Tax on Commercial Real Estate: What You Need to Know

Taxes play an important role in determining the profitability of commercial real estate investments. Understanding the various types of taxes involved and the strategies to minimize tax liability will significantly impact an investor’s financial success.

This article will guide you through the world of tax on commercial property, including property tax, federal income tax, state and local taxes, and capital gains taxes. We will also discuss the benefits of working with tax professionals and strategies, such as 1031 exchanges and opportunity zones, to reduce your tax burden and maximize your investment returns.

Commercial Real Estate Tax Takeaways

• The impact of taxes on commercial property is significant and greatly affects an investor’s profitability. From property tax, federal income tax, state and local taxes to rental or sales tax, each has a unique impact and requires careful planning for optimizing financial benefits.
• Strategic planning of expenses and using tax incentives such as 1031 exchanges and Opportunity Zones greatly reduces tax liability. These strategies not only defer capital gains taxes on commercial real estate but also contribute to the economic revitalization of low-income communities, making them a win-win for commercial real estate investors.
• Working with knowledgeable tax professionals is important to navigate the complex landscape of commercial real estate taxation. A qualified tax professional helps identify potential tax risks, optimize tax planning, and ensure compliance with tax laws and regulations. Regular consultation with a tax professional keeps commercial real estate investors informed about tax implications and strategies throughout the investment process.
• Understanding the various taxes on a commercial investment property, and the strategies to manage them, is essential for anyone looking to invest in commercial real estate. This knowledge is power in staying informed about the ever-changing tax landscape, making informed decisions, and maximizing investment returns.

Tax on Commercial Property

Investing in commercial real estate comes with myriad tax implications that affect the profitability of your investments. The primary taxes on commercial property include:

• Property tax
• Federal income tax
• State and local taxes
• Rental or sales tax

Each of these taxes uniquely impacts the commercial real estate investor’s bottom line and requires careful tax planning to optimize the financial benefits.

For commercial property owners, comprehending these numerous taxes is key to managing investments and adapting to the dynamic tax landscape.

Property Tax

Commercial property owners must give considerable attention to property tax. It is calculated based on the property’s assessed value, which considers recent similar property sales, improvements made, and sometimes the income generated by the real estate. Generally, commercial property taxes are higher than residential property taxes, making it an essential factor in evaluating the profitability of a commercial real estate investment.

The revenue collected from property taxes is used to fund essential community improvements, such as schools, roads, and infrastructure. Therefore, monitoring property tax obligations is vital for both financial planning and acknowledging your contribution to the broader community.

Bear in mind property tax rates and assessment methods differ among jurisdictions; hence, staying informed on your area’s specific tax laws is important when you pay taxes.

Federal Income Tax

Another tax of importance for commercial property owners is the federal income tax. This tax is levied on the net income or profit generated from the property. Maximizing your expenses, such as maintenance and repairs, decreases the net income subject to federal income tax and thereby reduces your tax liability. Property owners need to pay federal income tax on time to avoid penalties.

Note that security deposits held by the property owner are not considered income for federal income tax purposes. As a commercial property investor, understanding the nuances of federal income tax and strategically planning your expenses helps you minimize the impact of this tax on your investment returns.

State and Local Taxes

State and local taxes on commercial properties are typically computed like federal taxes. These taxes include property taxes, state income taxes, and local taxes such as sales or business taxes. The rate of these taxes depends on the local property tax rate set by the municipality or jurisdiction in which the property is situated.

In many scenarios, commercial property owners mitigate the impact of these taxes on their bottom line by passing state and local taxes onto tenants. Awareness of your area’s specific state and local tax laws is vital for efficient tax planning and sustaining a profitable commercial real estate investment.

Rental or Sales Tax

Some states and cities collect rental or sales tax as a percentage of the monthly rent collected from commercial properties. This tax is calculated based on the gross income generated from the property. Commercial property owners can pass these rental or sales tax costs onto their tenants, which helps alleviate the overall tax burden.

Tenants are responsible for paying customers’ rental or sales tax directly to the state and city. As a commercial property owner, understanding your jurisdiction’s rental or sales tax laws and ensuring your lease agreements accurately reflect the responsibility of both parties regarding these taxes is crucial.

