Owning commercial real estate may seem intimidating at first but it doesn’t have to be. With a little guidance and research, the tax benefits of investing in commercial real estate become relatively easy to understand and apply. In this article we will touch on five of the most common and beneficial tax benefits investing in commercial real estate can provide to the everyday investor.
Likely one of the most commonly known tax benefits in commercial real estate is depreciation. Like all structures, commercial real estate suffers wear and tear over time. The tax code allows a certain amount to be depreciated, or claimed as an expense, during the tax year.
For commercial properties the depreciation period is 39 years, and for rental properties 27.5 years. Let’s look at how powerful depreciation can be in assisting your tax return benefits. If an investor were to purchase a commercial property for $1,000,000, he or she can then claim a depreciation expense of $25,641 per year. This is deducted from the investor’s ordinary income for the tax year. It is also important to note that the depreciation expense is a non-cash expense. Essentially, depreciation allows an investor to reduce their tax bill without negatively impacting cash flow.
Taking this example further, if the income from the property is $20,000 for the year, net income for the tax year would be -$5,641.
Property Income $20,000
Depreciation Expense ($25,641)
Net Income ($5,641)
In this case the investor would have $20,000 in tax free income, and can offset the net loss against profits he or she may have from other properties.
2. Mortgage Interest Deduction
The mortgage interest deduction is another powerful tax benefit investors can use to minimize their tax burden. Investors can deduct the amount of interest paid on their mortgage during the tax year. This can be particularly powerful when dealing with high interest mortgages, or during the early years of a mortgage when a substantial amount of mortgage payments goes towards interest.
3. Lower Tax Burden for Beneficiaries
If an investor’s plan is to buy and hold a piece of commercial real estate for the benefit of his or her children, the tax code provides a powerful tool to lower the tax burden on beneficiaries when they decide to sell the property. When the child completes the sale of an inherited piece of commercial property, they are only taxed on gain in value from the date of inheritance. Let’s look at an example:
- An investor buys a piece of commercial property for $5,000,000, and it is fully depreciated when the investor dies.
- The value of the property has appreciated substantially, and is now worth $10,000,000.
- A year later, the beneficiary decides to sell the property for $11,000,000.
- Instead of being taxed on the gain calculated from the investor’s purchase price, the beneficiary is only taxed on the gain in value since he or she inherited the property.
In this case, that would be a taxable gain of $1,000,000. Although less known, these tax benefits can be powerful.
4. Section 1031 Exchanges
Although depreciation and increasing property values are both desirable outcomes for commercial real estate investors, successful investors could face a large tax bill when it is time to sell. For example, suppose an investor buys a property for $5,000,000 and has taken depreciation deductions of two million dollars when she decides to sell. At this time, the property has also appreciated in value to $10,000,000. This is undoubtedly a good thing for the investor, but the taxable gain she faces, which is calculated by subtracting the cost basis from the selling price, is substantial.
Section 1031 of the tax code allows an investor to defer taxes on the gains of a property sale as long as the sale proceeds are “exchanged” for a property that is considered “like kind.” We are not going to go into “like kind” exchanges in this article, so it is best to consult a tax professional to see if the property the investor is considering qualifies under section 1031. There is also no limit to the number of Section 1031 exchanges an investor can engage in. In theory, a savvy investor can grow his or her portfolio with tax deferred gains indefinitely.
5. Tax Benefits at Retirement
Commercial real estate is also an excellent addition to one’s retirement portfolio. Distributions from a traditional IRA are taxed at ordinary income rates, while income from the sale of commercial real estate is taxed at capital gains rates, which are significantly lower and can substantially add to one’s retirement income.
In this article, we have discussed the most common tax benefits of owning commercial real estate, and hopefully have made clear that investing in commercial real estate is a wise decision for both the present and the future. If you are in the process of acquiring commercial real estate, we highly recommend you begin with tax planning.
Katz Khayut & Stroll LLP offer tax planning services that take into consideration both your business and personal finance goals. If you are ready to work with an accountant who can provide the full range of services you need, send us a message at Info@kksllp.com.