- Under current income tax laws, there are two major real estate tax benefits offered to commercial real estate investors who deploy their capital into commercial real estate assets: Depreciation and 1031 Exchanges.
- The combination of annual depreciation and rising market values can result in a hefty long term capital gains tax bill upon the profitable sale of a property.
Much is known about the most commonly cited benefits of purchasing commercial real estate (“CRE”) investment property – price appreciation, passive income / cash flow, portfolio diversification – but, there is another major benefit that can be a little bit more difficult to understand because it is intangible and can be complicated, taxes.
Under current income tax laws, there are two major real estate tax benefits offered to commercial real estate investors who deploy their capital into commercial real estate assets: Depreciation and 1031 Exchanges.
Real estate is a physical asset whose condition degrades over time. To account for this, tax rules allow a commercial property owner to “depreciate” the value of the asset a little bit each year and list the amount as an expense on the property’s income statement (similar to interest expense or property taxes). As a result, the property’s taxable income is reduced, which can result in significant tax savings over time. But, and this is key, depreciation is a non-cash expense so it does not affect the amount of cash available to be distributed to property owners and investors.
To illustrate the power of depreciation, consider a simple example. The table below shows a summary income statement with and without a depreciation line item on the income statement:
From the example, it can be seen that the property’s Net Operating Income with no depreciation taken is $600k, while it is reduced to $500k with the inclusion of the depreciation expense line item. Assuming a 35% tax rate, the $100k in depreciation expense results in $35k of tax savings in one year alone. Over the course of a multi-year investment holding period, the savings can be significant.
Given the obvious benefits of depreciation, it follows that a property owner has a strong incentive to maximize the amount of deductible depreciation that they can take in a given year. The IRS tax code allows for a property to be depreciated over 27.5 (apartments) or 39 years (other commercial assets). So, for example, if a property has a value of $10M, the owner could expense $256k per year ($10M / 39) in depreciation expense. But, the most experienced investors know that there is an advanced depreciation strategy called “Cost Segregation” that allows depreciation deductions to be accelerated, thereby maximizing the tax advantages from it.
In a Cost Segregation study, an owner hires an outside expert to review all components of the property and “segregate” them into buckets, for which depreciation can be accelerated. For example, furniture, fixtures, carpeting, and window treatments can be classified as “Personal Property” and depreciated over 5 or 7 years. Or, sidewalks, paving, and landscaping can be classified as “Land Improvements” and depreciated over 15 years. In either case, the shorter time horizon allows the depreciation deductions to be maximized and allows the property’s overall tax liability to be reduced further.
It should be noted however, that accelerated depreciation can be a double-edged sword. The increased tax deductions are great, but each one lower’s the property’s overall “cost basis.” As such, it may increase the chance that the owner will have to pay taxes on the “depreciation recapture” upon sale. In short, the total amount depreciated could be subject to income tax, in addition to capital gains tax, upon sale. The actual amount is dependent upon the property owner’s tax bracket and the prevailing income tax rate at the time of sale.
The combination of annual depreciation and rising market values can result in a hefty long term capital gains tax bill upon the profitable sale of a property. For example, assume that a property was purchased for $5M and held for 10 years. Also assume that the property’s “cost basis” was depreciated from $5M to $3M over the same 10 years while market forces have pushed the property’s value to $7M. The difference between the cost basis, $3M, and the sales price, $7M, is considered to be a “gain” and it is taxable. Again, the amount of the bill is dependent upon the size of the gain and the prevailing capital gains tax rate at the time of sale. So, a property owner’s enthusiasm about a profitable sale can be quickly dampened upon the realization that a big tax bill is likely to follow. Fortunately, there is a strategy that can defer the bill to a later time.
Section 1031 of the Internal Revenue Service Tax Code allows an investor to defer taxes on the profitable sale of a property as long as they “exchange” the sale proceeds into another property that is considered to be “like kind.” There is no limit to the number of 1031 Exchanges that can be completed so, in theory, an investor could complete a series of successive exchanges over time, allowing their profits to grow tax deferred indefinitely.
In order to receive the tax breaks associated with a 1031 Exchange, there are a few rules that must be followed:
- Like Kind Test: The Replacement Property must be “of the same nature or character” as the Relinquished Property. In addition, it must be located in the United States and held for “productive use in a trade or business or for investment.”
- Time: From the sale date of the Relinquished Property, the Replacement Property must be identified within 45 calendar days and the purchase of it must be completed within 180 calendar days.
- Value: The market value and equity of the replacement property must be the same as, or greater than, the value of the relinquished property. For example, a property with a value of $5M and a mortgage of $3M must be exchanged into a property that is worth at least $5M with $3M worth of debt.
- No “Boot”: The term “boot” refers to any non-like kind property received in a 1031 Exchange. It could take the form of cash, installment notes, debt relief, or personal property and it is valued at “fair market value.” If boot is received, it doesn’t disqualify the exchange, but it could make it taxable.
- Held For Sale: The replacement property cannot be “held for sale.” In other words, it can’t be purchased for the tax deferral benefits, held for a short term, and then immediately sold. 1031 Exchange rules do not define a specific period of time that the replacement property must be held for, but it is generally agreed that a minimum of 12-24 months is a best practice.
- Same Taxpayer: The taxpayer associated with the relinquished property must be the same as the one associated with the replacement property. In addition, both properties need to be similarly titled.
- Property Type: A 1031 Exchange can be completed for any of the common commercial real estate property types including: apartment buildings/multifamily, retail, industrial, or office.
Depending on the specific needs of the investor, there are four different types of 1031 Exchanges that can be utilized: the like-kind exchange, delayed exchange, reverse exchange, and construction or “improvement” exchange. Further, on occasion, the replacement property could be located in a tax advantaged district, known as an opportunity zone, that can add another layer of tax benefits to the transaction.
For investors and business owners who are smart about their use of 1031 Exchanges, they can grow their portfolio over time to include bigger and bigger properties based upon their realized tax savings. But, these transactions can be complicated, so it is always a good idea to work with a CPA, financial advisors, and/or qualified intermediary to ensure it is completed 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.
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.
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