Are you a commercial property owner looking for an effective tax strategy? You’re not alone. Each year, millions of business owners seek to maximize their deductions and increase their income through the proper use of taxes. While creating and implementing a sound tax plan can be complicated, there are relatively simple steps you can take to ensure that your investments generate the most favorable tax benefits.
From understanding the different types of deductions available to make sure you qualify for each deduction, this blog post will outline some key strategies aimed at making sure your commercial property yields maximum return with minimal taxation. So if you’re ready to make sure your investment is working in its fullest capacity, read on!
To optimize tax strategies for commercial property owners, consider leveraging depreciation to offset income, utilizing interest deductions on loans, deducting operating expenses, repairs, and improvements, offsetting gains with losses through ‘like-kind’ exchanges, maximizing tax credits (such as those related to energy efficiency), and exploring the benefits of Opportunity Zones for deferring tax on capital gains.
Key Takeaways
- Tax laws related to commercial property ownership can be complex, but understanding them can lead to substantial tax savings.
- Utilizing advanced tax strategies such as 1031 Exchanges, cost segregation, and opportunity zones can further reduce tax liability and maximize returns.
- Engaging a professional tax advisor who understands the specific needs of commercial property owners can be invaluable in navigating tax laws and implementing effective tax strategies.
Table of Contents
Understanding the Basics
Owning commercial property can be a profitable endeavor, but it also involves intricate tax implications. Knowledge of relevant tax laws is crucial to managing your expenses effectively, optimizing your income, and minimizing your tax liabilities. Here are some key concepts and tax strategies for commercial property owners:
- Depreciation: The IRS allows commercial property owners to write off the value of the property over time due to wear and tear, decay, or obsolescence. This is a non-cash expense that decreases taxable income. For most commercial real estate, the depreciation period is 39 years. However, certain improvements or parts of the property may depreciate over a shorter timeframe, which can offer tax benefits sooner.
- Capital Gains Tax and 1031 Exchanges: When you sell a property for more than you purchased it for, you generally must pay capital gains tax on the profit. However, Section 1031 of the Internal Revenue Code allows property owners to defer paying capital gains tax if they reinvest the proceeds in a similar “like-kind” property. This process, known as a 1031 exchange, can be a powerful strategy for wealth building and tax deferment.
- Opportunity Zones: An Opportunity Zone is a designated area that provides tax benefits for property owners who invest and hold their capital gains in these zones. Property owners can defer capital gains taxes until 2026 (or until they sell their property), reduce the tax they owe by up to 15% after 7 years, and pay no tax on gains earned from an Opportunity Zone fund if they hold the investment for 10 years.
- Mortgage Interest Deduction: Interest on a mortgage for commercial property can typically be deducted from your taxable income, reducing your overall tax bill.
- Cost Segregation Study: A cost segregation study is a valuable tool that identifies and reclassifies personal property assets. By doing so, it effectively shortens the depreciation time for tax purposes, leading to a reduction in current income tax obligations. While this advanced tax strategy requires professional assistance, it offers substantial tax savings.
- Property Tax Deductions: Commercial property owners can usually deduct the amount they pay in property taxes during the tax year.
- Carry Forward/Backward Losses: If your expenses exceed your income from the property in any given year, you may have a net operating loss. The IRS allows you to apply this loss to past or future tax years to offset income, which can result in a tax refund or reduced tax liability.
Understanding and effectively implementing these tax laws and strategies can significantly improve the profitability and cash flow of your commercial real estate investments. However, the complexity of these laws underscores the importance of seeking advice from qualified tax professionals, such as Certified Public Accountants (CPAs) or tax attorneys, to ensure you comply with all applicable rules and regulations and maximize your tax benefits.
Common Tax Deductions for Commercial Property Owners
Income Tax Deductions for Depreciation
Similar to any other physical asset, commercial real estate gradually depreciates over time. As a result, investors are allowed to deduct a certain amount from their annual income taxes to account for this depreciation. Currently, the IRS allows owners to depreciate commercial buildings over a span of 39 years, whereas residential buildings can be depreciated over 27.5 years. As an illustration, if an investor buys a commercial building valued at $5 million, they can deduct approximately $128,000 each year as depreciation expenses.
Interest Expense Tax Deductions
One of the key tax advantages of commercial real estate is the ability to deduct the interest paid on a commercial mortgage from your federal income taxes. For example, if a borrower pays $10,000 per month for a commercial real estate mortgage, with $2,000 of that being interest, they can claim a mortgage interest tax deduction of approximately $24,000 for that year. This can have a significant impact, especially when using higher-interest financing like a construction loan.
