There is no avoiding taxes, but investors can at least reduce or defer the amount they pay through their commercial real estate investments. Potential tax benefits add to the advantages of commercial real estate (CRE) investing. In order to take advantage of these potential benefits, however, you need to know what they are and how they work.
Investors earn returns on their CRE investments in two ways: cash flow generated by the property and capital gains from appreciation. The way their profits are taxed depends on whether the profit is cash flow or capital gains.
Cash flow an investment property generates is the income an investor receives after covering expenses. It may also be referred to as net cash flow. This kind of income is taxed like ordinary income, with the tax rate based on the investor’s tax bracket. Cash flow is also paid at both the federal and state level like any other business income.
Capital gains are most simply explained as the difference between what an investor paid for something, such as a property, versus what the investor sells it for. A simplified example of capital gains would be if you bought a property for $2 million dollars and sold it for $3 million, giving you a capital gain of $1 million. In reality, however, calculating capital gains is much more complicated because of factors such as depreciation.
Capital gains are assessed separately from income, typically at a different rate than income taxes. In a traditional investment, this might include stocks, bonds, and mutual funds, but may also include real estate. Generally, capital gains are triggered by the sale of an investment.
The capital gains tax rate is lower than the income tax rate for most taxpayers, though you should always consult with an experienced tax professional.
An advantage of investing in commercial real estate are the potential tax benefits that come with an investment. Investors can potentially take advantage of these benefits to reduce or defer the amount required to pay in income and capital gains tax. From depreciation to mortgage interest deductions and tax advantages for an investor’s beneficiaries, these benefits may increase returns. To make use of these advantages, however, you need to know what they are and how they work.
Depreciation may be one of the most well-known tax benefits in commercial real estate. It is a non-cash expense, meaning you get a write-off each year but do not have to spend any money to get it. The IRS determines the useful life– the expected operating life– of a commercial real estate investment based on factors such as the condition of the property and changes that affect the asset’s economic usefulness, though there are other items and calculations that affect the calculation of depreciation.
With depreciation, the value of a property is depreciated over the amount of time determined by the IRS. For example, if the IRS determines an investment has a useful life of 39 years, you would be able to write off 1/39 of the property’s value as a depreciation deduction. There are limits to depreciation, however. Using the previous example, once the 39 years are up, you cannot continue to depreciate the property.
Depreciation is written off against ordinary income, so the amount of taxes paid on cash flow generated from the property is potentially reduced each year.
When it comes time to sell the property, however, you will likely have to deal with depreciation recapture. This means you will have to pay taxes on the amount you depreciated while you owned the property. Fortunately, the tax rate for depreciation recapture is usually less than the income tax rate. The amount you save in taxes each year with the depreciation tax deduction will likely outweigh the tax bill for depreciation recapture.
Depreciation and interest expense deductions may help lower the income tax burden, but they cannot be written off against capital gains. However, investors may defer their capital gains when they sell their commercial property and reinvest the proceeds into another like-kind property with a debt-to-equity ratio equal to or greater than the property being sold. This is done through a 1031 exchange.
There is no limit to the number of 1031 exchanges that can be made, so in theory, an investor could complete a series of exchanges over time. In order to receive these tax deferrals through the 1031 exchange, there are guidelines that need to be followed, including that the new property must be of like kind and have a similar or greater debt-to-equity ratio compared to that of the sold property.
Depending on an investor’s specific needs, there are four types of 1031 exchanges available: like-kind, delayed, reverse, and a construction or “improvement” exchange.
The 1031 exchange only allows investors to defer their capital gains tax, not completely avoid it. As an investor, when you finally sell your property, your tax will be based on the cost basis of the original property. If you plan to pass your commercial real estate down to any heirs in your will, however, they can take advantage of a certain tax benefit.
Any heirs who inherit your commercial property will get a “step-up” in cost basis. When they choose to sell the property, they will only pay the capital gains tax based on the property’s value when they inherited from you.
When you use a loan to purchase a commercial property, you may write off the amount of mortgage interest paid on the loan each year against your income. It may be a substantial write-off, especially in the first few years of the loan, when the interest payments outweigh principal payments, but it is not guaranteed.
Investors are able to deduct property repairs, maintenance costs, certain property management expenses, and many other operating expenses from their income taxes. This may even include the cost of traveling to and from the rental property, hotels, and some of the cost of food and beverages.
General property improvements, such as renovations or new furnishings, generally cannot be taken as deductions in the year they were done. Instead, they are depreciated over the useful life of the property.
Investors are able to deduct property repairs, maintenance costs, certain property management expenses, and many other operating expenses from their income taxes. This may even include the cost of traveling to and from the rental property, hotels, and some of the cost of food and beverages.
General property improvements, such as renovations or new furnishings, generally cannot be taken as deductions in the year they were done. Instead, they are depreciated over the useful life of the property.
If you incur losses on a commercial real estate investment, you may be able to take them as a tax deduction. This varies based on several factors.
There are three different taxpayer classifications when it comes to rental losses from commercial real estate investments.
