- Rental income, price appreciation, and portfolio diversification are among the most widely recognized benefits of commercial real estate investment.
- But, there are also a number of tax benefits that can be realized. Broadly, they can be grouped into the treatment of rental income and capital gains.
- Commercial real estate investments are structured in a tax efficient manner that allows income and capital gains to flow through the ownership LLC and directly to individual investors.
- Income is reduced by maximizing tax deductible expenses, like depreciation, which in turn minimizes individual investor tax liability.
- Capital gains taxes are dependent upon the length of time an investment is held. Short term gains are taxed as ordinary income and long term gains are taxed based on the investor’s individual tax bracket.
- Capital gains can be deferred by using a 1031 Exchange, which mandates that an investor use property sales proceeds to purchase another property of “like kind.”
- Finally, Opportunity Zones are specialized economic areas that have been designated as needed investment. Individuals can invest in a “Qualified Opportunity Fund” where taxes on profits are reduced or even eliminated if the investment is held for more than 10 years.
The major benefits of a commercial real estate investment—such as rental income, price appreciation, and portfolio diversification—are widely known to be primary drivers of investment activity. But, these aren’t the only benefits that should be considered. Even if the income and appreciation for a property are relatively limited, there are a number of significant tax benefits and tax deductions that can be realized. In order to fully understand them, it is first necessary to understand how a typical commercial real estate investment—like the ones we offer—is structured.
Commercial Real Estate Investment Structure
The first tax benefit of a commercial real estate (“CRE”) investment offered by a private equity firm like ours is that these options are structured in a tax-efficient manner.
When a commercial real estate transaction sponsor identifies a promising investment opportunity, this sponsor will form a Limited Liability Company, which is used as the vehicle to purchase the asset. To finance the transaction, the sponsor will work with a lender to obtain senior debt, which typically accounts for 60% to 75% of the purchase price. To obtain the remaining funds, the sponsor will sell shares in the Limited Liability Company to commercial real estate investors, which will likely include the transaction sponsor(s) themselves. In return for their share purchase, equity investors are entitled to a percentage of the income and profits produced by the underlying property.
For IRS purposes, the Limited Liability Company is categorized as a “pass-through entity” which means that property income and profits flow through the LLC and are taxed at the individual investor level. To illustrate this point, consider an example. Assume that an LLC was formed to purchase a property with two investors who each own 50% of the outstanding shares. In the first year of operations, the underlying property produced $100,000 in cash available to be distributed to investors. This money is not taxed at the LLC level. Instead it flows through the LLC and to the individual real estate investors ($50,000 each), where they claim the income on their own personal tax returns. The actual tax rate applied to the income depends on each individual’s own tax bracket.
To notify each investor of their distributions, the LLC issues a document called a “Schedule K-1” to each investor at the end of the year. Among other things, this document contains information about what happened with each investor’s capital account during the course of the year. It starts with the beginning balance and nets the capital contributed during the year, LLC net income/loss, other increases, and any withdrawals or distributions. This is the key document that determines the individual’s tax liability. If someone has several real estate investments, he or she will get a K-1 for each of them.
At the individual level, each investor benefits from a number of tax advantages.
Commercial Real Estate Tax Advantages
For the purposes of this article, the tax advantages associated with a commercial property investment are grouped into two buckets: tax treatment of income, and tax treatment of capital gains (including Opportunity Zones).
Treatment of Income
At its core, the premise behind real estate investing is a simple one: an investor purchases a property that produces “X” amount of income from tenant leases and costs “Y” amount of dollars to operate. If the income is more than the expenses (including debt service), the property produces positive cash flow, which flows through the LLC to investors and is ultimately taxed at the individual levels.
Given this framework, commercial property owners are incentivized to maximize the amount of deductible expenses they take, which in turn minimizes the income that flows to investors and their own individual tax liability. One of the ways this is done is through an accounting concept known as “depreciation.” Because commercial properties are physical structures that deteriorate over time, the Internal Revenue Service (IRS) tax code allows the property owner to expense a portion of the property’s value each tax year to account for this fact. We use an advanced strategy known as “Cost Segregation” to maximize the amount of allowable depreciation annually, which serves to further minimize the property’s tax liability each year. Depreciation isn’t the only allowable expense deduction for commercial rental properties, though; other options include property tax, management fees, utilities, insurance, mortgage interest, and marketing costs. Bottom line: whatever money is left after all expenses are paid (including debt service) is what is available to be distributed to be investors, and it is in the sponsor’s best interest to do everything necessary to manage this tax liability, while maximizing the amount of cash to be distributed.
Treatment of Capital Gains
Income isn’t the only source of return for a commercial real estate property. If the supply and demand characteristics of the local market are favorable, the property will increase in value. For example, if a property is purchased for $1 million and sold for $1.25 million, the investor will book a $250,000 “gain” on the property. This gain is subject to “capital gains tax,” and is included on the aforementioned K-1 statement to LLC investors once the transaction is finalized. Short-term capital gains are taxed as ordinary income, and long-term capital gains tax rates (for assets held for more than one year) can be 0%, 15%, or 20%, depending on an individual’s filing status, tax bracket, and taxable income. As a result, if the gain is large, the associated tax bill can be large, as well.
However, one of the other major tax benefits of a commercial real estate investment is that IRS rules allow an individual investor/taxpayer to use a tax deferral strategy known as a 1031 Exchange. Employing this strategy, the taxpayer can defer the entirety of his or her capital gains tax bill by reinvesting the sales proceeds into another property of “like kind.” These “like-kind exchanges” allow an investor’s money to grow tax-deferred over time, and can be repeated indefinitely for maximum tax deferral. The rules for a 1031 Exchange can be complicated, but it is imperative to follow them strictly, lest the gain becomes taxable. To help, some seek a “Qualified Intermediary” to facilitate the transaction on the investor’s behalf.
One lesser known—and somewhat temporary—tax benefit of commercial investment property ownership comes from deploying capital into designated “Opportunity Zones.”
The IRS defines an Opportunity Zone as “an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.”
The idea behind identifying Opportunity Zones and giving them preferential tax treatment is simple: to define the areas of greatest need, and then create an incentive for private investment to flow into them. In doing so, the resulting projects create jobs and income that can be further reinvested in a harmonious cycle meant to lift the community out of distress.
To realize the tax benefits from an Opportunity Zone investment, investors must place their money in a “Qualified Opportunity Fund.” Once this is underway, these investors may realize reduced, deferred, or eliminated capital gains taxes on their investment, depending on how long it is held. If it is held for more than five years, there is a 10% tax reduction. If it is held for more than seven years, there is a 15% reduction. 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.
Opportunity funds are specialized investment opportunities and should only be considered in conjunction with the advice of a qualified CPA and/or legal professional.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, 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 are an Accredited Investor and would like to take advantage of the tax benefits offered by a commercial real estate investment, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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