Tax Benefits of Commercial Real Estate

Including commercial real estate in their portfolio provides investors with numerous advantages. Investment properties can bring a reliable stream of passive income through rents and leases. They typically appreciate over time and allow investors to leverage the equity they build to expand their portfolio or finance further improvements. Furthermore, investing in commercial real estate also allows investors to take advantage of numerous tax benefits. 

Here are some of the reasons why investors should consider commercial real estate to benefit from fiscal advantages.  

Commercial Real Estate Depreciation 

Every asset loses some of its value over time, typically due to normal wear and tear. However, commercial real estate investors can deduct depreciation from their taxes as a business expense. Therefore, they can reduce their company’s tax liability. The IRS currently allows property owners to depreciate commercial buildings over a 39-year period and residential buildings over 27.5 years. Investors can accelerate the process even further by taking advantage of the regulations set by the Tax Cuts and Jobs Act of 2017. In place at least until 2025, the new rules allow them to deduct up to 100% of the property’s value as a depreciation deduction in their first year of ownership. 

However, property owners will need to pay back the tax deductions issued from depreciation to the IRS if they decide to sell the property if the sale price is higher than the property’s adjusted cost basis. It is known as depreciation recapture. This can be avoided using the 1032 Exchange, which will be discussed below. 

Tax Deductible Expenses 

Real estate investors can deduct business expenses from their taxes.  

Mortgage Interest 

In commercial real estate, investors can deduct any interest paid on a commercial mortgage from the federal income taxes. It is a particularly lucrative option since commercial loans typically have a higher interest rate than residential mortgages.  

Non-Mortgage Related Expenses 

Investors can also deduct any qualified business-related expenses to lower their taxable income. These expenses may be related to the operation and the management of the property: for example, property management fees, property taxes, condo and HOA fees, cost of repairs and upgrades, and so on. Commercial real estate investors can also deduct expenses related to the running of the business itself, such as marketing cost, office space, supplies, business-related travels, etc.  

Lower Capital Gain Rate Tax Rate 

Investment properties offer an excellent alternative to IRA if investors are planning for their retirement. The long-term capital gain tax rates for commercial real estate are typically lower than IRA or other investment funds rates, usually taxed at the personal rate when withdrawn. If investors start their careers early on, they can often keep more money in their pocket when they decide to sell the property to fund their retirement.  

Pass-Through Deductions 

Commercial real estate offers significant tax incentives for investors but also for their heirs. The beneficiaries of a commercial property only pay taxes on the increased value of the asset from the time of the inheritance if they decide to sell it.  

Tax Incentive Programs 

The government has developed two specific tax codes designed to entice investors to invest in new ventures.  

1031 Exchange 

The 1031 exchange was intended to encourage investors to reinvest their profits earned from real estate deals into new assets. The program allows investors to swap “like-kind” properties of equal or greater value with a certain period of time without recognizing a taxable capital gain.  

Since 1031 exchanges can be used indefinitely, investors can delay paying tax gain as long as they swap properties.  If the investors decide to sell the latest property, they will need to pay their taxes in full.  

Opportunity Zones 

Opportunity zones were designated by the US Department of Treasury in the 2017 Tax Cuts and Jobs Act. These 8700 census tracts are located in low-income or disadvantaged communities. Investors can benefit from multiple tax advantages by investing their assets in commercial real estate or qualified businesses in these selected zones.  

They may choose to delay paying their capital gains until 2026, grow their capital gain by 10% as long as they hold the fund for five years (15% for seven years.) They can even avoid paying capital gains entirely as long as they maintain their investment for over ten years.  

Avoiding FICA Tax 

Many investors are self-employed and must therefore pay both the employer and employee portion of the FICA tax, which covers Social Security and Medicare. However, for real estate investors who own rental properties, the rental income is not classified as earned income. In consequence, investors may be able to qualify for a tax break.  

Federal Tax Credits 

The federal government has instituted several tax break programs for specific categories of real estate investments.  

Among them, the Low-Income Housing Tax Credit (LIHTC) – which may be combined with the Opportunity Zones - provides incentives for investors in qualified low-income properties. The New Market Tax Credit program encourages commercial development in low-income areas. Finally, the Historic Tax Credit (HTC) program focuses on eligible expenses used to repurpose and rehabilitate a historic building for commercial use.  

Tax Deduction on Losses 

Investing in commercial real estate, like other forms of investment, can be a gamble. Although one can always hope that new ventures will be profitable, investors may be able to deduct losses incurred from their investment from their taxes. The maximum amount to be deducted depends on their status (real estate investor or real estate professional) and income.  

Conclusion 

Investing in commercial real estate provides investors with a wide range of tax advantages. These benefits vary widely depending on the type of assets, the status and income of the investors, and many other different factors. To take full advantage of the fiscal benefits of commercial real estate, investors should consult an accountant.