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Investing in commercial real estate can provide stable, long-term passive income streams, in addition to windfall profits when properties are sold. But while the benefits of investing in commercial real estate are many, the tax implications can prove complicated and costly if they aren’t carefully considered.
To help you get a firm grasp on the tax rules and loopholes involved in commercial real estate investment, we’ve put together this article about the different considerations to keep in mind when deciding on which commercial property deal structure is best for your financial goals.
The first criteria for determining what taxes will be required on a commercial real estate investment is 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.
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. The federal tax rates on income in 2021 range from 10% to 37%, the highest level of taxes when it comes to commercial real estate investing.
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 $1.5M and sell it two years later for $1.8M, 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’d pay 35% in taxes if filing as single. It’s easy to see how the timing of the sale of only a few months can make a massive difference in taxes when it comes to capital gains.
As long as you sell after the one-year mark from the purchase date, the capital gains are considered long-term, which taxes them at a far lower rate than cash flow income is taxed, sometimes as low as 0%, but not exceeding 20%.
That said, if the capital gains are earned on a property that’s sold within a year of purchase, the proceeds will be taxed as income instead, subjecting it to as much as 37% rates of taxation.
Now that we’ve covered how commercial real estate investment earnings are taxed let’s go over the numerous tax benefits of real estate that could help reduce your tax burden.
Maybe the best tax benefit of commercial real estate is depreciation because it's a non-cash expense, providing a substantial write-off without actually having to spend any money for it.
The value of a piece of commercial real estate is depreciated over 39 years. So each year, the commercial property owner is allowed to write off 1/39th of the property value as a depreciation deduction. The downside, of course, is after 39 years, this deduction is no longer available.
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.
While depreciation is mostly a major benefit, when you sell the property, you may have to pay depreciation recapture taxes on the amount you depreciated during your ownership. That said, this rate is typically lower than the income tax rate, likely far outweighing any recapture taxes.
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.
Of course, the most significant downside to interest and depreciation deductions is that they’re only able to be taken against income taxes—not capital gains taxes. Thankfully, the Section 1031 exchange might still help reduce your capital gains tax burden.
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.
Commercial real estate investors are able to use the Section 1031 exchange to purchase larger and larger properties without having to pay capital gains tax along the way, making it far easier to grow a high-quality portfolio.
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’s called a “step-up” cost basis.
With the step-up cost basis, capital gains are calculated starting at the time of inheritance of the property rather than the original purchase.
Depending on how long you hold the property or when you started with the first 1031, this could mean massive tax savings for your heirs.
Commercial real estate investing can provide numerous ways to minimize taxes when you’re also aiming to diversify your investment portfolio. But hands-on real estate investing isn’t for everyone. Thankfully, getting help from a team of commercial real estate experts is easy with Saint Investment Group.
We carefully analyze every deal and provide you with detailed reporting about your commercial real estate investment performance. Saint Investment Group is here to help you start investing. Call (323) 483-0291 today to learn more.
Commercial real estate investments can provide a variety of tax advantages, including the opportunity to deduct property depreciation, offset rental income with expenditures such as mortgage interest, property taxes, and maintenance costs, and even delay taxes through a 1031 exchange.
In addition, commercial real estate investment can provide passive income, which may be subject to a lower tax rate than regular income.
Yes, commercial real estate investments are eligible for depreciation deductions. Depreciation allows property owners to take a tax deduction for the wear and tear on the property over time, which can offset rental income and reduce tax liability. The amount of the depreciation deduction is calculated using the cost of the property, its expected useful life, and the method of depreciation chosen.
Owning commercial real estate can have a significant impact on an individual's taxable income. Rental income from the property is generally taxed as ordinary income, while any depreciation taken on the property can also be used to offset taxable income. Additionally, the sale of a commercial real estate investment may result in capital gains or losses, which can also impact an individual's taxable income.
A master in Investment, Marketing, and Capital Raising.
Nic has honed his focus on the Real Estate and debt markets with Saint Investment Group and pursues large-scale Distressed Asset purchases with his partners and syndications.
