The Tax Benefits of Commercial Real Estate Ownership Explained
Unlike stocks, bonds, and other financial products, commercial real estate is known for the variety of tax benefits it can offer investors. From accelerated depreciation to mortgage interest deductions and tax advantages for an investor’s heirs, these benefits can lead to a massive difference in returns, especially over an extended period of time. However, to make use of commercial real estate’s tax advantages, you need to know what they are and how they work.
In this article, we’ll review a few of the most common ways that real estate investing can reduce an investor’s tax bill, including:
Depreciation Deductions for Income Taxes
Interest Expense Tax Deductions
Non-Mortgage Tax Deductions
Utilizing Real Estate Taxes Losses to Your Advantage
Reduced Tax Burdens for Beneficiaries
Tax Benefits of Commercial Real Estate vs. IRAs for Retirement
Qualified Business Income (QBI) Deductions
1031 Exchanges for Capital Gains Tax Deferral
The LIHTC, HTC, and NMTC Programs
1. Depreciation Deductions for Income Taxes
Just like any other physical asset, a piece of commercial real estate wears down over time. Due to this, investors can deduct a certain amount off of their income taxes each year in order to account for this. Right now, the IRS permits owners to depreciate commercial buildings over a 39-year period, and residential buildings over a 27.5-year period. For instance, if an investor purchases a $5 million commercial building, they can take approximately $128,000 of depreciation each year.
Cost Segregation Studies and Accelerated Depreciation
While depreciation itself is fantastic for investors, there are a variety of things an investor can do to take larger depreciation deductions over a shorter period of time. In many cases, an investor can order a cost depreciation study from an engineering firm, which will identify various parts of a property that can be depreciated over a shorter period of time, say, 5 or 10 years. For instance, if $1 million of the property in the example above (such as roofing and electrical components) can be depreciated over a 10-year period, an owner could take the depreciation for that part of the property as an $100,000 per year deduction over their first 10 years of ownership.
This would lead them to be able to take approximately $202,000 a year of deductions/year over the first 10 years, and approximately $102,000 a year of deductions over the remaining 29 years. While cost segregation studies can be used for both multifamily and commercial properties, they are more commonly used for multifamily properties.
The Impact of Bonus Depreciation
While ordering a cost segregation study can certainly accelerate depreciation, investors may be able to take depreciation even faster, in the form of bonus depreciation. In fact, due to new regulations in the Tax Cuts and Jobs Act of 2017, some investors can take up to 100% of the property’s value as a depreciation deduction in their first year of ownership, at least until 2025.
Depreciation Recapture: A Necessary Evil
Despite the benefits of depreciation, investors will eventually have to pay back the IRS when they sell the property, in the form of the depreciation recapture. Depreciation recapture is triggered when an investor sells their property for more than the property’s adjusted cost basis, which consists of the original cost of the property minus any depreciation deductions that have been taken. For instance, in the example above, if the investor sold the property after 10 years for more than $4 million (calculated by taking the original price, $5 million, minus the depreciation taken up to that point, $1 million), depreciation recapture would be triggered. Because of this, the investor would need to pay their regular income tax rate on the property sale proceeds instead of the capital gains tax rate, which is much less.
2. Interest Expense Tax Deductions
Another important tax advantage of commercial real estate is the fact that you can deduct any interest you pay on a commercial mortgage off of your federal income taxes. For instance, if a commercial real estate borrower pays $10,000/month in mortgage payments, $2,000 of which is interest, they would be able to take a mortgage interest tax deduction of approximately $24,000 for that year. This can be especially impactful if a borrower is utilizing higher interest financing, such as a construction loan.
3. Non-Mortgage Tax Deductions
In addition to mortgage interest costs, commercial and multifamily real estate investors can deduct property repairs, maintenance costs, certain property management expenses, and many other operating expenses from their income taxes. This includes costs to travel to and from a rental property, including hotel expenses and 50% of food and beverage costs. Investors may also deduct the cost real estate investment related seminars, conferences, conventions, and other similar education events.
However, general property improvements, such as renovations or new furnishings, cannot generally be taken as deductions in the year they are incurred. Instead, these must be depreciated over the regular life of the property.
4. Utilizing Real Estate Taxes Losses to Your Advantage
While investors generally want their properties to make as much money as possible, if you incur losses on a commercial real estate investment, you may be able to take them as a tax deduction. However, this varies based on several factors. In general, there are three different taxpayer classifications when it comes to rental losses from commercial real estate.
Commercial real estate investors making less than or equal to $100,000 a year: These individuals can take a loss of up to $25,000 against their income. So, for instance, if an investor earned $90,000 a year and had a loss of $25,000 or more, they could reduce that year’s taxable income to $65,000. Those making more than $100,000 and up to $150,000 can take some deductions, but not nearly as much as those making less than $100,000.
