Do you want to maximize your investment returns and minimize your tax liability to create more cash flow?
If so, investing in commercial real estate empowers you to utilize various tax benefits that can help you do that.
This article highlights the top 10 commercial real estate tax benefits and how each can save you money on your taxes while boosting your returns. Let’s start!
Table of Contents
What Are The Top Tax Benefits Of Owning Commercial Real Estate?
There are several tax benefits of commercial real estate investing that can be very powerful. The top tax benefits of owning or investing in commercial property include:
- Expense Write-offs
- Reduced Tax Burdens for Beneficiaries
- Lower Tax Rate on Capital Gains
- 1031 Exchanges
- Opportunity Zones
- Federal Tax Credits
- Qualified Business Income
- Commercial Real Estate Losses
- Self-Employment Without FICA Tax
As with all things related to commercial real estate investing, it’s vital to reiterate that every situation is different. Always consult with tax professionals and legal counsel to determine which tax benefits are available to you and whether or not you should use them. Additionally, consult with financial advisors and other professionals to ensure you have the proper legal entities, processes, and qualifications to utilize them fully.
Now, let’s explore each commercial real estate tax benefit in more detail.
Depreciation is a tax benefit for commercial real estate that allows investors to recover the cost of the building over time. The Internal Revenue Service (IRS) allows commercial real estate investors to write off a building’s cost basis over 39 years.
For example, suppose an investor purchases a building for $1M. The investor can separate the cost of the physical asset and the land and depreciate the cost of the physical asset (typically the greater value). In this example, let’s say the land is worth $250,000, and the building is worth $750,000, for the total purchase price of $1M. The investor can deduct $750,000 from the property’s rental income over 39 years for a total of $19,230 per year ($750,000 / 39 years = $19,230 per year).
As you can see, depreciation is a significant benefit from a tax perspective, but there is even more commercial real estate professionals can do with depreciation!
In addition to standard depreciation, investors can conduct a Cost Segregation Study for an additional depreciation expense.
Because a commercial property is rarely just the building itself. Other components, such as HVAC systems, plumbing, electrical fixtures, and more, lose value over time. A Cost Segregation Study effectively takes inventory of these components and assigns a value to them based on their useful life. Once the study is complete, investors can also depreciate the value of these items.
As you can imagine, the number of depreciation deductions you have and the speed you choose to depreciate them (e.g., $10,000 depreciated over ten years for $1,000 per year vs. $10,000 depreciated over five years for $2,000 per year) can have a dramatic impact on your federal tax return.
It’s worth noting that eventually, the depreciation needs to be repaid in what’s called depreciation recapture. However, the economic benefits of leveraging depreciation often outweigh the depreciation recapture.
2. Expense Write-Offs
The IRS has a list of items and qualification criteria determining what does and doesn’t qualify as an expense write-off. As an investor in commercial properties, you can write off most expenses necessary for the investment property to generate revenue.
Expense write-offs allow commercial property investors to substantially reduce their tax bill by writing off the expenses incurred to operate investment properties against the property’s gross income. Utilizing write-offs to the maximum degree allowed by the IRS can lower an investor’s taxable income and thus create tax savings.
What can you write off on your taxes for commercial property?
For a commercial real estate investment, you can write off the cost of any improvements or renovations necessary for operating the property and generating revenue. Necessary renovations or improvements may include maintenance costs such as upgrading the electrical or plumbing systems, installing new windows or doors, or adding a new roof and operating expenses like property manager fees and landscaping services.
Investors may also be able to write off the cost of any furnishings or equipment they purchase for the property, such as furniture or appliances, if the items are necessary for the property’s successful operation (e.g., a hotel or short-term rental property).
Another potential write-off for commercial real estate investors is the interest on any loans they use to purchase or improve a property. Writing off mortgage interest can provide a significant tax benefit, as the interest on these loans is often a significant monthly expense for investors.
Whenever you write off expenses, you must consult a tax professional to determine which expenses associated with your commercial property may be deductible from your taxes. Additionally, the tax laws and regulations governing commercial property deductions can change, so it is vital to stay updated on the latest information.
Is the down payment on commercial property tax deductible?
In general, the down payment for a commercial property isn’t tax deductible. The down payment is the preliminary payment made when acquiring a property. The down payment is currently not deductible at this time because it is not recognized as an expense under the U.S. tax code.
However, it’s possible for a portion of the down payment of a commercial property to be tax deductible. For example, if the down payment is made with a loan, the loan interest may be tax deductible.
Because of these subtleties, it is always necessary to consult licensed professionals in your area to determine the best methods to lower your tax burden.
Are Commercial real estate closing costs tax deductible?
