The primary benefit of a passive real estate investment is that an individual investor can leverage the relationships, resources, and expertise of an experienced sponsor to gain access to a commercial-quality asset that they wouldn’t otherwise be able to invest in. But, like any investment, there are tax implications – positive and negative – that should be considered prior to committing to a deal.
Commercial Real Estate Tax Types
Taxes on a commercial investment tend to fall into one of two categories:
- Income: Property cash flow is paid to investors in the form of periodic payments known as distributions. Typically, they are taxed as “Ordinary Income” – like a paycheck – based on the tax bracket of the investor.
- Capital Gains: In an ideal situation, a property is sold for a price that is higher than what was paid. The difference between the purchase price and the sales price is known as a “gain” and it is taxable. The tax treatment of a gain is different based on whether the gain is classified as short-term” or “long-term.”
In both categories, the tax bill can be material if the investment is successful. However, one of the major advantages of a passive commercial real estate investment is that there are options to reduce it.
The Tax Benefits of Private Commercial Real Estate
In almost every commercial real estate investment, a “special purpose vehicle” is created to purchase the property. In most cases, this “vehicle” is a Limited Liability Company (LLC) whose only purpose is to own and operate the real estate asset.
When an investor contributes funds to a transaction, they are not actually purchasing a share of the property directly, rather they are purchasing shares in the LLC that owns the property. LLCs are classified as “pass-through entities,” which means that the income and expenses associated with the property “pass-through” it and flow to the individuals who have a membership interest in it. This creates several benefits:
- Income from the investment is taxed at the ordinary marginal tax rate
- Losses can be used to offset passive income from other investments
- Profits from passive investments are not subject to self-employment tax
To optimize these benefits, there are a series of allowable “deductions” that can be used to reduce the overall tax burden.
The tax treatment of a commercial real estate property allows for four different types of deductions, each of which can be used to offset the income produced by the property:
- Operating Expenses: Costs associated with running the property such as taxes, insurance, and maintenance can be deductible. This means that they are “deducted” from the property’s income to reduce the tax liability.
- Depreciation: Commercial real estate is a “hard” asset and the physical condition of its components (concrete, lumber, marble, electrical, etc) can degrade over time. To account for this, the owner can “depreciate” the value of the asset annually and use this amount to offset income. Depending on the asset class, it can be depreciated over 27.5 or 39 years. For example, if a property has a value of $10,000,000, the owner could take $10,000,000 / 39 = $256,410 in depreciation per year.
- Interest Expense: Most commercial investment properties have a loan against them, and the owner can deduct the annual interest expense against income.
- Operating Losses: A property’s income less expenses is its “Net Operating Income.” If this calculation results in an operating loss, it can be used to offset other gains or passive income.
Each year, passive investors will receive a document called a “K-1” that lists each partner’s share of income, deductions, and credits. For investors with multiple passive investments, they will receive a K-1 for each, and their tax liability is calculated in aggregate. This means that if one investment was very profitable and another performed poorly and resulted in a loss, these numbers are netted against each other to calculate the tax liability.
Firms like ours operate nationally, which means that our properties and investors are in various states across the country. If the state that a property is located in (the “source income state”) is different than the state in which an investors lives, it is likely that they will have to file a tax return in that state. For example, if an investor lives in Florida, which does not have a state income tax, but invests in a property located in New York, which does have a state income tax, they will have to file a state tax return in New York to account for the income earned.
For investors with holdings in multiple states, filing an annual tax return can be a complex and time-consuming endeavor. These individuals are likely to require the assistance of a Certified Public Accountant who have the tools and expertise to ensure that it is done correctly.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well 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.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.