Capital Gains Taxes on Commercial Property

Capital gains taxes on commercial property sales significantly impact your investment returns when the property is sold. These taxes are imposed on the profit derived from the sale of the property, with the applicable tax rate depending on the duration of ownership and the amount of gain realized.

This section will discuss the distinction between short-term and long-term capital gains taxes and the impact of capital gains tax calculations on commercial real estate investments.

Short-term vs. Long-term Capital Gains

Short-term capital gains taxes apply to profits made on the sale of a property held for less than one year, while long-term capital gains taxes apply to properties held for more than one year. The key distinction between these two capital gains taxes is their tax rates. Short-term capital gains are taxed as ordinary income at the investor’s regular income tax rate, while long-term capital gains are taxed at a lower rate to encourage long-term investment.

For example, single tax filers with incomes below $41,675 are eligible for the zero percent long-term capital gains tax rate, while the maximum long-term capital gains tax rate is 20%.

Comprehending the distinction between short-term and long-term capital gains taxes is key for commercial property investors to make informed decisions about property sales timing and potential tax implications.

Calculating Capital Gains Tax

Calculating capital gains tax on commercial property involves the following steps:

1. Determine the difference between the sale price and the cost basis, which includes the purchase price and any improvements made to the property.
2. The resulting capital gain is subject to capital gains tax.
3. The capital gains tax rate depends on the investor’s taxable income and marital status.

Commercial property investors should consult a tax professional to ensure accurate capital gains tax calculation and explore potential strategies for deferring or minimizing this tax burden. This may include utilizing 1031 exchanges or investing in opportunity zones, which will be discussed in the following sections.

Tax Benefits of Commercial Real Estate Investment

Commercial real estate investments offer several tax benefits that improve overall returns for commercial real estate investors, including depreciation deductions, mortgage interest deductions, and tax advantages for heirs.

Comprehending these tax benefits and designing your investment strategy for their full utilization will significantly impact your financial success in the commercial real estate market.

Depreciation Deductions

Depreciation deductions are a valuable tax benefit for commercial property investors. They allow investors to offset a portion of their income taxes each year due to the wear and tear on the property. This can lower the taxable income and, consequently, reduce the overall tax liability of the investor.

The real estate investment property’s cost basis is decreased by the depreciation taken annually. This lowers the overall value of the asset. However, be aware that triggering depreciation recapture can diminish investment returns, as the accumulated depreciation is taxed at the investor’s regular income tax rate rather than the capital gains tax rate upon property sale.

Mortgage Interest Deductions

Mortgage interest deductions are another tax benefit for commercial property investors. Investors can use deductions to reduce the federal income tax they must pay. This includes any interest incurred on their commercial mortgage. Investors lower their taxable income and reduce their overall tax burden by taking advantage of mortgage interest deductions.

For example, if a commercial real estate investor pays $10,000 in interest on a commercial mortgage, they deduct that amount from their federal income taxes. This tax benefit significantly improves the overall returns on commercial real estate investments and should be considered when planning your investment strategy.

Tax Advantages for Heirs

Heirs of commercial real estate investments also benefit from tax advantages. When inheriting a commercial property, heirs may be subject to a “step-up” in cost basis, which allows them to value the property at its current market value upon inheritance. This means that when the heirs sell the property, they will only be liable for capital gains tax on the appreciation in value from the time of inheritance rather than from the original purchase price.

In addition to the stepped-up basis, heirs can benefit from the ability to pass on the property without incurring capital gains taxes. Passing on property significantly reduces the tax burden for heirs and maximizes the value they receive from the inherited commercial property.

Strategies to Reduce Tax Liability

Investors can understand and manage taxes on commercial property and implement strategies that allow investors to defer their tax liability and enhance their investment returns. Two popular methods for deferring capital gains taxes are utilizing 1031 exchanges and investing in opportunity zones.

These strategies warrant a more detailed exploration.