The Opportunity Zones program was created as a result of the Tax Cuts and Jobs Act of 2017. It was designed to stimulate investment in some of the lowest-income communities throughout the US. This act permits investors to defer eligible capital gains until December 31, 2026, if they choose to invest in an Opportunity Zone Fund.
An Opportunity Zone Fund places at least 90% of its assets in commercial real estate or qualified businesses within designated Qualified Opportunity Zones. Investors can take advantage of a 10% reduction in capital gains tax basis if they hold their investment a minimum of 5 years prior to December 31, 2026. Investors may get a further 5% reduction in capital gains tax basis if they hold the investment a minimum of 7 years. If the investment is held for at least 10 years in an Opportunity Zone Fund, you do not have to pay capital gains tax at its sale.
The federal government offers federal tax credits based on certain programs, including the Low-Income Housing Tax Credit, the Historic Tax Credit, and the New Markets Tax Credit.
This tax benefit is for any active or passive investors, such as those who invest through private equity firms. Passive income is defined as any money earned from rental-related business activities in which an investor does not actively participate. This would include investing through private equity firms or crowdfunding. In the case of active investors, they are able to qualify for this deduction so long as they declare all their income, including from their investments, on their personal tax return rather than a corporate tax return.
Historically, this income was not eligible for pass-through tax benefits. With the Tax Cuts and Jobs Act of 2017, however, there is a new pass-through tax deduction for certain investors called the Qualified Business Income (QBI) deduction. It was established in 2018 and is scheduled to expire in 2025.
With this deduction, qualified individuals may deduct up to 20% of their net rental income received from pass-through entities. This includes, but is not limited to:
A “pass through” business is generally defined as one that doesn’t pay any taxes itself, but passes its income, and therefore its tax liability, to its owners. Note that C-Corporations do not qualify for the IRS pass-through deduction.
It is important to keep in mind that the pass-through deduction isn’t an itemized deduction, but it’s not an above-the-line deduction either. You do not need to itemize your deductions to take advantage of the QBI deduction, but it does not reduce your adjusted gross income (AGI) the way other above-the-line deductions, such as student loan interest, might.
You should also keep in mind that not all investment income is eligible. Whether it qualifies for this deduction or not depends on many factors, including how the dividends are paid out. The tax documents you receive from the investment should tell you how the money you received will be treated by the IRS. A tax professional can also help you understand whether you qualify for this deduction or not.
Some of the most well-known benefits are deductions for operating and owner expenses, depreciation, capital gains tax deferral and the 1031 exchange.
This largely depends on the individual property itself. Some solo investors can deduct up to $25,000 a year in losses, depending on their own income and other factors. The best option is to speak with an experienced tax professional and review your property’s expenses and other information to learn how much can be deducted.
If you’re investing in commercial properties, you can benefit from learning about the capital gains tax.Simply put, the tax is a levy on the profit an investor makes when an investment is sold.This means if a property is sold for a higher price than what the investor bought it for, the government will tax the income made in the sale.
Avistone is a fully integrated real estate investment firm engaged in the acquisition, development, management and disposition of high-quality commercial and hospitality properties in select markets nationwide. Founded in 2013, Avistone has acquired 24 commercial projects with more than 3.9 million square feet of space. The firm’s current offerings include a multi-tenant industrial fund and a strategic fund focused on opportunities in the hotel sector.
Our investment strategy includes the following elements:
The executive management team of Avistone has been assembled over the last 8 years and contributes extensive experience in real estate-related assets across all real estate asset classes. The firm has the unique ability to integrate extensive capital market knowledge with “boots-on-the-ground” real estate and hotel expertise to deliver investors cash distributions, inflation protection and the potential for attractive risk adjusted returns.If you want to begin investing in commercial real estate properties, contact us today.
*Important Disclosures:
This communication is intended solely for accredited investors as such is defined in the Securities Act, and is not intended as an offer to sell, or the solicitation of an offer to buy any securities or ownership interests. The opinions and forecasts expressed herein are solely those of Avistone, LLC, as of February 24, 2023, and subject to change. Actual results, future events, predictions, circumstances and events will vary and be different from those set forth herein, and there are no guarantees that any positive or successful results, express or implied, by investors will be realized. Avistone specifically disclaims any right or obligation to provide investor returns at forecasted levels. Avistone’s track record from 2013 to December 2022; no guarantee of future results. The performance information of Avistone’s prior projects has not been audited by any third-party. The track record metrics reflect the weighted average performance of all our clients, and not every investor experienced exactly these same returns. Any and all evaluations for investment purposes must be considered in conjunction with a final Private Placement Memorandum (the “PPM”); all prospective investors are strongly encouraged to read all “risk factors” in the PPM. Further, some of the initial information provided above contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve numerous risks and uncertainties, and investors should not rely on them as predictions of future events. Investments in private securities contain a high degree of risk and often have long hold periods. They are illiquid and may result in the loss of principle. Avistone’s strategy may not occur due to numerous external influences.