The Commercial Real Estate Investors Guide to Tax Strategy
Tax benefits are a compelling reason to invest in commercial real estate if maneuvered correctly. Strategies like selling on an installment sales basis to defer taxes, avoiding payroll taxes on rental income, or deducting expenses related to ownership are relatively straight forward. There are, however, a few tactics that can exponentially reduce investors' tax exposure. This isn’t a comprehensive list, but rather a glimpse into a few potential approaches commercial owners and investors can leverage.
Very simply, a 1031 exchange allows an investor to defer capital gains taxes by selling, and subsequently buying a like-kind property, with the sale proceeds. IRS tax code outlines several critical requirements for a transaction to be 1031 eligible.
Timeline: Unless investors are prepared to conduct an immediate exchange, most 1031 transactions fall into the category of a delayed exchange. Following the successful sale of a property, an investor has a maximum of 45 days to identify the replacement property and 180 days to complete the purchase.
Definition and scope of like-kind: As long as the exchanged properties are investments, you can transfer almost any type of property. Tax code considers most real estate of the same nature or character, even if they differ in grade or quality. However, there are more stringent requirements regarding the value of the exchanged properties. Identified replacement properties need to follow the 95% and 200% rules.
Benefits of a 1031 exchange:
- Recapture depreciation: When a property is sold, capital gains are calculated based on the original purchase price, plus capital improvements less depreciation. If a property sells for more than its book value, the law requires you to recapture depreciation, which is recorded as ordinary income. A 1031 exchange enables an investor to avoid a substantial increase in taxable income.
- Portfolio consolidation & repositioning: A portfolio with mispositioned, or too any assets can be a drain on time and profitability. 1031 exchanges allow an investor to exchange multiple underperforming properties, roll their cumulative value up, and purchase one asset with the proceeds. This could be beneficial to get out from under management heavy properties with full-service tenants, and transition to often-preferred triple-net and absolute net investments.
- Reduction of Capital Gains: Perhaps most importantly, a like-kind exchange allows the exchanger to reduce their capital gains tax exposure. Often considered an "interest-free loan" from the IRS, an investor would defer the liability instead of paying tax on the transaction and recognize it only when the property is sold for cash.
A cost segregation study is a tool that allows investors to preserve capital and experience significant tax benefits through asset reclassification and accelerated depreciation. Typically, real commercial property depreciates over a 39-year life-span. An investor can lump assets into groups that will depreciate at a much quicker pace by segregating personal property from the building.
Although depreciation is a non-tax expense, placing assets on accelerated schedules of 5,7 and 15 years enables investors to reduce their income tax exposure. Indirectly, a reduction in tax liability will also decrease the associated cash outlay and increase cash inflows.
Cost segregation may not be beneficial to all investors, though. A property owner who consistently operates at a net operating loss should probably avoid the strategy. Conversely, an investor who purchased a building, or an owner with recent capital expenditures, may benefit from deferring their tax burden.
Qualified Business Income (QBI) Deductions
A qualified business income deduction allows eligible taxpayers to deduct up to 20 percent of their QBI, plus 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income.
The QBI component is subject to certain limitations, depending on the taxpayer's taxable income, and does not include capital gains. Recently enacted safe harbor rules allow certain interest in rental real estate to be treated as a trade or business for QBI deduction. Rental real estate that does not meet the requirements of safe harbor may still be eligible for QBI deduction if it qualifies as a section 162 business.
Defined as “economically distressed communities where new investments, under certain conditions, may be eligible for preferential tax treatment," qualified opportunity zones (QOZ) offer a potential tax haven for investors.
The Tax Cuts and Jobs Act of 2017 created opportunity zones to equitably distribute capital investment across the country. For the last hundred years, investment, for the most part, has been uniformly distributed to certain regions, leaving many parts of the country feeling left behind. So instead of using taxpayer funds to spur revitalization, this system aims to promote the investment of trillions of dollars of unrealized gains held by investors.
There are several ways to invest in an opportunity zone:
- Invest in an opportunity fund: An opportunity fund is an investment vehicle that is organized to invest in QOZ property.
- Acquire a QOZ business property: IRS rules dictate precisely what constitutes a QOZ business property. Generally, any property purchased after December 31, 2017, that is used in a trade or business in an opportunity zone, will suffice. If a property is purchased, the owner needs to make “substantial” improvements (double an investor’s adjusted basis in the property after purchase) to the property within the first 30 months.
- Tax deferral: Investors who invest realized gains on asset sales within 180 days can receive substantial capital gain tax incentives.
- Capital gains step up: An investment held for five years is subject to a 10% reduction of the original deferred gain. Investment holdings longer than seven years are subject to a 15% reduction.
- Exclusion: Capital gains on any opportunity zone investment sustained for ten years are permanently excluded from capital gains taxation.
The U.S. tax code is complex. Each strategy is multifaceted, has a distinct but often convoluted set of rules to follow, and is rife with penalties if not adhered to correctly.
The material provided is for information purposes only. For tax or financial advice, you should consult with a licensed tax attorney or certified public accountant concerning your specific needs.