Most closing costs on a commercial real estate transaction are not tax deductible. Closing costs are fees and expenses incurred when purchasing a property. They typically include fees for services such as title insurance, legal fees, and real estate broker commissions.
Since these costs are not expenses in the internal revenue code, they are not tax-deductible. However, there may be certain circumstances where a portion of the closing costs on a commercial real estate transaction could be tax deductible, so always consult with a tax advisor to confirm what you can and can’t write off.
3. Reduced Tax Burdens for Beneficiaries
Commercial real estate can provide large tax benefits to an owner’s descendants in addition to delivering tax benefits to the owner. Through various tactics, including the use of trusts, limited liability corporations, and other legal structures, a commercial real estate owner can help lower tax costs for beneficiaries.
For example, by holding the property through a trust rather than the individual beneficiaries, an owner might distribute revenue from the property to the beneficiaries in order to reduce their tax liability.
Similarly, by placing the property under a limited liability business, owners might lower tax obligations for beneficiaries (LLC). Holding property in an LLC can give various benefits, including the opportunity to split revenue and losses from the property among the LLC members in a tax-efficient manner. It can also give liability protection to the LLC’s members, which is especially crucial for commercial real estate ventures.
Finally, suppose an owner passes and leaves the property in a beneficiaries name. In this case, the investor’s beneficiary only needs to pay taxes on the appreciation accumulated during the owner’s life rather than the entire purchase price. For example, suppose an investor purchases a commercial property for $3 million and it appreciates to $4.5 million before the investor dies. In this case, the investor’s beneficiary only needs to pay taxes on the $1.5 million in appreciation, not the total $4.5 million purchase price. This tax benefit can spare the heirs of the investor thousands, or even millions, of cash.
Overall, the potential for reduced tax burdens for beneficiaries is just one of the many advantages of commercial real estate investments. By using the right strategies and taking advantage of the various tax advantages available, investors can help their beneficiaries minimize their tax liability and maximize their returns from the investment.
4. Lower Tax Rate on Capital Gains
Another significant benefit for a commercial property owner during tax time is the opportunity to pay tax on capital gains rather than ordinary income.
Capital gains tax rates are lower than ordinary income tax rates, so being taxed on capital gains rather than ordinary income can reduce an investor’s tax obligation for the tax year and help investors maximize their investment returns. For example, in 2021, the capital gains tax rate for individuals in the highest tax bracket was 20%, while the ordinary income tax rate for the same individuals was 37%. That 17% is a big difference.
Another benefit of being taxed on capital gains rather than ordinary income is that it can provide investors with greater flexibility in terms of when they sell their property. For example, investors can defer paying taxes on the gain until they sell the property. This can allow them to hold onto the property for a more extended period and potentially benefit from additional appreciation in its value.
Capital Gains Exclusions
Capital gains exclusions are another tax benefit available to commercial real estate investors.
Capital gains exclusion allow investors to exclude a certain amount of the gain from selling a property from their taxable income. This can reduce the amount of money investors must pay in taxes for selling the property.
Different types of capital gains exclusions are available to commercial real estate investors. One potential capital gains exclusion is the exclusion for selling a property used for business purposes. Under this exclusion, investors can exclude up to $500,000 of the gain from the sale of the property from their taxable income. This exclusion is available to married couples who file their taxes jointly and individuals who file their taxes as head of household or single.
5. 1031 Exchange
Another potential tax benefit of commercial real estate ownership is using a 1031 exchange. A 1031 exchange, additionally known as a like-kind exchange, is a transaction that allows you to exchange one real estate investment property for another real estate investment property while deferring capital gains taxes.
A 1031 exchange can provide a significant tax benefit because it allows investors to postpone paying taxes on the financial gain from selling the property until later.
For example, if an investor purchased a property for $500,000 and sold it three years later for $600,000, they would have a financial gain of $100,000 and would need to pay taxes on that $100,000. Using a 1031 exchange, the investor can sell the property for $600,000 and use the gain from the sale ($100,000) to purchase a similar property without paying taxes on the $100,000 profit.
The investor will eventually need to pay taxes on the financial gains, but there’s currently no limit to how many 1031 exchanges you can use.
As you can see, a 1031 exchange can help investors manage their overall tax liability. This is because it allows them to defer paying taxes on the gain from the sale of a property until a later date which gives investors more time to plan their taxes and save money.
Note: You must meet several qualifications to utilize a 1031 exchange. For example, the property purchased must be of “like-kind” to the sold property, and the proceeds from the sale must be used to buy the new property within a specific time frame. With this, if you’re considering a 1031 exchange, consult a professional to receive the best guidance on your situation.
