Investing in commercial real estate properties has many known benefits, such as improving your cash flow, diversifying your portfolio, and increasing your overall net worth. However, there are several major advantages to commercial real estate ownership that some people–especially those who are new to the business–may not be privy to, such as tax benefits.
As a general rule, commercial real estate tax benefits are government-set regulations that are designed to help individuals and legal entities such as corporations reduce their overall tax bills. These benefits come in different forms, with the most common being tax deductions and tax credits.
While these two may be similar in that they both essentially reduce the amount you pay to the state, they differ considerably in how they operate. Deductions, for instance, reduce how much of your income is subject to taxes, whereas tax credits directly reduce the amount of taxes you have to pay.
Read on as we lay out everything there is to know about commercial real estate tax benefits, and how you can use them to your advantage.
What are the tax benefits you can get from commercial real estate investments?
Commercial properties provide owners and investors with multiple tax benefits, all of which work to reduce the amount owed annually to both federal and state governments. Here are some of the most common commercial real estate tax benefits that you can enjoy.
- Tax Deductible Expenses for Commercial Properties
The IRS allows commercial real estate owners and investors to write off a wide range of expenses for commercial properties as tax deductions. These include:
- Property taxes
- Mortgage interest
- Property insurance
- Property management expenses
- Advertising expenses
- Energy-efficiency upgrades
- Property upkeep, renovation, and maintenance costs
- Travel expenses related to the business
- Professional fees for accountants, lawyers, and others
- Commercial property depreciation
Much like any other structure, commercial properties such as office buildings and multi-family dwellings are subject to wear and tear over the years, which causes them to steadily depreciate in value. This is something that investors can capitalize on since the Internal Revenue Service (IRS) permits owners and investors to write off depreciation as a tax deduction for commercial properties over a period of 39 years, and residential buildings for a period of 27.5 years, with exceptions.
According to the IRS, commercial real estate property owners and investors can find the value of their property’s annual allowable depreciation expense by using the following formula:
Cost of property – Land value = Basis
Basis / 39 years = Annual allowable depreciation expense
At present, commercial real estate properties that fall into one or more of the following categories can be depreciated, as per IRS regulations:
- Apartments and other income-generating residential properties
- Supermarkets, shopping centers, and other retail spaces
- Office buildings
- Factories, warehouses, and other industrial spaces
- Hotels and motels
Residential rental buildings, on the other hand, are defined as structures that make at least 80% of their profit from housing units.
Furthermore, the IRS also states that you can begin depreciating commercial real estate properties only once they are put into service and start generating income. These properties will then continue to be depreciated until one of the following scenarios occur, whichever comes first:
- The entire basis of the property has been recovered
- The asset has been sold or taken out of operation as an income-producing property.
- Federal Tax Credits
The United States government offers a variety of tax credit schemes that are beneficial to commercial real estate property owners and investors. These include:
- Low-Income Housing Tax Credit (LIHTC) – Established in 1986, the Low-Income Housing Tax Credit (LIHTC) program provides investors in eligible low-income rental properties a dollar-for-dollar deduction from their federal income taxes. The amount of credit that can be claimed is determined by applying a credit percentage to the property’s qualified basis.
- Historic Tax Credit (HTC) – Investors–whether individuals or corporations– who work in rehabilitating historic buildings are eligible for tax credits under The Historic Tax Credit (HTC) program. Instituted in 1971 and more recently amended in 2017, this program grants a 20% tax credit for qualified expenses associated with rehabilitating a building for commercial use. To be eligible, the building must be certified as historic by the National Park Service.
- New Markets Tax Credit (NMTC) – The New Markets Tax Credit (NMTC) program, which was established in 2000, offers tax credits to qualified entities who invest in commercial developments in low income areas.
- Tax deductions for commercial real estate losses
Commercial real estate property owners and investors who incur losses on their investments have a safety net in the form of tax deductions. Presently, investors can file their losses as deductions on their taxable incomes, subject to certain factors such as their income and whether they are working full-time or at least 750 hours a year in the real estate industry.
