The basic premise behind a rental real estate investment is relatively simple: an investor purchases a property, leases it to an individual or business, and uses the rental income to pay the expenses needed to operate the property. If there is any money left after all expenses are paid (including debt service), it is returned to the investor. After a certain period of time, assuming market conditions are favorable, the investor can sell the property and use the proceeds to pay off the loan. And if there are any funds remaining after the loan has been repaid, these funds are also returned to the investor(s).
This summary of the investment lifecycle represents three sources of income for real estate investors: Operating Income (or losses) from the day-to-day operations of the property, Capital Gains (or losses) from the sale of the property, and “Depreciation Recapture” that may occur on the sale of the property. The tax treatment for each of these income sources varies slightly, and it’s important to understand the nuances between them.
Operating Income
To understand how Operating Income is taxed, it is first important to understand the typical structure of a commercial real estate transaction. In such a scenario, a lead investor (or company like ours) finds a property that they believe has a good opportunity for return. To place it under contract, they form a Limited Liability Company (LLC) and use it as the vehicle through which to make the purchase. To finance the purchase, they obtain a loan (debt) for ~70% of the purchase price, and sell shares in the LLC to raise the remaining ~30% needed to complete the transaction (equity). Investors who purchase shares in the LLC are entitled to their proportionate share of the property’s operating income. For IRS tax purposes, the LLC is considered a “pass through entity,” which means that income and expenses flow through it and to its investors, which they claim as taxable income on their own individual tax returns. Depending on each investor’s tax bracket, the resulting tax rate may vary. To illustrate how this works, consider a very simple example.
Assume that a lead investor finds a rental property that they believe represents a good opportunity for return. They form an LLC and place the property under contract for $1 million. To finance the purchase, they arrange a $700,000 loan from a bank and raise $300,000 from two equity investors, who each purchase 50% of the LLC. In year one of the investment holding period, the property produces $100,000 in gross income and generates $70,000 in deductible operating expenses, which include property taxes, insurance, and mortgage interest. Of the $30,000 remaining, $15,000 is distributed to each of the two investors because they each own half of the company. This distribution is documented on a Schedule K-1, which is sent to each investor at the end of the tax year and included as part of their own tax return. Depending on each taxpayer’s tax bracket, other ordinary income and other passive losses, the distributed income is ultimately taxed at the ordinary income tax rate.
The bottom line is that the property’s purchase vehicle is considered a “pass through entity,” such that Operating Income is distributed to equity investors, documented on a Schedule K-1 and taxed at the appropriate ordinary income tax rate on their personal returns.
Capital Gains
Real estate prices tend to rise slowly over time, which is why many investors prefer a 5-10 year investment holding period. These price increases are typically driven by two factors: Net Operating Income (NOI) and market dynamics.
Unlike residential properties, which are valued on comparable sales, commercial properties are valued based on a metric called Net Operating Income. Because this is calculated as the property’s income less operating expenses, the owner can have a direct impact on the equation. By pursuing projects that increase income, decrease expenses—or both—it’s possible to increase Net Operating Income and “force” the property to appreciate in value. In a very simple example, assume that a property has Net Operating Income of $50,000 in year one of the investment holding period, and that it improves to $75,000 by year five. At a 7% cap rate, the property’s value has increased from $714,000 to $1.07 million without any changes in market dynamics.
The supply and demand characteristics of a local market have the potential to substantially magnify property appreciation. Using the example above, assume that the property is located in a market where there is significant commercial real estate demand and not enough supply. As a result, investors are willing to pay a premium for properties, which drives cap rates lower. If Net Operating Income is rising and real estate cap rates are falling, gains can accelerate rapidly. Again, $50,000 in Net Operating Income at a 7% cap rate is valued at $714,000. But if NOI rises to $75,000 and market cap rates fall to 6%, the value rises to $1.25 million. This premise is the holy grail of commercial real estate investing.
The difference between the price paid for a property and its price sold is a “Capital Gain,” and it is taxable. Depending on the taxpayer’s tax bracket and the length of time that the property is held, it could be subject to short-term capital gains tax or long-term capital gains. Generally, properties that are held less than one year will pay short-term capital gains tax at the ordinary income tax rate for that investor. Properties held more than a year are taxed at the long-term capital gains tax rate, which is 0%, 15%, or 20%, depending on the investors’ Ordinary Income.
For larger commercial properties, the Capital Gain—and the associated tax bill—can be significant. Fortunately, IRS tax rules provide investors with an opportunity to defer taxes on the gain through a 1031 Exchange. With this strategy, also called a “Like-Kind Exchange,” capital gains taxes can be deferred provided that the property sale proceeds are reinvested into another property that is “like kind” to the one that was sold. There is no limit on the number of 1031 Exchanges that can be performed, so an investor could, theoretically, repeat this process over and over, thus allowing their profits to grow tax free over a long period of time.
Depreciation Recapture
Real estate is an asset with a physical condition that can degrade over time. To account for this, IRS tax rules allow property owners to take a tax deduction for a portion of the property’s value each year, which decreases its overall tax liability. But, these depreciation deductions can be a double-edged sword. Over the course of a multi-year investment holding period, the property’s depreciated cost basis decreases while the property’s value rises. When it comes time to sell the property, the gap between these two numbers can become significant and it is subject to a “depreciation recapture” tax. For example, assume that a property was purchased for $1 million and IRS rules allow $20,000 per year in depreciation deductions. After five years, the property’s depreciated cost basis has fallen $100,000 down to $900,000, at which point the property is sold for $1.25 million. The portion of the gain that is attributable to the depreciation deductions previously allowed will be subject to depreciation recapture, which is taxed at 25% at the time of this publishing.
The ability to deduct depreciation is one of the major tax advantages of a commercial real estate investment. However, when doing so, the tax implications of this strategy should be considered carefully since it will be recaptured at the time of sale. Depreciation recapture calculations can be complex and should be done by a qualified CPA.
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.
As part of our value-add strategy, we seek to maximize property value by taking advantage of all available tax benefits. If you would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrealtypartners.com for more information.