6. Opportunity Zones
Opportunity zones are a tax incentive program created by the Tax Cuts and Jobs Act of 2017. The program provides tax benefits to investors who invest in designated opportunity zones, which are low-income communities identified as having significant potential for economic growth.
One of the key tax benefits of opportunity zones for commercial real estate investors is the ability to defer paying taxes on the gain from the sale of a property.
Investors who invest in an opportunity zone can defer paying taxes on the gain from the sale of a property until 2026 as long as they invest the proceeds from the sale in an opportunity zone within 180 days.
Additionally, investors who hold their investment in an opportunity zone for at least five years can exclude 10% of the gain from their taxable income. If they keep the asset for at least seven years, they can exclude an additional 5% of the gain.
7. Federal Tax Credits
Because commercial real estate is a critical component of our economy’s and society’s infrastructure, the federal government of the United States offers a variety of tax credits to promote the upkeep and growth of commercial real estate. The idea behind these tax credit programs is to spur investment capital into areas that will help underserved populations, elevate communities, and promote general economic health at a local level.
The following are some of the most prevalent federal tax credits:
- The Low-Income Housing Tax Credit (LIHTC): The LIHTC program offers tax incentives to real estate investors who build and invest in affordable housing for low-income families.
- The New Markets Tax Credit (NMTC): The NMTC program provides tax incentives to commercial developers and investors who engage in real estate developments located within low-income communities.
- The Rehabilitation Tax Credit (RTC): The RTC provides tax credits to investors who rehabilitate historic buildings. The tax credit is based on a percentage of the rehabilitation costs and can be a significant incentive for investors interested in restoring and preserving historic properties.
- The Energy-Efficient Commercial Buildings Tax Deduction (179D): This program provides tax deductions to investors who renovate and enhance commercial buildings in a way that makes them more energy efficient. The amount of the tax deduction is calculated based on the cost of the improvements and can be a valuable incentive for investors interested in reducing global emissions while simultaneously reducing the energy bill of their building(s).
Real estate investors and developers who strategically incorporate these tax programs into their plans can substantially reduce their tax burden, secure cash to fund their projects, and contribute to the economic stability and growth of local communities.
8. Qualified Business Income Tax Deduction
The Qualified Business Income (QBI) Tax Deduction is a tax benefit introduced as part of the Tax Cuts and Jobs Act of 2017. It allows individuals and businesses to deduct up to 20% of their qualified business income from their taxable income.
Commercial real estate investors must meet specific requirements to qualify for the QBI Tax Deduction. For example, investors must be individuals or pass-through entities (such as a partnership, S corporation, or sole proprietorship) engaged in a qualified trade or business.
9. Commercial Real Estate Losses
While no investor likes to lose money, commercial real estate losses can provide tax advantages. Losses, for example, can be used to offset other types of income, such as wage or company revenue, lowering an investor’s overall tax liability.
One of the most significant advantages of commercial real estate losses is that they can be carried over to subsequent tax years. In other words, even if an investor doesn’t have income to offset in the current tax year, they can utilize their losses to offset their income in future years.
Another advantage of commercial real estate losses is that they can be used to reduce the taxes that investors must pay on their Social Security payments in some cases. This can result in large tax savings for high-income investors who are subject to the Social Security levy on their benefits.
10. Self-Employment Without FICA Tax
When you work for yourself in the United States, you must pay both the employer and employee portions of the Federal Insurance Contributions Act (FICA) tax to cover Social Security and Medicare.
However, income from rental properties is not always categorized as earned income. As a result, full-time, self-employed investors can avoid the FICA tax, often known as the payroll tax, by structuring their business as a corporation or partnership. This is because the FICA tax only applies to wages and salaries, and corporations and partnerships are not subject to this tax.
Here’s a quick look at how this works: Suppose a self-employed individual has a full-time job as a commercial real estate investor and structures their business as a corporation. They can avoid the FICA tax by taking their income as dividends rather than wages or salaries. Dividends are not subject to the FICA tax, which can provide substantial tax savings for the investor.
Alternatively, suppose a full-time, self-employed commercial real estate investor structures their business as a partnership. In this case, they can avoid the FICA tax by taking their income as a share of the partnership’s profits rather than wages or salaries. Profits from a partnership are not subject to the FICA tax, which can also provide significant tax savings for the investor.
If you are interested in pursuing this tax benefit, consult with tax and legal professionals to determine how to do it correctly in your unique situation.
Summary of Commercial Real Estate Tax Benefits
The federal government provides several tax incentives for commercial real estate investors to lower the amount of federal income taxes owed on their federal tax returns.
Whether investing in a multifamily property such as an apartment building or a retail property such as a shopping center, commercial real estate tax incentives can assist in boosting the ROI.