For instance, commercial real estate property owners and investors who make less than or equal to $100,000 a year can deduct a loss of up to $25,000 against their income. Those who earn anywhere between $100,000 and $150,000 a year, on the other hand, may also take deductions, although at a lesser rate than the former. Properties that earn more than $150,000 annually are not eligible for any deductions.
- Deferred payment of capital gains
Commercial real estate property owners and investors have the capacity to defer tax payments on their property’s capital gains.
As defined by the IRS, capital gains refer to the increase in value of an asset once it is sold, specifically when it is sold for a much higher price than what it was originally paid for. The seller must subtract the original price of the property from its current sales price in order to determine its capital gains, which are then taxed by the state.
Commercial real estate property owners and investors who want to defer payment of capital gains taxes have multiple options, the most popular of which is called a 1031 Exchange.
Also known as a “like-kind exchange,” a 1031 Exchange allows commercial real estate property owners and investors to exchange one investment property–in this case, real estate–for another while deferring capital gains tax that would otherwise be due at the time of sale.
To avail of a 1031 Exchange, here are the steps you should follow:
- Determine the property you want to buy and sell. As stipulated by the IRS, the property you sell and the property you acquire must be “like-kind.” This means that the replacement property must be similar in nature to the relinquished one, although not necessarily of the same overall grade or quality.
- Work with a qualified intermediary.The main premise behind a 1031 exchange is that if you don’t receive any funds from the sale, there won’t be any income for the state to tax. Because of this, investors must work with a qualified intermediary who will hold the proceeds of the relinquished property’s sale in escrow before investing it in its replacement.
- Pay attention to the calendar. There are two rigorous deadlines for 1031 Exchanges that must be met in order to keep your earnings from being taxed. Once you have sold your relinquished property, you have 45 days to find a possible replacement, and another 180 days to close on it.
- Inform the IRS about the transaction.Once you have closed on the replacement property, inform the IRS by filing a copy of IRS Form 8824 alongside your tax return. On that form, you will be asked to indicate the money involved in the transactions, as well as the transaction’s timeline.. You will also be asked to list down every individual involved in the process, and describe the properties that have been sold and bought.
- Pass-through deductions
Also known as a Qualified Business Income (QBI) deduction, a pass-through deduction allows commercial real estate property owners and investors to enjoy an additional tax break of up to 20% on their income. Determining the deductible amount is a rather complex process, so it’s best to consult with your CPA.
Only sole proprietorships, partnerships, S corporations, and some trusts and estates may be eligible for the said deduction, which expires in 2025 alongside other provisions in the Tax Cut and Jobs Act of 2017.
Specialized tax treatment in Arizona
Aside from the commercial real estate tax benefits set by the federal government, commercial real estate property owners and investors in Arizona can also take advantage of the tax treatments adopted by the state.
- Enhanced Commercial Property Depreciation
Since 2011, Arizona has made use of an enhanced additional depreciation formula that allows eligible commercial real estate property owners and investors to apply even more deductions on their property taxes for a limited period of time.
Acting as an incentive for business owners and investors, this tax rule under the Arizona Competitiveness Package allows eligible commercial real estate owners and investors to further diminish their tax liabilities by reducing their property’s total cash value during their first five years of operation: 75% in their first year, 59% in their second year, 43% in the third, 27% in the fourth, and 11% in the fifth.
- Foreign Trade Zones
Another way to save up on taxes in Arizona is to invest in commercial properties located in the state’s many Foreign Trade Zones (FTZ).
Commercial properties located within an FTZ, or a subzone that is activated for FTZ use, are classified as Class 6 and assigned a 5% assessment ratio. This assessment ratio can help investors see a reduction of up to 72.9% in their property taxes, making them more cost-competitive in the long run.
- Opportunity Zones
Commercial real estate owners and investors in Arizona can also choose to invest in Opportunity Zones. Opportunity Zones, according to the 2017 Tax Cuts and Jobs Act, are areas that are “economically challenged,” and need significant investments.
