How to Utilize Commercial Real Estate for Taxes
Traditional reasons for investing in commercial real estate (CRE) include cash flow, passive income, portfolio diversification and price appreciation over the long-term. In one way or another, these benefits generate consistent income for investors.
But another, often-overlooked, benefit of commercial real estate investing is the tax advantages.
Thinking of taxes as a benefit may seem odd because taxes decrease the income that real estate investors earn. However, by taking a closer look at CRE taxes, it’s easier to understand why many investors think of this asset class as a tax-benefit-rich space.
In this article, we’ll explain how to utilize the efficient tax methods for commercial real estate, along with some targeted tax credits that even experienced real estate investors may be unaware of.
How to Utilize Commercial Real Estate for Taxes
Although none of us enjoy paying taxes, it’s fair to say that the tax code in the U.S. is very friendly to property owners. Here’s a closer look at some of the many tax benefits commercial real estate investors enjoy.
Commercial Real Estate Investing
Depreciation is a non-cash deduction that commercial real estate investors use to reduce their taxable net income.
The concept of depreciation is based on the idea that physical assets wear out over time. For example, refrigerators last about 13 years, HVAC systems about 15 years and roofs about 20 years on average before they need to be replaced.
According to the IRS, commercial real estate depreciates (or wears out) after 39 years. Of course, that doesn’t mean the investment stops producing income, only that the depreciation expenses an investor can incur ends.
Here’s an example of how commercial real estate depreciation works.
Let’s assume an investor purchases a single tenant net leased (STNL) property in Texas for $1.5 million in cash that is leased to Walgreens. The property trades at a 5% cap rate, so the investment generates a net operating income (NOI) of $75,000 per year.
Each year (for up to 39 years), the investor can claim a depreciation deduction of a little more than $38,460, which is used to reduce the amount of taxable income generated by the property. In other words, instead of paying taxes on $75,000 of income the investor only pays tax on $36,540 ($75,000 NOI – $38,460 depreciation deduction).
Another tax benefit of depreciation is that the depreciation is investor-specific, not property-specific. Each time the property changes hands, the depreciation clock is reset. If Investor A holds the property for 5 years, the remaining depreciation period would be 34 years for Investor A. However, when Investor A sells the property to Investor B, the 39-year depreciation period starts all over again.
Another way investors utilize commercial real estate for tax advantages is with a 1031 tax-deferred exchange.
Section 1031 of the Internal Revenue Code allows real estate investors to defer paying tax on capital gains by conducting a “like-kind” exchange. Provided a real estate investor sells one investment property and purchases another investment property within a certain period of time, any capital gains tax normally due is deferred to a later date.
Here’s an example of how a 1031 tax deferred exchange works. After holding the Walgreens STNL investment for 5 years, the asset has a fair market value of $2 million and the investor decides the time is right to sell.
Over the 5-year holding period, the investor has claimed a total depreciation deduction of $192,300, so the adjusted cost basis is now $1,307,700 ($1.5 million original purchase price – $192,300 depreciation). This makes the taxable gain on the transaction $692,300 ($2 million sale price – $1,307,700 adjusted basis).
If the investor does not conduct a 1031 exchange, he would be liable for the following taxes, assuming the investor is in the top income tax bracket:
- Depreciation recapture tax rate of 25% x $192,300 depreciation = $48,075
- Capital gains tax rate of 20% x $500,000 remaining gain after depreciation recapture = $100,000
- Total potential tax liability = $148,075
- Remaining capital to reinvest = $544,225 ($692,300 gain – $148,075 taxes)
However, by conducting a 1031 exchange the investor can defer paying the $148,075 in taxes to a later date. By paying taxes at a later date, the investor retains the entire gain of $692,300 to reinvest today.
There are five main rules that an investor must follow when conducting a 1031 exchange in to be able to defer paying capital gains tax:
- Property must be held for business or investment purposes.
- Property must be “like-kind” but can differ in type of quality, such as a portfolio of single-family homes being sold and replaced with one or more single tenant net leased properties.
- Replacement property must be of equal or greater value to the relinquished property.
- One or more replacement properties must be identified within 45 days of the sale of the relinquished property.
- Within 180 days of selling the original property, the replacement property must close escrow.
Interest Expense Deduction
A third way that investors use commercial real estate investing for taxes is with the conservative use of leverage. Interest payments on a commercial mortgage are deductible from a property’s NOI, which further reduces an investor’s taxable income.
Rather than using cash to purchase the $1.5 million Walgreens STNL property, the investor could finance the transaction instead.
Let’s assume the investor made a 30% down payment and secured a CRE loan at a 4% interest rate amortized over 25 years with a 7-year call. The tax-deductible interest payment part of the mortgage would be about $38,000 per year, with this interest expense deduction used to reduce the taxable net income.
By combining the interest deduction with the depreciation expense, the investor has completely eliminated his taxable income:
- Net operating income = $75,000
- Less interest expense deduction = $38,000
- Less depreciation expense = $38,460
- Taxable income = – $1,460
Non-Mortgage Tax Deduction
Non-mortgage tax deductions, such as property operating expenses and business-related travel costs, are another tax benefit of owning commercial real estate.
Repair and maintenance expenses, property taxes and leasing and property management fees are some of the many costs that can be deducted from the gross income generated by a property. However, capital expenses (CapEx), like replacing a heating and cooling system, must be added to the property basis and depreciated over the life of the property instead of being expensed in one lump sum.
One advantage of investing in a single tenant net leased (STNL) property is that most, if not all, of the operating costs and capital expenses are passed to the tenant, depending on whether the property lease type is double net (NN) or triple net (NNN).