Tax Credits: The Low-Income Housing Tax Credit (LIHTC), Historic Tax Credit (HTC), and New Markets Tax Credit (NMTC) Programs
Beyond the Opportunity Zones program, the federal government has further initiatives that offer attractive tax advantages to the right investors. One such initiative is the Low-Income Housing Tax Credit (LIHTC) program. This program rewards investors in qualified low-income properties with a dollar-for-dollar deduction on their federal income tax. In some instances, investors can synergize the LIHTC program with the Opportunity Zones initiative to optimize their return on investment.
Additional tax credit programs include the Historic Tax Credit (HTC) program, which grants a tax credit corresponding to a percentage of eligible expenses incurred during the commercial rehabilitation of a historic building. There’s also the New Markets Tax Credit program, which furnishes a tax credit for commercial development projects in low-income regions. These programs, due to their competitive nature, tend to be utilized predominantly by institutional investors and funds rather than by individuals.
Given this landscape of diverse and nuanced tax benefits, it’s imperative for commercial real estate investors to collaborate with a seasoned tax professional. Such a partnership can facilitate a deeper understanding of how these tax benefits could work for each investor’s unique circumstance. Navigating the labyrinthine world of real estate taxes can indeed be complex. Still, the energy invested in thorough preparation and meticulous documentation can yield significant financial savings in the long run. Moreover, it can help investors sidestep the unwelcome scenario of a potentially challenging encounter with the IRS.
Advanced Tax Strategies
1031 Exchanges
The 1031 exchange represents a remarkable opportunity for commercial real estate investors to strategically navigate the world of taxation. By leveraging the provisions of this mechanism, investors can defer their capital gains tax obligations to the IRS, provided they reinvest in a “like-kind” commercial property within a specified timeframe.
In essence, the replacement property should hold an equal or higher value than the relinquished one, and it’s important to note that the investor’s primary residential property doesn’t qualify for this exchange.
Interestingly, the 1031 exchange does not confine investors to swap identical asset types. For instance, a mixed-use property that accommodates both apartments and retail outlets can be exchanged for a full-scale shopping center. The versatility of this regulation can unlock new avenues of investment and expansion for savvy commercial real estate stakeholders.
However, it’s crucial to remember that a 1031 exchange isn’t a permanent escape from capital gains tax. While it offers an effective method of deferring tax, the due amount is payable in full once the new property is eventually sold. This aspect doesn’t detract from the overall appeal of a 1031 exchange, as it doesn’t preclude investors from initiating another round of exchange post-sale.
This cyclic process of ‘exchange, defer, and repeat’ makes the 1031 exchange a powerful tool in the arsenal of commercial real estate investors, helping them manage their tax liabilities and optimize their investment growth over time. As always, it’s advisable to engage professional tax advisors to navigate the intricacies of this process effectively.
Cost Segregation
Cost segregation is a tax strategy that allows commercial property owners to accelerate depreciation deductions, reducing tax liability in the short term. It involves identifying and separating personal property assets and land improvements from the overall real property, which can be depreciated over a shorter time frame.
For example, suppose you own a commercial office building. In this case, the building structure may depreciate over a 39-year life. However, through a cost segregation study, you can identify assets like carpeting, landscaping, and specialty electrical systems that can be depreciated over 5, 7, or 15 years. This accelerated depreciation allows you to significantly increase your tax deductions, especially in the early years of property ownership.
Qualified Opportunity Zones
Established by the Tax Cuts and Jobs Act of 2017, the Opportunity Zones program emerged as an innovative measure aimed at promoting investment within some of the most economically disadvantaged communities across the United States. This unique program offers individuals the ability to defer eligible capital gains until December 31, 2026, under one crucial condition – they must invest in an Opportunity Fund.
This Opportunity Fund isn’t an ordinary investment platform. It’s a specialized financial vehicle mandated to allocate at least 90% of its assets to commercial real estate or qualified businesses within specific geographical zones. These areas, comprising around 8,700 census tracts, are officially designated as Qualified Opportunity Zones.
The benefits of investing in Opportunity Zones extend beyond capital gains deferral. Investors can also unlock a 10% reduction in their capital gains tax basis if they demonstrate a commitment to their investments by retaining them for a minimum of five years prior to the end of 2026. This incentive increases for long-term investors, with an additional 5% reduction in capital gains tax basis offered to those who maintain their investment for at least seven years.
Also, I wrote an article about Reducing Taxes on Commercial Real Estate: Strategies & Tips, which explains the various strategies you can employ to reduce taxes on commercial real estate investments.
The Role of a Tax Advisor
Role of a Tax Advisor
A tax advisor, also referred to as a tax consultant, is a financial expert skilled in tax law. Their main role is to assist individuals and businesses understand and comply with tax legislation. The specific roles of a tax advisor can include the following:
- Planning and Compliance: Tax advisors assist in tax planning to ensure you take full advantage of tax benefits while remaining compliant with the law. They help in understanding new tax regulations, and preparing and filing tax returns accurately and timely to avoid penalties.