At present, the Opportunity Zones Program allows investors to reinvest their capital gains into the state’s Opportunity Zones. As a way to incentivize investors, significant tax benefits await in these opportunity zones, including:
- Temporary gain deferral – Any capital gain that is invested in an OZF within 180 days is subject to a tax deferral. These include gains from the sale of stocks, real estate, operational businesses, personal assets, and more. Taxes on these gains may be deferred until December 31, 2026, or until the day the investment is sold, whichever comes first.
- Permanent exclusion – If an investment is held for five years in an Opportunity Zone, investors may permanently exclude 10% of the capital gain deferred. If the initial deferred gain is held for at least seven years, the excluded amount rises to 15%.
- Forgiveness of appreciation – If they are able to hold their investment for at least 10 years, investors get to enjoy forgiveness of tax due on any capital gain of their initial OZF investment.
In order to qualify for the mentioned benefits, commercial real estate owners and investors must first meet the following guidelines:
- Investors must use a Qualified Opportunity Fund to make the investment. A privately managed investment vehicle, an “Opportunity Fund” is set up either as a corporation or a partnership, and is dedicated solely to making investments in eligible Opportunity Zones. At least 90% of the fund’s assets must be in this type of property.
- Investors must deposit their capital gains into an Opportunity Fund within 180 days.
Things to consider when investing in commercial real estate
Investing in commercial real estate is one of the most important decisions you can make. After all, commercial real estate is extremely lucrative and is proven to among the most stable items you can add to your portfolio.
That said, it must be noted that investing in commercial real estate can be a complicated affair–especially for beginners. Here are some of the things you have to keep in mind if you are planning to invest in commercial real estate:
- Study the market – Before investing in commercial properties, it is highly recommended that you first study the market. This means taking the time to carefully analyze current and projected federal rate hikes, the latest economic trends, and local market data, among others. Aside from that, you will also have to decide on what type of property to invest in, as well as the risks and benefits that come with each one. Doing this will help you see if the prospect is sound and if it aligns with your overall financial goals.
- Consider your budget and financing – Commercial real estate properties tend to be more expensive than residential properties. One way to finance your investment is to secure funding from lenders. Do note, however, that different types of loans exist for different types of properties and needs, with each one having different eligibility requirements and terms.
Some of the loans you can take out to finance a commercial real estate investment include:
- Small Business Administration (SBA) Loan
- Certified Development Company (CDC) Loan
- Conventional Loan
- Commercial Bridge Loan
- Hard Money Loan
- Conduit Loan
- Do thorough due diligence – Conducting due diligence is an important part of the investment process, as it can help keep you from making potentially expensive mistakes. During this period, you should take the time to look over the property’s records, as well as other related paperwork such as tax returns, profit and loss statements, property inspection reports, and surveys, to see how the property fared before it was sold. You should also conduct feasibility studies and other research during this period to get an idea of how you can make the most out of your prospective investment.
- Work with professionals – From locating properties to purchasing, renovating, and managing them, investing in commercial real estate involves many moving parts, which can get very intimidating and stressful for first-time investors. One way to address this is by working with real estate professionals. Real estate professionals–just like the ones from our team at Prescott Commercial Real Estate (PCRE)–can guide you through the entire process, as well as help protect you from the potential complications and problems that come with owning and managing commercial real estate properties.
Explore your investment options with Prescott Commercial Real Estate today!
Minimize the stress and uncertainty in investing in commercial properties by working with us at Prescott Commercial Real Estate. We are a team of highly experienced brokers, business experts, and other real estate professionals who know the business inside and out.
Equipped with more than 80 years of combined industry experience, in-depth market knowledge, and a keen understanding of real estate processes–not to mention clear and effective communication skills–our team is more than prepared to give you the guidance you need to successfully invest in Yavapai County.
Whether you are looking to invest in apartment complexes, office buildings, warehouses, or retail spaces, we can provide you with impeccable services unlike any other.
Ready to get started with your investment? Get in touch with the Prescott Commercial Real Estate team today at 480.309.1089. You can also send us a message here here or send us an email at Matt(at)prescottcre(dotted)com to schedule a private meeting.