Are there any commercial real estate tax benefits? Of course there are! This article will highlight some of the more commonly used tax strategies and their benefits using a layman’s description of what they are, how they work, and how CRE owners and investors can advantageously use these benefits.
In commercial real estate, structures and other assets on properties usually don’t last forever. They experience wear and tear, and therefore, their value depreciates over time. Commercial real estate properties have a depreciation period of 39 years, as set by the IRS. This means that a commercial real estate owner can deduct the cost of a property over 39 years. In the simplest example, if a building on a property is worth $390,000, an owner can take a tax deduction of $10,000 every full year for 39 years and a prorated amount for a partial year.
These depreciations are used to offset the taxes that are owed on the profits made from the property. And to be clear, land does not depreciate; only the buildings or structures on that land do. This deduction will lower the yearly taxable income of a CRE property, and it can even get to a point where the property will show a zero taxable income and still be producing a profit!
Another benefit of depreciation applies to different parts of a property that depreciate at various rates. An owner can hire an engineering firm to conduct a cost segregation study on individual components of a property, such as a roof. If the life expectancy of the roof is 15 years, the value of the roof can be depreciated on a 15-year schedule instead of the usual 39 years, thus lowering the taxable income even faster. In some cases, the Tax Cuts and Jobs Act of 2017 will even allow investors to take a 100% tax depreciation deduction toward the value of the property in an owner’s first year of owning the property. This law is applicable up until at least 2025.
If an owner took out a loan to purchase a commercial real estate property, they can deduct the interest portion of the mortgage payment. For example, if the monthly mortgage payment of a property is $5000 and $1000 of that applies to the interest, the owner can claim $12,000 (12 months X $1000) for that year as a commercial mortgage interest tax deduction. This can be very helpful if the property owner is paying a high-interest rate. If there is a high enough interest deduction, it can completely offset the taxes that would normally be owed from the profit made on the property.
Deductible Non-Mortgage Expenses
There is a list of other expenses that are deductible for a commercial real estate investor. Owning and maintaining a commercial property involves time, effort, and other expenses. Therefore, a commercial real estate owner can deduct costs related to maintenance, management, upgrades, repairs, some renovations, and other operations-related activities. Even when an investor has to travel for property-related reasons, those expenses are also deductible. That includes travel expenses, hotel expenses, and a portion of dining expenses. Other non-mortgage expenses that are deductible include the cost of attending educational events conferences, seminars, and events related to real estate.
Lower Taxes for Beneficiaries
When a commercial real estate owner passes away and leaves a property to a beneficiary, the heir does not have to pay taxes on the full value of the property. As the new owner of a commercial property, the heir (beneficiary) is only required to pay taxes on the increased value of the property from the time it was purchased until the time it was passed on to the beneficiary. For example, if a property were purchased at $1 million and was worth $1.5 million when the investor passed away, the beneficiary would only be responsible for the $500,000 of appreciation on the property.
Lower Capital Gains Compared to Traditional IRA
When a commercial real estate investor sells a property, they must pay the capital gains tax rate. When someone withdraws from their IRA gains, they must pay taxes at a personal rate. The capital gains tax rate is significantly lower than personal tax rates, making commercial real estate an attractive option for retirement plans.
Section 1031 Exchange
Section 1031 involves swapping a property for another property. The newer, like-kind property must be of equal or greater value than the initial property, and must not be a single-family home where the investor lives. The payment of capital gain taxes is deferred to the IRS until that newly acquired property is sold. There is no limit to how many times investors can swap a property, so they can just keep swapping properties without paying taxes until the most recently acquired property gets sold.
Commercial Real Estate Losses
Sometimes with commercial real estate, an investor has to take a loss. However, those losses may be used as a tax deduction. In addition to other criteria, these deductions largely depend on the investor’s income and if the IRS considers the investor a designated commercial real estate professional. If they are considered a professional, they can deduct a limitless number of losses in a year.
The Opportunity Zones program has only been around since the Tax Cuts and Jobs Act of 2017. It allows several tax benefits, one which defers the capital gains tax until the end of 2026 if the commercial real estate investment is in a Qualified Opportunity Zone, which is a lower-income community. The intent of this benefit is to stimulate investments in these communities.
Qualified Business Income Tax Deduction
A basic definition of The Qualified Business Income (QBI) deduction is a deduction allowing certain small business owners and the self-employed to take a deduction of 20% of qualifying income in addition to 20% of qualifying real estate investment trusts (REIT) dividends. Income from selling the property does not qualify while income from rental properties does. Click here for more information.
There are other commercial real estate tax benefits not mentioned here including federal tax benefits related to the Low-Income Housing Tax Credit (LIHTC), Historic Tax Credit (HTC), and the New Markets Tax Credit (NMTC). If you own commercial real estate property or are interested in investing in commercial real estate, consult with your accountant to take maximum advantage of the tax benefits that are available.