- Advice on Tax Issues: They offer advice on a variety of tax-related topics. For instance, they can guide on the tax implications of major business decisions such as mergers, acquisitions, or expansions.
- Representation: If the Internal Revenue Service (IRS) or other tax authorities raise issues or conduct audits, tax advisors can represent clients, helping them to understand their rights and obligations and navigate the complex process.
- Forecasting and Strategy: Tax advisors can also assist in forecasting future tax liabilities based on potential business decisions or changes in tax law, thus helping to shape business strategy.
Importance of Having a Professional Tax Advisor
Having a professional tax advisor can bring several benefits:
- Savings: They can help to identify legal deductions and credits you may not be aware of, potentially saving substantial amounts of money.
- Time-Saving: Understanding tax law can be complex and time-consuming. A professional tax advisor can take care of this, allowing you to focus on other things.
- Avoiding Penalties and Legal Issues: By ensuring compliance with tax laws and timely filing, a tax advisor can help avoid costly penalties and legal complications.
- Peace of Mind: Knowing that a professional is handling your tax matters can provide peace of mind, especially if you’re dealing with complex issues or large amounts of money.
How to Choose the Right Tax Advisor
Choosing the right tax advisor is crucial. Here are some factors to consider:
- Credentials and Experience: Ensure the tax advisor is certified and experienced in your specific needs. For instance, a Certified Public Accountant (CPA), an Enrolled Agent (EA), or a tax attorney might be suitable based on your circumstances.
- Specialization: If you have specific needs (like international business operations, self-employment, and real estate investments), find a tax advisor with experience in that area.
- Reputation: Check reviews, ask for references, and consider their reputation in the field.
- Fees: Understand their fee structure. Some may charge per service, while others may charge an hourly rate.
- Communication: Your tax advisor should be someone you feel comfortable communicating with. They should be able to explain complex tax issues in a way you can understand.
Remember, the goal is to find a tax advisor who is not only knowledgeable and experienced but also fits your personal or business needs.
Tax Strategies for Commercial Property Owners FAQs
Can I use qualified opportunity zones to reduce my tax liability?
These zones, which were established as part of the Tax Cuts and Jobs Act of 2017, offer investors a chance to defer or reduce their capital gains taxes by investing in designated low-income communities. Not only can this strategy help to lower your tax bills, but it can also support economic development in these underinvested areas. Of course, investing in any opportunity zone should be carefully considered and researched before any commitments are made.
How does a tax advisor help with my commercial property tax strategy?
They can provide valuable assistance in developing a tax strategy that minimizes your property tax liability. A tax advisor can analyze your property’s value, suggest ways to increase your deductions and exemptions, and help you navigate the appeals process if necessary. They can also keep you up-to-date on changes in tax laws that could affect your property tax liability.
How do I choose the right tax advisor?
Choosing the right tax advisor can be a daunting task, but it is crucial for your financial success. The first step is to determine your specific needs, whether it be tax preparation, planning, or auditing. You should also consider the advisor’s credentials and experience, as well as their fee structure and availability. Look for an advisor who is knowledgeable, trustworthy, and a good communicator. Consider asking for references from previous clients and reading online reviews before making a decision.
What are the common tax deductions available to me as a commercial property owner?
As a commercial property owner, you can generally deduct mortgage interest, property taxes, operating expenses, depreciation, and repairs. Additionally, you may qualify for deductions related to insurance, utilities, property management fees, and certain improvements, known as capital expenditures. Always consult a tax professional to understand your specific circumstances.
How else can tax planning help reduce my liability?
Tax planning is a great way to optimize your financial situation and potentially reduce your overall liability. Some strategies that could be considered include utilizing deductions for dependents, taking advantage of retirement savings plans, transferring assets between family members, and establishing trusts.
Conclusion
Commercial property owners should be aware of the many tax strategies available to help lower their overall tax burden. By utilizing 1031 exchanges, cost segregation, and opportunity zones, they can maximize their returns and reduce their liability. Additionally, working with an experienced professional who is knowledgeable in the specific area of commercial property ownership can be key in successfully navigating through the maze of tax laws. When considering which steps to take in order to make the most out of commercial property investing while minimizing associated taxes, engaging a qualified expert should always be part of that decision-making process.
If you’re seeking assistance related to your commercial investments’ taxes, don’t hesitate to reach out for help. Call or Schedule a free consultation with me today — I am a real estate professional specializing in providing sophisticated yet practical tax advice that will have a positive impact on your bottom line!