1031 Exchanges

A 1031 exchange is a powerful strategy for commercial property investors looking to defer capital gains taxes. It allows investors to:

• Exchange their property for a like-kind commercial property within a specified time frame
• Effectively postpone the capital gains tax liability
• Reinvest in like-kind properties
• Potentially defer their capital gains taxes indefinitely

However, there are strict rules and regulations governing 1031 exchanges, making it crucial for investors to work with a qualified intermediary and consult a tax professional before initiating the process.

Careful planning and execution of a 1031 exchange enables commercial property investors to maximize their tax benefits and enhance their investment returns.

Opportunity Zones

Opportunity zones offer another attractive strategy for investors seeking to reduce their tax liability. These zones are designated low-income areas throughout the United States that offer tax incentives for investors who invest in them. The benefits of investing in opportunity zones may include the deferral of capital gains taxes and the potential elimination of taxes if the investment is held for 10 years or more.

To invest in an opportunity zone, investors must establish a qualified Opportunity Zone Fund and invest in a property within a designated zone. This strategy provides significant tax advantages for commercial property investors and contributes to the economic revitalization of low-income communities.

Working with Tax Professionals

Navigating the complexities of taxes on commercial property is challenging. Therefore, working with tax professionals who assist in maximizing tax benefits and reducing liability is important.

This section will explore the importance of selecting the right tax advisor and maintaining continuous consultation with a tax professional throughout the investment process.

Choosing the Right Tax Advisor

Choosing the right tax advisor is crucial to receiving expert guidance on the nuances of commercial real estate taxation. A qualified and experienced tax professional can help you:

• Navigate complex tax laws
• Identify potential tax risks
• Optimize your tax planning to maximize your investment returns and minimize tax liabilities.

To confirm the experience and credentials of a commercial real estate tax advisor, you can:

• Verify their enrollment as an agent licensed by the IRS
• Examine certifications specific to commercial real estate tax advising
• Validate their credentials through the IRS Directory of Federal Tax Return Preparers with Credentials and Select Qualifications.

Engaging a qualified tax advisor ensures you receive the best guidance and support throughout your commercial real estate investment journey.

Importance of Ongoing Consultation

Continuous consultation with a tax professional is key to staying informed about tax implications and strategies throughout the investment process. Tax laws and regulations are subject to frequent changes, making it essential to stay up-to-date and seek advice before making significant decisions, such as selling a property or optimizing tax deductions.

Regular consultation with a tax professional helps investors navigate the intricacies of commercial real estate taxation and ensure compliance while optimizing their tax strategies. By maintaining an open line of communication with your tax advisor, you can make informed decisions that align with your financial objectives and maximize the potential of your commercial real estate investments.

Summary

Understanding and managing the various taxes on commercial property is essential for anyone looking to invest in this lucrative market. By familiarizing yourself with property tax, federal income tax, state and local taxes, and capital gains taxes, you can make informed decisions that maximize your investment returns and minimize your tax liabilities. Utilizing strategies such as 1031 exchanges and opportunity zones and working with qualified tax professionals further enhances your financial success in the commercial real estate market. Remember, knowledge is power, and staying informed about the ever-changing tax landscape is crucial for optimizing your commercial real estate investments.

What is the tax basis of commercial real estate?

The tax basis of commercial real estate is the original purchase price plus any out-of-pocket expenses or closing costs related to the acquisition. This is also known as “cost basis” or “tax basis”.

How much is capital gains tax?

Capital gains taxes are generally owed on the profits from the sale of investments held for at least one year. The tax rate is 0%, 15%, or 20%, depending on your taxable income, with higher earners paying more. Most people pay no more than 15% on their long-term capital gains.

Do commercial renters pay property tax?

In a single net lease, commercial renters pay property taxes as they are responsible for their portion of the tax burden in addition to rent and other costs associated with their unit.

Are commercial property taxes higher than residential?

Commercial property taxes are typically higher than residential taxes due to commercial real estate’s higher assessed value and ability to generate income.

What is the primary difference between short-term and long-term capital gains taxes?

Short-term capital gains are taxed as ordinary income at the investor’s regular income tax rate, while long-term capital gains are taxed at a lower rate, providing an incentive for long-term investment.