We assume that if you earn high earnings, then you are probably paying a great deal in taxes, right? Well, you may be playing it wrong! What if we tell you that there is a way to earn more and pay lesser taxes? Yes, you heard us right! By investing in commercial real estate you get to enjoy several tax advantages.
Many reasons make real estate investments worthwhile and lucrative. But one of the biggest reasons investors keep choosing commercial real estate space time and again is because of its tax benefits.
No other form of investment comes close to commercial real estate when it comes to tax advantages.
Irrespective of the type of property you invest in, commercial real estate investments provide several tax benefits.
However, to enjoy the tax benefits you’ll need to understand the different strategies of tax advantages and identify the right opportunities for when and how to use them.
Here, Lilypads bring you the 7 best ways to use commercial real estate for tax benefits, as compiled by Lilypads.
1. Tax Deduction Through Depreciation Of Assets
Being a physical asset, commercial real estate properties are subject to wear and tear.
Although there may not be significant damage to the physical structure, as a building gets older it depreciates its aesthetic look. Thereby, it loses its intrinsic value over time.
As per rules set by the IRS, commercial properties have a depreciation period of 39 years. This allows commercial real estate property owners to deduct tax amounting to the initial cost of the property over 39 years.
For instance, if you purchase a property worth $390,000 in that case you can deduct $10,000 of taxes every year for 39 years.
Moreover, you can take large depreciation deductions over a shorter time period by consulting an engineering firm.
They determine the current life expectancy of property by conducting a cost segregation study of various components.
This will help in lowering the taxable income if the estimated life of the property is found below 39 years.
Furthermore, the Tax Cuts and Jobs Act (2017) allows you a depreciation deduction of up to 100% of a property’s value during the first year of the ownership until 2025.
However, if you decide to sell the property at a price higher than the original value minus the depreciation deduction, then you need to pay the IRS in form of depreciation recapture. It allows you to pay regular income tax based on the earnings from the sales which is much less than the capital gains tax rate.
2. Mortgage Interest Expense Deduction
Apart from depreciation deduction, you can write off expenses related to your property maintenance and operations. One such biggest perk among them is the mortgage interest deduction.
You can deduct the interest portion of a mortgage payment if you acquire commercial real estate through a mortgage. For example, if your monthly mortgage is $4000 and $800 of that applies to interest, in that case, you can claim $9600 as a mortgage interest deduction.
It would be helpful if you have a high-interest rate. However, the TCJA has set a limit of a maximum of $750,000 for mortgage rate deductions.
3. Non-Mortgage Tax Deductions
Besides monthly interest expenses, you can also deduct other expenses related to property operation and maintenance.
Non-mortgage tax deductions include expenses such as building repairs, maintenance costs, and operational expenses including commuting expenses to and from the investment property.
However, it does not include property improvements, renovations, or new addition to the building. These expenses can be deducted through regular depreciation of the property.
4. Pass-Through Deductions Or Qualified Business Income (QBI) Tax Deduction
When the profits and losses of a business are directly passed on to the business owner in that case the business is labeled as a pass-through business. Generally, most small businesses are pass-through businesses.
These types of firms do not pay taxes directly and include individuals like sole proprietors, partners, LLCs, LLPs, and S Corporations.
The Tax Cuts and Jobs Act of 2017 allow business owners to benefit from a significant tax deduction. Also known as the Qualified Business Income Tax Deduction, it allows investors having a positive taxable income can deduct as much as 20% percentage o of the income tax.
It includes income from investments like rental properties, Real estate investment trusts REITs, or publicly traded partnerships. Generally, any kind of income generated from passive real estate investments falls under the QBI tax deduction.
For example, if you have invested in a rental property and enjoy an annual rental income of $100,000. With the QBI deduction, you can deduct up to $20,000 from your taxable income.
5. Capital Gain Tax Advantages
As with any source of income, the government wants a part of your income as a tax. Similarly in CRE investments the government also wants a cut from your profits or in this case capital gains.
A capital gain is only taxable when you’ve decided to sell your investment property. Furthermore, it can be divided into two categories: Short-term and Long-term capital gains.
Short-Term Capital Gains: If you decide to sell your property within a short time period after purchasing the property. Then the profit realized is termed a short-term gain. Generally, the holding period for a short-term gain is one year of utmost. This gain is taxed at a higher rate than normal income tax.
Long-Term Capital Gains: The key to making money in commercial real estate investments is patience. If you decide to hold your property for a long-term period of more than two years will give you long-term capital gains. Compared to short-term capital gains if you hold your investment property long enough you make more money and enjoy a lower tax rate than standard income. The tax system in the US favors long-term investors more than short-term investors.
6. 1031 Exchanges For Capital Gains Tax Deferral
This is the most useful tool and is considered the most beneficial tax deferral among commercial real estate investors.
As per section 1031 from the IRS code, you can avoid capital gain taxes by reinvesting the entire proceeds into a “like-kind” commercial real estate property of the same or greater value.
1031 exchange allows you to keep rolling over your capital gains for an indefinite time until you decide to sell the property. Once you’ve decided to sell your investment property you‘ll have to pay the taxes in full.
However, you must identify and purchase the property within a given time and provided that the property cannot be a single-family home used as a personal residence.
To successfully pull off a 1031 exchange, it is advised to consult with your team of real estate professionals. Since time is an important factor here, you must construct a fail-proof plan while working with your team.
Some of the benefits of a 1031 exchange are:
- Diversification of investment portfolio
- Ability to reset depreciation
- Exposure to new markets
- Estate planning
- Improved cash flow
- Property and asset management
Check out Lilypads’ blog about the benefits of the 1031 exchange to know more.
7. Opportunity Zones To Defer Capital Gains.
According to the Tax Cuts and Jobs Act, Opportunity Zones is a program created to stimulate investments in developing and economically distressed communities.
Real estate investors are rewarded with preferential tax treatment if they invest in opportunity zones. The main motive behind this initiative was to be an economic development tool and drive money in poor-performing regions.
According to the IRS regions that have a minimum 20% poverty rate and median family income of less than 80% of statewide median family income can be qualified as an opportunity zone.
Investing in Opportunity Zones can be beneficial to investors who want to defer capital gains temporarily by timely investing in Qualified Opportunity Funds (QOF).
Investors can defer tax on capital gains until the amount of the gains is reduced or terminated in the QOF before December 31, 2026, whichever occurs first.
In general, the taxpayer’s tax benefits depend on how long they hold the QOF investment. If you hold a QOF investment for at least five years it increases the basis of the investment to 10% of the deferred gain. Whereas the same investment when held for 7 years increases the basis of QOF investment to 15%.
In certain cases, if you can hold the investment for 10 years, then you are eligible of increasing the basis of QOF investment equal to the market value. The day when the QOF investment is sold or exchanged.
To read more about Opportunity Zones, click here.
The Lilypads Bottomline
Commercial real estate investments are full of opportunities and benefits, tax benefit is just one of the many. But only knowing the benefits is not enough, you’ll need to apply the right strategy at the right place to successfully avail the tax benefits. Lilypads community connects you with the right team of highly experienced real estate professionals to guide you in your investment to maximize your tax benefits.
This article is for knowledge-sharing purposes, it is advised to consult with a licensed professional for a more accurate and appropriate situation that meets your need.