Commercial real estate investors making more than $150,000 a year: Cannot take any commercial real estate loss-related deductions.
Commercial real estate professionals: If you are considered a designated commercial real estate professional by the IRS, there is no limit to the amount of real estate losses you can take in one year. To qualify, an individual needs to work a minimum of 750 hours per year in a real estate related position, such as a property manager, broker, agent, or investor. They must also generally work in this position for more hours than any other job they have.
Due to the tax benefits of being a real estate professional, some investors decide to quit their full-time jobs to pursue full time property management and investment, especially if their rental income is high enough to exceed their annual expenses. In other cases, they may have a spouse become a full-time property manager for their investments in order to take advantage of these loss deductions.
5. Reduced Tax Burdens for Beneficiaries
Commercial real estate doesn’t only have tax benefits for owners-- it can also have significant tax advantages for an owner’s heirs. For instance, if an investor buys a commercial property for $3 million, and its value increases to $4.5 million before the investor passes away, the investor’s beneficiaries will only need to pay taxes on the $1.5 million that the property has appreciated, not the entire $4.5 million sale price. This can save an investor’s heirs hundreds of thousands or even millions of dollars.
6. Tax Benefits of Commercial Real Estate vs. IRAs for Retirement
Unlike IRAs, which are taxed at an investor’s regular personal tax rate when funds are withdrawn, when a borrower sells commercial real estate, they will pay capital gains taxes, which are generally much less than personal income taxes-- at least for most investors. However, it should be noted that this is not the case for Roth IRAs.
7. Qualified Business Income (QBI) Deductions
The Qualified Business Income (QBI) deductions is another, somewhat complex deduction that commercial real estate investors may be able to take against their income taxes. The QBI deduction includes income from passive sources, and permits eligible individuals to deduct 20% of qualifying income. However, determining how much can be deducted is somewhat difficult.
Certain limitations include the greater of 50% of W-2 wages paid or, 25% of W-2 wages paid plus 2.5% of the depreciable basis of the property in question. In most cases, the second calculation is used, due to the fact that the majority of CRE investments are held in SPEs with few (or no) employees. It should also be noted that capital gains income from the sale of a commercial property does not count as eligible income for the QBI deduction.
8. 1031 Exchanges Allow Owners to Defer Capital Gains
The 1031 exchange is another extremely helpful tool that commercial real estate investors can utilize to their benefit. 1031 exchanges allow commercial real estate investors to defer the payment of capital gains taxes to the IRS, as long as they exchange their property for another “like-kind” commercial property within a certain period of time. This like-kind property must be of greater or equal value to the initial property, and cannot be a single family home used as the owner’s personal residence.
However, the property types exchanged do not have to be of the same asset type; for instance, a mixed-use apartment/retail property could be exchanged for a shopping center. However, the 1031 exchange does not necessarily allow an investor to defer their capital gains indefinitely; once the new property has been sold, the investor will have to pay their taxes in full. However, there is nothing stopping the investor from selling the property and engaging in yet another 1031 exchange.
9. Opportunity Zones Also Allow Owners/Investors to Defer Capital Gains
The Opportunity Zones program was created as a result of the Tax Cuts and Jobs Act of 2017, and was designed to stimulate investment in some of the lowest-income communities throughout the United States. The Opportunity Zones program permits individuals to defer eligible capital gains until December 31, 2026, provided that they invest in an Opportunity Fund, a specialized financial vehicle which must place at least 90% of its assets in commercial real estate or qualified businesses within one of America’s 8700 census tracts designated as Qualified Opportunity Zones. In addition, investors can take advantage of a 10% reduction in their capital gains tax basis, provided they hold their investment for a minimum of 5 years before December 31, 2026. Investors may utilize a further 5% reduction in their capital gains tax basis if they hold the investment for a minimum of 7 years.
10. Tax Credits: The LIHTC, HTC, and NMTC Programs
In addition to the Opportunity Zones program, the federal government’s LIHTC (Low-Income Housing Tax Credit) program allows investors in qualified low-income properties to take a dollar-for-dollar deduction against their federal income taxes. In certain cases, the LIHTC program may be combined with the Opportunity Zones program to maximize returns. Other widely used tax credit programs include the HTC (Historic Tax Credit) program, which offers a tax credit based on the percentage of eligible expenses used to rehabilitate a historic building for commercial use, and the New Markets Tax Credit Program, which provides a tax credit for commercial development in low-income areas. In general, these tax credits programs are competitive, and thus, are typically utilized by institutions and funds rather than by individual investors.
With all this in mind, it’s important that commercial real estate investors consult with an experienced tax professional in order to better understand how each of these tax benefits may be able to work for them. Real estate taxes can be incredibly complex, and the more effort you put into preparation and documentation, the more money you’ll save in the long run— not to mention avoiding the possibility of an unpleasant visit from the IRS.