The majority of commercial real estate investment (“CRE”) returns come from two sources: income, which is produced from a property’s rental payments, and capital gains, which occur when an investor is able to sell a property for a price that is higher than what they paid. But, there is also a third source that, when managed correctly, can make a major contribution to an investment’s overall return in the form of reduced income and/or capital gains taxes.
While the general tax benefits of commercial real estate investment are widely known, it may come as a surprise to some that there are up to eight specific ways that they can be used to reduce or defer taxes.
#1 – Depreciation
Commercial real estate is an asset whose physical condition degrades over time. To account for this, the IRS tax code allows a property owner to expense a portion of the property’s value each year in a process known as “depreciation.” This expense is listed on the property’s Income Statement and serves to reduce its overall tax liability. And, because it is a non-cash expense, it does not reduce the property’s cash available for distribution.
Given the role that depreciation deductions play in reducing a property’s tax liability, property owners have a strong incentive to maximize the amount taken each year. Experienced property owners can do this by utilizing an advanced depreciation strategy known as “Cost Segregation,” which segments the property’s assets into buckets and depreciates them over accelerated time periods. For example, the IRS tax code allows a multifamily property as a whole to be depreciated over 27.5 or 39 years. But a Cost Segregation Study can divide the components of the asset into buckets like Personal Property, which can be depreciated over 5 or 7 years, or Land Improvements, which can be depreciated over 15 years. These accelerated timelines can maximize both the depreciation deductions and the tax savings that goes with it.
#2 – Lower Tax Rate on Capital Gains
Some investors prefer to make investments through their Individual Retirement Account (IRA), which allows investment funds to grow tax deferred until retirement age. After this point, money pulled from the account is taxed as ordinary income at income tax rates as high as 37%, depending on the account owner’s tax bracket. However, when a profitable real estate investment is made, the profits are taxed as a “Capital Gain,” which carries a lower tax rate than ordinary income. For example, in 2020 the highest long term capital gains tax rate is 20%, which is clearly lower than the highest ordinary income tax bracket. This opportunity is a significant advantage for those actively planning for retirement and considering commercial real estate as part of that plan.
#3 – Non-Mortgage Expenses are Tax Deductible
The itemized income and expenses for a commercial property are recorded on an accounting report known as the “Income Statement.” While the specifics can vary from one property to another, the general format is that all rental payments are booked as rental income and all of the costs associated with operating the property, including property taxes and the loan’s debt service, are booked as expenses. When expenses are subtracted from income, the remaining amount is taxable. As such, property owners have an incentive, and the ability, to manage their expenses to minimize the amount of income that is taxable.
#4 – Using Commercial Mortgage Interest as a Tax Deduction
Commercial real estate investors and homeowners share a similar advantage in that they can both deduct the interest expense on the property’s mortgage. In some cases, this deduction may be larger than actual profits earned by the property, which helps to offset the tax bill. If the interest rate on the mortgage is particularly high, this is a benefit that can pay off every year.
#5 – Federal Tax Credits for Real Estate Investors
One of the major tools that governments and regulators use to incentivize investment in affordable housing and overlooked parts of town is something called a “tax credit,” which is an amount of money that can be subtracted from an investor’s income taxes, thereby reducing their overall tax liability. The specifics of the tax credit deductibility can vary based on the program that administers them, but one example that exemplifies this benefit is the Low-Income Housing Tax Credit.
The Low-Income Housing Tax Credit program (LIHTC) subsidizes the acquisition, construction, and rehabilitation of affordable housing for low- and moderate-income tenants. Each year, the federal government issues tax credits to state governments, who in turn award them to private developers through a competitive process. For those who receive them, they can be used to offset taxable income for a period of up to 10-years.
#6 – Defer Tax on Capital Gains with a 1031 Exchange
An investor’s enthusiasm over the profitable sale of an investment property can be quickly diminished by the realization that
a big tax bill is likely to follow. Fortunately, a provision in the US tax law , Section 1031, allows for the deferral of taxes when an investor “exchanges” sale proceeds into another property of equal or greater value that is considered to be “like kind” to the property sold. Further, there is no limit to the number of 1031 or “like kind exchanges” that an investor can complete. So, in theory, an investor could complete a series of successive 1031 Exchanges that would allow their profits to grow tax deferred over a long period of time.
#7 – Tax Benefits for Capital Gains in Opportunity Zones
The Tax Cuts and Jobs Act of 2017 created the “Opportunity Zone” Program, which is an economic development tool whose purpose is to spur economic growth and job creation in low income communities while providing tax benefits to investors.
The way the program works is fairly simple, investors can place their money in a Qualified Opportunity Fund, who then deploys capital into “Opportunity Zones” for various development projects. If the investment is held for more than 5 years, an investor’s Capital Gains taxes are reduced by 10%. If it is held for more than 7 years, they are reduced by 15%, and if it is held for more than 10 years capital gains taxes are eliminated completely through a step up in cost basis equal to 100% of the investment’s market value at the time it is sold or exchanged.
#8 – Commercial Real Estate Losses Qualify as Tax Deductions
On occasion, a commercial real estate investment does not work out as planned. In such cases, it is possible that investors could experience a loss on some or all of their investment principal. If this happens, the amount of the loss can be used to offset taxable income, thereby reducing the investor’s income tax liability. If the amount of the loss is large, or if it exceeds the entirety of an investors taxable income, it can potentially be taken over multiple years. So, while a loss is never the desired outcome, it can provide ancillary income tax benefits that help to mitigate the impact.
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 firstname.lastname@example.org for more information.