Capital Gains Tax Considerations for Commercial Real Estate Investors

When an individual profits from selling an asset, such as stock in a company, commercial real estate, or other investments, a capital gain has occurred.

Instead of paying ordinary income tax, an individual generally must pay a special tax rate on these gains. This is known as a capital gains tax.

Capital gains taxes vary depending on how long you hold and how you divest from a commercial property.

For commercial real estate investors, understanding the impact of capital gains taxes — and how to minimize their impact — is essential if you want to maximize the profitability of your investment.

In this article, we’ll discuss:

• Short-Term vs. Long-Term Investment Strategies: Commercial real estate investors with different goals often have different holding/exit strategies for commercial real estate.

• Short-Term vs. Long-Term Capital Gains: Investors are taxed at different rates depending on how long they hold onto an asset.

• 1031 Exchanges: 1031 exchanges allow investors to defer capital gains taxes by using proceeds from an investment property to purchase a “like kind” property.

• Depreciation Recapture Taxes: When an investor sells a property they have used to take depreciation deductions, they will have to pay taxes on those deductions.

• The Opportunity Zones Program: The Opportunity Zones program allows investors to defer paying capital gains taxes until Dec. 31, 2026, provided they invest in a Qualified Opportunity Fund. Additional benefits are provided by those who invested before Dec. 31, 2019.

Short- vs. Long-Term Investment Strategies

When investing in commercial real estate, understanding your exit strategy is key. Some investors like to purchase underperforming properties with potential, increase occupancies and rents, and (if needed) do some value-add repairs, and sell the property within a few years.

Others prefer to buy an investment and hold it for the long run, allowing them to collect a steady income from the investment for several decades. Whichever strategy an investor chooses will have a significant impact on their capital gains tax burden — and how they should address that burden to maximize profitability.

Breaking Down Capital Gains Taxes

Taxes on capital gains are different for long-term capital gains and short-term capital gains. Short term capital gains are generally defined as gains on assets held for less than one year, while long term capital gains are generally defined as gains on assets held for more than one year. Both types of capital gains taxes are based on a taxpayer’s income and filing status.

Long-Term Capital Gains Taxes in 2023

Long-term federal capital gains taxes are outlined in the table below, based on data from the Internal Revenue Service.

Remember that, just like with income taxes, the tax rate is applicable only to the dollar amounts within their respective range.

For example, capital gains of $50,000 for a single filer would incur only a 15% tax on any amount above $44,625. In this example, that tax would equal $806.25 ($5,375 x 15%).

Short-Term Capital Gains Taxes in 2023

Short term capital gains taxes are taxed at a taxpayer's ordinary tax bracket.

Single Filer Short-Term Capital Gains Taxes

Federal income tax rates for 2023 for single filers are listed below.

Married (Filing Separately) Filer Short-Term Capital Gains Taxes

For individuals who are married but filing separately, the following rates are used.

Married (Filing Jointly) Filer Short-Term Capital Gains Taxes

Married filers who file jointly must pay the following rates for their income in 2023.

Head of Household Filer Short-Term Capital Gains Taxes

Finally, the income tax brackets below apply to short-term capital gains and any other income for head-of-household filers in 2023.

Recapture Tax

As a way to reduce their taxable income, commercial and multifamily investors are permitted to depreciate a property. This means that, as a property ages, they can take part of that aging as a loss and utilize it as an income tax deduction. However, they will still have to pay taxes on this amount later.

For instance, if an investor purchase a $500,000 property, and, while holding it, was allowed to take $150,000 in accumulated depreciation, they would need pay taxes on that $150,000 when they sell the property — but only if they sell the property for more than the depreciated value. For instance, if the investor sold the property for less than $350,000, the investor would not need to pay taxes on the $150,000 of accumulated depreciation they took. Accumulated depreciation, which is also called a Section 1250 gain, is taxed at up to 25%.

In addition, it may be important to note that commercial real estate investors, particularly multifamily investors, may be able to “accelerate depreciation” by ordering a cost segregation study, which will identify areas of a property that can be depreciated more quickly. This can greatly reduce an investor’s tax burden in the initial years of an investment, but all accumulated depreciation will still be subject to the depreciation recapture tax.

State Capital Gains and Income Taxes

In addition to federal tax considerations, investors also will generally have to pay state capital gains taxes or state income taxes, if they reside in a state with an income tax.

Different states will calculate an investor’s capital gains tax burden in different ways, so it’s essential to understand your state’s tax regulations if you want to minimize your capital gains tax bill. A map of the U.S. with tax rates for individual states can be found here.

1031 Exchanges and Capital Gains Taxes

One of the best ways to reduce the impact of capital gains taxes on a commercial real estate portfolio is to utilize a 1031 exchange. 1031 exchanges permit investors to defer the payment of capital gains taxes on commercial real estate, provided that they purchase a similar, “like-kind” commercial property of equal to or greater value. Homes used as a primary residence are not eligible.

While the investor will eventually have to pay taxes if they sell the second property (unless they engage in another 1031 exchange) avoiding paying taxes in the present is highly advantageous — as you undoubtedly know, a dollar today is worth more than a dollar tomorrow. In fact, some investors elect exchange properties indefinitely, acquiring increasingly profitable pieces of commercial real estate while avoiding capital gains taxes.

Opportunity Zones and Capital Gains Taxes

The Opportunity Zones program, created as a result of the Tax Cuts and Jobs Act of 2017, is another way that commercial real estate investors can defer paying capital gains taxes on the sale of investment properties. The program permits investors to defer their capital gains taxes until Dec. 31, 2026, provided they reinvest their money into an Opportunity Fund. Opportunity Funds are specialized investment vehicles which must place at least 90% of their assets in qualified businesses or investment properties located in one or more of the 8,700 Qualified Opportunity Zones throughout the United States. Opportunity Zones consist of some of the lowest-income census tracts in country, and, as such, have been deemed as areas ripe for economic redevelopment.

In addition to deferring capital gains taxes for up to eight years, investors who hold their investments for a minimum of five years prior to Dec. 31, 2026, can take a 10% reduction in their capital gains tax basis. And, investors who hold their investments held for a minimum of seven years prior to Dec. 31, 2026, can take an additional 5% reduction in their capital gains tax basis (for a total 15% reduction). To take full advantage of the program, however, investors must have placed their money in an Opportunity Fund before the end of 2019.

In contrast to 1031 exchanges, investors aren’t limited to reinvesting funds from the sale of commercial property. Instead, they are permitted to reinvest funds from the sale of stock shares, the sale of a business, or the sale of other types of investments into an Opportunity Fund in order to defer their capital gains taxes.

When It Comes to Capital Gains Taxes, Strategy is Key

While no one likes paying taxes, with sufficient knowledge, commercial real estate investors can turn a burden into an opportunity — whether by getting creative with their income (for instance, a business owner who wants to take a smaller salary for tax benefits), engaging in a 1031 exchange, or even deferring taxes via investing in the Opportunity Zones program.

However, to maximize their chances of success, investors should think through a concrete exit strategy and begin the tax planning process before they make a commercial real estate investment — not after.