Unlike stocks, bonds and cash equivalents, which are all considered “traditional” investments. Investors have long considered commercial real estate and “alternative” investment. There are several reasons for this classification, including but not limited to the fact that the sector is highly nuanced.
Information about individual assets is not always widely available to the marketplace. Therefore, people consider it “riskier” than other investment options. Real estate also has notoriously high barriers to entry.
That said, the federal government has recognized the risks associated with owning commercial property. In turn, they have made changes to the tax code that make real estate a highly tax-advantaged asset class for those willing to invest.
In this article, we look at the tax benefits for investment property owners. As well as the many benefits of owning commercial property.
By far, the most significant tax benefit of owning rental property is the ability to take “depreciation” deductions. The IRS allows investors to deduct “a reasonable allowance for exhaustion or wear and tear. This includes a reasonable allowance for obsolescence.” In other words, although a property’s actual market value may be appreciating in value.
The IRS allows investors to write off a portion of that value with the understanding that properties eventually physically deteriorate. Depreciation is a way for investors to offset the costs of making property improvements necessary to maintain a building over time. An owner of rental property can use depreciation to reduce the amount of taxes they own on the income generated by the property during that year.
- Commercial Real Estate – 39 years
- Residential Real Estate – 27,5 years
The two methods that are commonly used to depreciate investment property are straight-line depreciation or accelerated depreciation.
Straight-line depreciation is when an investor writes off an equivalent share of the property each year. The IRS allows owners of residential properties to depreciate the property over a 27.5 year period. Commercial properties, such as office buildings or retail centers, are considered to have a 39-year lifespan. Therefore those are depreciated accordingly.
Depreciation is a way for investors to offset
the costs of making property improvements
necessary to maintain a building over time.
Accelerated depreciation is an increasingly popular way for investors to recover the value of property depreciation earlier in the hold period. Using what’s known as a “cost segregation study,”. An investor can front-load the value of their depreciation in the first few years of ownership.
Cost Segregation Study
A cost segregation study essentially assigns a useful life to each individual building component, from individual locks and doors to appliances, HVAC systems and more. Depending on the remaining life of each building component, an investor may fully depreciate a property in just a few years rather than equally over 27.5 or 39 years.
There are practical implications to utilizing accelerated depreciation. For example, an investor who invests $200,000 in an investment property and then front-loads depreciation, may be able to take a $100,000 depreciation deduction the following year. This allows an investor to earn a 50% return on their initial capital investment after the first year of ownership. This is in addition to any cash flow or other dividends collected during that period.
By putting more money back into their pocket sooner, an investor can then redeploy that capital into another investment as he or she chooses.
A few things to note about the depreciation deduction. First, it is important to note that the depreciation can only be used to reduce the income generated by the property. If there is no (or otherwise insufficient revenue) generated during that period, you can only carry forward or backward the depreciation deduction and apply it to income earned in other years.
Second, you can only depreciate real property. This means that the owner can depreciate the value of the building and physical improvements on the land. However, still not the value of the land itself.
Finally, when the property is sold, the IRS may require the owner to pay back some or all of the depreciation deductions taken through a process known as “depreciation recapture.”
The current depreciation recapture rate is 25%. Which is often lower than the taxes an investor would otherwise owe on capital gains if they are in a higher tax bracket.
Mortgage Interest Expense Deduction
The mortgage interest expense deduction, often referred to as simply an “interest expense” deduction. This is a deduction investors can take equal to the amount of mortgage interest they pay each year.
For example, if an investor purchases a $10 million property with a $7 million loan. They might be spending tens of thousands of dollars on interest payments each year. Let’s say, for example, that the mortgage interest expense is $8,000 per month. That translates into a $96,000 interest expense deduction each year.
The interest expense deduction is especially valuable to
anyone with a high-interest rate, or for those utilizing short-term,
more costly construction loans.
Of course, the way loans are structured, most borrowers pay a disproportionately high percentage of interest relative to principle in the first half of property ownership. This makes the interest expense deduction more valuable in the first few years of ownership as loans first begin to amortize.
Enter details to calculate your mortgage interest expense deduction.
To calculate this we divide the maximum debt limit by the remaining mortgage balance, then we take that result and multiply it by the interest paid.
Over the lifetime of the loan, the balance between mortgage payment vs. interest payment begins to flip. The amount of interest paid each year th goes down. Correspondingly, the value of the mortgage interest expense deduction will go down as well.
The interest expense deduction is especially valuable to anyone with a high-interest rate. Or for those utilizing short-term, more costly construction loans.
Non-Mortgage Income Tax Deductions
While owning rental property can be highly lucrative, it also comes with many expenses. These costs are referred to as “non-mortgage income tax deductions,” and all be written off as well.