While an STNL investor may not benefit from non-mortgage tax deductions, the investor does benefit from passing ownership risk, like increased operating expenses and capital expenses, to the tenant.
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Use Losses to Your Advantage
There are times when even the best real estate investment will generate a loss. While no investor wants to lose money, the good news is that some investors can use rental losses as a tax deduction.
Losses from rental properties are classified as “passive losses” for tax purposes by the IRS and generally can only be used to offset passive income earned from rental real estate or other passive ventures, like being a silent partner in a business.
However, there are three general exceptions to passive loss (PAL) rules:
- Commercial real estate investors with a modified adjusted gross income (MAGI) of $100,000 or less may deduct rental losses of up to $25,000 per year—provided the investor actively participates in management decisions and has more than 10% ownership interest in the investment.
- Commercial real estate investors with a MAGI between $100,000 and $150,000 have the rental loss deduction of $25,000 per year gradually phased out, with the deduction entirely eliminated for investors with annual modified gross incomes greater than $150,000.
- Investors who qualify as commercial real estate professionals may deduct any amount of rental losses from their non-passive income. To qualify as a real estate professional, the investor (or a spouse) must:
- Spend more than half of his working hours each year in the real estate business, for at least 751 hours each year.
- Materially participate in his rental property business.
Reduce Tax Burden
Commercial real estate can also have significant tax benefits for an investor’s heirs.
If our owner if the STNL Walgreen’s property passed away five years after purchasing the property, the heirs would only pay tax on the $500,000 difference between the original purchase price of $1.5 million and the current fair market value of $2 million.
After inheriting the property and holding it for a short period of time, the heirs might decide to sell. If they do, the property basis used for calculating capital gains tax would increase to $2 million rather than the $1.5 million purchase price the original investor paid.
Qualified Business Income Deduction
A recent article from The Tax Institute at H&R Block explains how and if the QBI deduction can be used for rental income. But, QBI is somewhat complicated, in part, because the rules are fairly new.
There are several general guidelines real estate investors should understand about the QBI deduction:
- QBI is the net income from a qualifying business, such as commercial rental property, minus certain items like as capital gains.
- Commercial rental real estate ownership normally qualifies for QBI, while residential rental real estate income may or may not.
- Business owners can claim the QBI deduction for the tax years 2018–2025.
- Even if rental real estate activity is passive, it can still be treated as a trade or business for QBI deduction purposes.
- QBI deductions are generally equal to the lesser value of either 20% of qualified business income or 20% of taxable income minus net capital gain.
- Qualified Business Income is a deduction claimed on the investor’s individual return for income received from an entity that does not pay taxes at the company level—i.e. sole proprietorship, LLC, partnership or S corporation.
- Other limitations include the greater of either 50% of W-2 wages paid or 25% of W-2 wages paid plus 2.5% of the property’s depreciable basis.
There are also many targeted tax credits that CRE investors may be entitled to, depending on the type of real estate, property location and use for it:
- Opportunity Zones (OZs) were created by the TCJA of 2017, designed to stimulate investment in over 8,700 census tracts in low-income communities and neighboring areas across the U.S. The Opportunity Zone program allows investors to defer paying tax on capital gains reinvested in an OZ until December 31, 2026 and also pay no tax on any additional capital gain from an Opportunity Zone investment.
- The Low-Income Housing Tax Credit (LIHTC) program subsidizes the acquisition, construction and rehabilitation of affordable rental housing for low- and moderate-income tenants. Investors can claim the LIHTC credit over a 10-year period for eligible rental properties, including apartment buildings, duplexes and single-family homes. The annual LIHTC credit equals a credit percentage multiplied by the project’s qualified basis, and ranges from 9% for new construction or substantial rehabilitation to 4% for rehabilitation projects.
- The Historic Rehabilitation Tax Credit (HTC) program provides CRE investors with a tax credit based on a percentage of eligible expenses used to rehabilitate a historic building for commercial use. A recent example of how investors and the local community benefited from the HTC is the former Meir & Frank Delivery Depot in Portland that is now a LEED Platinum-certified office building.
- The New Markets Tax Credit (NMTC) program is designed to incentivize community development and economic growth by offering tax credits to attract private investment to distressed communities. Over the past five years, the NMTC has created 178 million square feet of manufacturing, office and retail space, financing over 5,400 businesses.
Investors utilize commercial real estate for taxes in a variety of ways, including depreciation, 1031 tax-deferred exchanges and the interest-expense deductions. CRE investors can also benefit from targeted tax programs and credits, such as Opportunity Zones, the Low-Income Housing Tax Credit and the Historic Rehabilitation Tax Credit, depending on where the property is located and how it is used.
A growing number of CRE investors are also discovering the strategic advantages of investing in single tenant net leased (STNL) properties for their stable returns and tax benefits.
Commercial real estate leased to a single national or regional credit-tenant on a long-term double or triple net lease is like owning a bond wrapped in real estate. The risk of ownership, like maintaining the property, is passed to the tenant while the investor receives consistent cash flow similar to the interest payment from a highly-rated bond.
Liberty Real Estate Fund focuses on acquiring single tenant net lease properties spread out over different essential-business industries and diverse geographical growth areas in the U.S.
These investments have proven to be the most stable and dependable asset class for commercial real estate investors. Liberty Real Estate Fund provides investors with low volatility, portfolio diversification, risk-adjusted returns and commercial real estate tax benefits as an alternative to owning other fixed income investments.
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