Stance Commerical Real Estate
The major benefits of Commercial Real Estate (CRE) – such as rental income, price appreciation, and portfolio diversification – is an attractive opportunity for many investors. Investing in commercial real estate can provide stable, long-term passive income streams, in addition to windfall profits when properties are sold. Over the course of the life of an investment, these tangible benefits can lead to a substantial difference in returns.
But, these are not 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. Understanding these tax benefits associated with CRE is more complex than it may seem on the surface, but if you are considering an investment, you need to understand the tax implications.
To help you get a firm grasp on the tax benefits involved in commercial real estate investment, the Stance team has put together a list of the different considerations to keep in mind when deciding on which commercial property deal structure is best for your financial goals.
The Two Ways Investors Earn Returns Determine Taxation
The first criteria for determining what taxes will be required on a commercial real estate investment are how the gains were earned.
The two ways investment properties earn money are cash flows and capital gains. Let’s cover the differences between the two and how each might impact you at tax time.
Treatment of Cash Flow
At its core, the premise behind real estate investing is a simple one: an investor purchases a property that produces income from tenant leases and costs a certain amount 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.
The cash flow a property generates is taxed as ordinary income, so the effective tax rate will be determined by the investor’s income tax bracket. Cash flow is the total rents less allowable expenses, which is the net income. As with any other income, these taxes are due at both the federal and state levels.
Treatment of Capital Gains
Income is not 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. Capital gains are simply the difference between what you paid and sold a property for. In many cases, capital gains are taxed differently than income, but not always.
For example, if you buy a commercial property for $2.5M and sell it two years later for $2.8M, you’ll have a capital gain of $300,000, taxed at a rate of 15% if filing single or married jointly. Comparatively, if this amount was cash flow income, you would pay 35% in taxes if filing as single.
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. We will discuss this later. 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.
Tax Benefits of Investing in Commercial Real Estate
Investors earn a return on their commercial real estate investment in two ways: the cash flow the property generates and in capital gains from appreciation. The way the profits on a commercial real estate investment are taxed depends on whether that profit is cash flow or capital gains. At Stance, our expert team can go over these tax benefits with you to educate your team on how to get the most bang for your buck!
Depreciation and Write Offs
Possibly the best tax benefit of commercial real estate is depreciation since it is a non-cash expense, providing a substantial write-off without actually having to spend any money for it. 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 property 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). The depreciation expense is written off against ordinary income, so any taxes that are paid on cash flow generated by the property is reduced every year the deduction is applicable.
As a property owner, one of your first and best benefits is your ability to write off the interest payments you make on your mortgage. So, not only are you using someone else’s money to buy commercial property, but you can also write off their profit for providing you with that capital.
Other write-offs include:
- Property management fees
- Property insurance
- Mortgage interest
- Property taxes
- Legal and other professional fees
- Property repairs, capital improvements, and/or ongoing maintenance
- Marketing expenses
Interest Expense Deductions
If there is a commercial real estate loan on the commercial property, an investor is allowed to write off the interest each year against their income, potentially providing a substantial write-off. This holds true especially during the early days of the loan when the mortgage payments are almost entirely interest rather than principal.
Section 1031 Exchange Tax Deferment
A 1031 Exchange gathers its name from section 1031 of the IRS code, which says:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
With a 1031 exchange, investors can use the capital gain to invest in another property, often one that produces income or the potential for greater capital gains at a later date. This can make a big difference in the total capital you have to invest in your next commercial property. To put it simply, this section allows you to avoid paying capital gains taxes when you sell a property and then reinvest the proceeds into a property of equal or greater value – if you locate and purchase the new property within a specific time frame.
Several reasons make 1031 exchanges attractive to investors. Here are just a few of them:
- Improved Cash Flow
- Property and Asset Management
- Estate Planning
- Asset Consolidation and Division
- Buying a Vacation Home
Reduced Tax Burden for Beneficiaries
Keep in mind—a 1031 exchange is really just a tax deferment, not a total tax write-off. When you do finally sell to cash out, the tax will be calculated on the cost basis of the original commercial property. If, however, the property is passed to beneficiaries, they may get some tax help with what is called a “step-up” cost basis.
A step-up in basis is applied to the cost basis of the asset transferred at death; the higher market value of the asset at the time of inheritance is considered for tax purposes. Instead of the original cost of an inherited asset as its basis, the stepped up basis loophole readjusts it to the value at their death
One lesser known—and somewhat temporary—tax benefit of commercial investment property ownership comes from deploying capital into designated “Opportunity Zones.” Each state has nominated certain localities within its domain, qualifying those zones as Opportunity Zones if that nomination has been certified by the Secretary of the U.S. Treasury. Opportunity Zones were intended to be an economic development tool.
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.
How Stance Real Estate Can Help You
Some of the greatest benefits of investing in real estate are the available tax breaks. Still, the barrier for many is being unaware of these opportunities and how to take advantage of them. Understanding which investment property tax benefits are at your disposal is one of the best ways that real estate investors can achieve long-term wealth. Take advantage of these tax breaks and ensure you stay on the path to financial freedom while protecting yourself from avoidable fees. Hiring the right team from the beginning will help you navigate the leasing process with ease as well as save you time and money. At Stance Real Estate, we live and breathe Riverside culture. We are not only working in the community, we live here… we love it and we want to help you succeed in it!
Call us today at (909) 772-1212 to see how our commercial property management strategies can help you!