Non-mortgage income tax deductions include, but are not limited to, the cost of repairs and maintenance, property management, utility bills, travel to and from properties, marketing expenses, attorney’s fees, and more.
Long-term capital improvements. For example major unit renovations or a roof replacement, must be depreciated instead of written off in the year in which the expense occurred.
Qualified Business Income (QBI) Deduction
In 2017, through the Tax Cuts and Jobs Act, the federal government introduced the “qualified business income” (QBI) tax deduction. The QBI deduction, sometimes referred to as the Section 199A or “20% Pass-Through Deduction” allows owners of pass-through businesses to deduct up to 20% of their qualified business income.
Figuring out how to leverage the QBI deduction as an investment property owner can be challenging. This is because rental property is considered to generate “passive income,”. Where these passive activities are typically excluded from the IRS definition of a qualified business or trade.
The IRS requires property owners to prove that the income generated from the property is related to a business and not just the return on an investment.
In order to qualify for the QBI deduction, an individual or entity must be able to show (with documentation) that their involvement in the rental property is “continuous” and “regular”. Their activities associated with the property must be for the sake of earning income or profit.
For those who qualify, the QBI deduction can be significant. It is equal to 20% of the property’s taxable income as calculated before the QBI deduction. Minus any net capital gains. For single filers with more than $207,500 in taxable income, the QBI deduction is limited to the greater of 50% of their share of W-2 income paid out in the business. (OR) 25% of their share of W-2 income paid out of the business PLUS 2.5% of qualified property.
The QBI deduction is set to expire in 2025. This is of course unless further congressional action is taken to preserve this tax benefit associated with owning rental property.
Delayed Payment of Capital Gains Taxes (1031 Exchange)
Another benefit to owning commercial real estate is the ability to take advantage of what’s known as a 1031 exchange. Using a 1031 exchange, investors can defer paying capital gains tax if they roll the proceeds from the sale into another “like-kind” property. Such as another piece of real estate of equal to or greater value.
Many real estate investors will use 1031 exchanges to continue growing their real estate portfolios. This often delays the payment of capital gains tax indefinitely.
Utilizing a 1031 exchange is often difficult. The IRS has strict guidelines that must be strictly adhered to. For example, an investor only has so much time to identify suitable investment properties and then close on that property in order for the proceeds from their sale to maintain their tax-deferred status.
Investors who rush a sale without taking the proper steps to line up the pieces needed for a 1031 exchange may find themselves subject to significant tax bills if their sales proceeds lose that tax-deferred status.
Many real estate investors will use 1031 exchanges to
continue growing their real estate portfolios,
often delaying the payment of capital gains tax indefinitely.
One of the primary benefits to using a 1031 exchange is that the tax savings associated with not having to pay capital gains tax in the short term allows investors to reinvest into other assets that allow them to grow their investment portfolios faster than if they were paying taxes after the sale of each individual property.
For example, an investor who might have been facing a $50,000 capital gains tax bill can instead use a 1031 exchange to invest that $50,000 into another like-kind property (in addition to the sales proceeds) which allows them to scale their rental portfolio.
Stepped-Up Basis for Beneficiaries
Another tax benefit associated with owning rental property is that a person’s heirs will often inherit property at a stepped-up basis.
Let’s consider an investor who uses 1031 exchanges for multiple property transactions. Over a person’s 30-year investment career, they may have deferred paying capital gains tax on multiple sales. In the process, they’ve grown their rental portfolio. Typically, if an investor eventually sells their property, they would then be forced to pay some or all of the deferred capital gains.
However, if those properties are held in a trust for the benefit of someone else, then when an investor passes away, the beneficiaries inherit the property at what’s called a “stepped-up” basis. Essentially, the IRS resets the value of the property to market rates. In that case, the investor will only owe capital gains taxes on the increase in value above the stepped-up basis.
For instance, an owner who may have otherwise owed $5 million in capital gains taxes if they were to sell their portfolio can instead pass these properties onto their heirs. Then those individuals can immediately resell the property on a stepped-up basis without having to pay these taxes at all. In other words, heirs can inherit property virtually tax-free.
Given the many tax benefits associated with owning commercial real estate, it’s no wonder the asset class has grown in popularity over the years. Investors can make their dollars stretch further by taking advantage of these savings. Compared to investing in traditional asset classes, like stocks, bonds or other equities.
Of course, navigating all of these tax benefits is no easy task. Real estate investors are always advised to consult with a CPA or tax attorney. Simply to ensure they are following all proper regulations when trying to leverage these cost-saving tools.
Another option is to invest with a qualified real estate sponsor. Someone who can help outline the relevant tax benefits for individual, passive investors. A sponsor will track all income and expenses on behalf of investors. Making navigating these deductions significantly easier come filing time.
Interested in learning more? Contact us today to learn about Smartland’s investment platform.