Of all the traditional investment vehicles, commercial real estate is arguably the most tax advantaged. Some of the most powerful commercial real estate tax benefits include lower capital gains, mortgage interest deductions, accelerated depreciation, and the ability to transfer assets to heirs tax-free, among others. Astute investors can even leverage their tax savings/deferral to acquire new cash flow generating assets. Here are a few of the more popular ways to defer, reduce, or eliminate your tax burden using real estate investments. Always refer to your tax professional for advice on how these items will directly benefit you.
Over time, real estate assets degrade and deteriorate. The IRS allows investors to claim that property depreciation on a set schedule, set at 27.5 years for residential real estate, and 39 years for commercial properties. This means that each year, you are allowed to deduct 1/27.5th or 1/39th of the value of the property on your annual tax bill, regardless of whether or not you actually need to use the deducted funds to repair or renovate the property.
The 2017 TCJA, or Tax Cuts and Jobs Act, added commercial real estate personal property, also known as chattels, into the list of eligible property for depreciation. Personal property refers to the additional items you place into a rental unit, things like refrigerators, microwaves, dishwashers, etc. As long as the property was put into service between September 30, 2017, and December 31, 2011, these items are considered qualified purchases under the new bonus depreciation rules.
Long-term investments in income-generating properties fall under long-term capital gains rules. Depending on your income bracket, you may be taxed on that income anywhere from 0 to 20 percent, substantially lower than short-term capital gains and other forms of earned income. Keep in mind that this benefit only extends to long-term holdings, any short-term capital gains are taxed at the higher short-term capital gains rate. Not only do investors end up receiving substantially lower capital-gains rates; in many cases, they can defer or even eliminate tax payments by selecting the right real estate investment vehicles or strategies.
In the vast majority of cases, income from a real estate investment is not considered business income, which means that under IRS regulations, you have no earned income as a real estate investor. There is one exception- if you own your RE assets through a holding company, and receive a salary, you will be liable for FICA taxes. However, as long as you are "materially participating" in business operations you may be eligible to deduct up to 25k of losses. Any losses can be carried forward to future tax periods to help offset gains.
If you are acquiring real estate assets using borrowed capital, you can improve your cash flow with mortgage refinance loans. A term and rate refinance will help reduce your monthly mortgage payment, or you can use a cash out refinance to borrow against the property tax-free until you sell the subject property.
Another tax-advantage presented by the 2017 TCJA are tax breaks offered by investments made in Qualified Opportunity Zones. These zones are federally designated census tracts that lag behind the rest of the country in development and investment dollars. There are three primary benefits offered by Opportunity Zones:
Permanent Exclusion
Investors in Opportunity Zones benefit from the permanent exclusion of taxable income from capital gains made from the sale or exchange of an OZ Fund investment, as long as that investment is held for at least 10 years.
Temporary Capital Gains Tax Deferral
OZ Fund investors can also enjoy a temporary deferral of inclusion in their taxable income, applicable only for capital gains that get reinvested into a Qualified Opportunity Zone Fund. Any deferred gain must be recognized before the Opportunity Zone disposal date, which is December 31, 2026.
Step-Up in Basis
The final tax benefit offered by Opportunity Zone investments is a step-up in the basis for any capital gains that are reinvested in a Qualified OZ Fund. In layman's terms, this readjusts the value of your OZ Fund investment for tax purposes when you leave the asset to your heirs, thus reducing your overall tax burden. Keep in mind that the basis is increased by a full 10 percent, as long as that investment is held in the OZ Fund for at least 5 years. Hold that same investment for 7 years, and the basis rises to 15 percent.
Section 1031 of the IRS code includes provisions that allow investors to avoid paying capital gains taxes on the sale of an investment property, as long as the proceeds from that sale are reinvested in a "like-kind" property of equal or greater value within a designated time frame. The primary benefit of using a 1031 exchange is the tax deferral. Investors can defer their capital gains tax and free up that capital to invest in a new property. 1031 exchanges require relatively high minimum investments, and a longer than average holding time- two years under IRS regulations.
Any proceeds from the sale of a property remain taxable, thus the funds must be transferred to a qualified intermediary, instead of being transferred directly to the seller of the property. The qualified intermediary facilitates the 1031 exchange by holding any proceeds from the sale until they are to be transferred to the seller of the property. The investor must identify a property to be purchased within 45 days, and the transaction must close within 180 days. Eligible properties for tax-deferral must be like-kind; for instance, you can't exchange a multifamily property for shares in a REIT, or a retail shopping center for precious metals.
As evidenced above, as an asset class, real estate is incredibly tax-advantaged compared to other popular investment vehicles, like equities, bonds, precious metals, etc. Remember that investors must be proactive in obtaining real estate tax benefits, either through self-initiated due diligence and research or by working with real estate and tax professionals. When leveraged correctly, real estate tax advantages can generate substantial returns above and beyond standard property appreciation and rental income alone.