculation of a gain for an investment property can be complicated so it should always be completed by a qualified CPA or tax advisor.
Strategies for Deferring Capital Gains Tax
A capital gains tax bill may come as a surprise to some real estate investors, but one of the major benefits of commercial real estate is that there are strategies that can be used to defer it. Doing so can allow an investor’s money to grow tax free over time. For this reason, investors are well served to consider one of the following seven strategies when booking a gain on the sale of a commercial property.
1. Sell the Property After 1 Year
One year is the dividing line between having to pay short term versus long term capital gains tax. There can be a big difference in the rate so it may make sense for some investors to wait at least one year before selling a property.
Short term capital gains are taxed as ordinary income. At the time of writing, the top income tax bracket is 37%. However, properties held more than one year are subject to long term capital gains tax. At the time of writing, the top bracket is 20%.
So, there can be up to a 17% difference in the tax rate applied when holding the property for less than one year or more than one year. As such, investors can potentially have a significant reduction in their tax rate when a property is held for more than one year.
2. Use the IRS Primary Residence Exclusion (If Applicable)
While not specifically related to the sale of a commercial property, IRS rules allow taxpayers to reduce the tax bill on the sale of their primary residence by utilizing an “exclusion.”
The Internal Revenue Code rules state that investors can exclude up to $250,000 for single filers or $500,000 in profits for joint filers when selling their home. So, for example, if a joint filer has a profit of $750,000 on the sale of their home, the exclusion would reduce the amount of the gain by $500,000 to $250,000. In order to benefit from this exclusion, there are two rules that must be met.
The first is the “ownership test” which states that the taxpayer must have owned the property for at least 24 months of the five years leading up to the sale date.
The second is the “use test” which states that the taxpayer must use the home as their primary residence for at least 730 days in the five years leading up to the sale date.
When both of these tests are met, the taxpayer may be eligible for the full exclusion.
3. Sell During a Lower Income Year
From the description, it may sound like capital gains taxes are assessed separately from an individual’s regular income. They aren’t. The gain is lumped in with all other types of income that an individual has earned during the year and taxes are assessed on the total amount.
As such, investors can lower their capital gains tax bill if they strategically time their sale so it occurs in a year where they earn less income from other sources This way the overall taxable income amount is lower because the gain is offset by the lower income amounts in other areas.
4. Keep Records of Renovation and/or Selling Costs
If the rental property owner completes renovations on the property, it is a best practice to keep track of the costs. In addition, if they incur costs associated with the sale of the property, they should keep records of those as well.
The reason for keeping track is that these costs may be able to be added to the property’s cost basis, which lowers the overall amount of the gain on sale. In the example above, the purchase price was $1,000,000 and the sales price was $2,000,000, which equates to a $1,000,000 gain. But, suppose that the owner invested $100,000 in renovations for the property and incurred $50,000 in closing costs associated with the sale. If allowed, the $150,000 could be added to the cost basis, increasing it to $1,150,000, and reducing the amount of the gain from $1,000,000 to $850,000.
Because the amount of the gain is reduced, so is the tax bill.
5. Perform an Installment Sale
By definition, an installment sale is described as “disposition of property where at least 1 loan payment is received after the close of the taxable year in which the disposition occurs.” In other words, an installment sale provides the seller with some initial sales proceeds and may push additional payments into future tax years.
The benefit of this strategy is obvious, it provides the seller with a bit of control over when their taxable income occurs. Or, put another way, they can spread the tax consequences of a profitable sale over multiple years, reducing the hit in any one year.
6. Invest in Opportunity Zones
An “Opportunity Zone” is an economically distressed area somewhere within the United States. To encourage investment in these areas, the IRS has created a program that allows investors to defer a certain amount of their capital gains taxes upon sale. In the most advantageous arrangement, investors can eliminate 100% of their capital gains taxes as long as they hold the asset for at least 10 years.
For many investors, the most accessible route to a Opportunity Zone investment is through an “Opportunity Fund” which is an investment vehicle set up specifically for this purpose.
7. 1031 Exchange
The 1031 Exchange is the holy grail of tax deferral opportunities. It allows investors to defer 100% of their capital gains taxes as long as they reinvest their sales proceeds into a “like kind property (the replacement property),” which is why this transaction is sometimes referred to as a “like kind exchange”.
There are a number of different rules that 1031 Exchange investors must abide by to ensure the tax benefits of this transaction are maximized. As such, it is a best practice that they work with a “qualified intermediary” to ensure that all rules are followed and that the transaction is completed within the allotted time frame.
Perhaps the greatest advantage of the 1031 Exchange is that there is no cap on the number of times it can be used. So, in theory, an investor could complete them over and over again, allowing their money to grow tax free indefinitely.
How to Identify 1031 Exchange Opportunities
One of the most important rules in a 1031 Exchange is that a suitable replacement property must be identified within 45 days of the sale and the purchase must be completed within 180 days. For this reason, it can be a challenge to identify suitable replacement properties.
Fortunately, there are options. 1031 Exchange investors can work with private equity firms (like us), a qualified broker, a Delaware Statutory Trust, or even find a property on their own. However, working with a professional can take some stress out of the process.
Summary of Deferring Capital Gains Taxes
Booking a gain on the sale of a commercial property can be exciting. However, investor enthusiasm may be somewhat dampened by the accompanying capital gains tax bill.
Fortunately, there are a number of strategies that can be used to reduce the amount of the capital gains tax due.
These strategies include investing in opportunity zones, utilizing 1031 Exchanges, or even pursuing an installment sale to spread the bill over multiple years.
However, it is critical to note that tax rules can be very complex and the treatment of a gain can vary based upon the unique circumstances of a sale. To determine the proper capital gains tax rate, it is always a best practice to work with a certified accountant or tax professional to make sure all rules are followed.
Want To Learn More About FNRP?
First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available below intrinsic value. We seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our investment opportunities, contact FNRP at (800) 605-4966 or firstname.lastname@example.org.