Capital gains taxes play a significant role in the financial considerations of commercial real estate (CRE) investments. Understanding how these taxes work is crucial for investors looking to maximize their returns and plan for tax liabilities when selling a property. In this guide, we’ll explore what capital gains taxes are, how they are calculated, and when it may be beneficial to defer or pay them.
What Are Capital Gains Taxes on Commercial Property?
In simple terms, a capital gain is the profit made from selling an asset, like a commercial property, for more than its purchase price. The IRS classifies commercial real estate as a “capital asset,” and the gain from its sale is subject to taxes.
To understand capital gains taxes, let’s break down the key components:
- Sales Price vs. Cost Basis: The cost basis of a property is the original purchase price plus any improvements made to it. Capital gains are the difference between the sales price and this cost basis, adjusted for factors like depreciation.
For example, suppose an investor purchases a property for $5 million and holds it for five years. During this time, the investor claims $100,000 in annual depreciation, reducing the property’s cost basis to $4.5 million. If the property is then sold for $6 million, the capital gain would be $1.5 million ($6 million sale price minus the $4.5 million cost basis).
Short-Term vs. Long-Term Capital Gains Taxes
The length of time a property is held significantly affects how the gain is taxed. The IRS treats real estate investments like other capital assets such as stocks and bonds.
- Short-Term Capital Gains: If the property is held for less than a year, the gain is classified as short-term and taxed as ordinary income, based on the investor’s regular tax bracket.
- Long-Term Capital Gains: For properties held longer than a year, the gain is considered long-term and taxed at a lower rate. The long-term capital gains tax rate is generally lower than the rate for ordinary income.
Here are the tax brackets for both:
Ordinary Income Tax Brackets:
| Filing Status | 10% Tax Rate | 12% Tax Rate | 22% Tax Rate | 24% Tax Rate | 32% Tax Rate | 35% Tax Rate | 37% Tax Rate |
|---|---|---|---|---|---|---|---|
| Single | $0–$10,275 | $10,276–$41,775 | $41,776–$89,075 | $89,076–$170,050 | $170,051–$215,950 | $215,951–$539,900 | $539,900+ |
| Married Filing Jointly | $0–$20,550 | $20,551–$83,550 | $83,551–$178,150 | $178,151–$340,100 | $340,101–$431,900 | $431,901–$647,850 | $647,850+ |
Long-Term Capital Gains Tax Brackets:
| Filing Status | 0% Tax Rate | 15% Tax Rate | 20% Tax Rate |
|---|---|---|---|
| Single | $0–$41,675 | $41,675–$459,750 | Over $459,750 |
| Married Filing Jointly | $0–$83,350 | $83,350–$517,200 | Over $517,200 |
As the table shows, long-term capital gains are taxed at significantly lower rates than ordinary income, especially for high earners. This creates a strong incentive for investors to hold properties for more than a year to take advantage of these tax benefits.
Important Considerations for Capital Gains Tax Planning
When planning for capital gains taxes, investors need to keep several key factors in mind:
- Depreciation Recapture: Over time, real estate investors can claim depreciation to account for the property’s wear and tear. This deduction reduces the property’s cost basis, which, when sold, results in depreciation recapture. Depreciation recapture is taxed at the ordinary income rate, which is in addition to the long-term capital gains tax on the sale.
For example, if the investor from earlier took $500,000 in depreciation over five years, that amount will be recaptured upon sale and taxed at the investor’s ordinary income rate, regardless of whether the gain is long-term.
Deferring Capital Gains Taxes
One of the major advantages of commercial real estate investments is the opportunity to defer capital gains taxes, which can help investors reinvest their profits and grow their portfolios without immediately incurring a tax liability. There are two primary methods for deferring taxes:
- 1031 Exchange: A 1031 Exchange allows investors to defer capital gains taxes by reinvesting the proceeds from the sale of one commercial property into another “like-kind” property. As long as specific IRS rules are followed, this can enable investors to defer taxes indefinitely.
- Opportunity Zones: The IRS’s Opportunity Zones program incentivizes investment in economically distressed areas by offering preferential tax treatment. Investors can reinvest the proceeds from a property sale into a qualified opportunity zone. Holding the investment for five years can reduce the capital gains tax rate by 10%, and after seven years, the tax rate can be reduced by 15%. If held for 10 years, capital gains taxes are eliminated entirely.
When It Might Make Sense to Pay Capital Gains Taxes
While deferring taxes is a great strategy for many investors, there are situations where paying the tax might make more sense. If investors need the proceeds for immediate personal expenses, such as medical bills or education, paying the taxes might be the best option.
The Importance of Professional Advice
Calculating capital gains taxes and determining the best strategy for your situation can be complicated. Working with a certified public accountant (CPA) or tax advisor is crucial to ensure tax liabilities are correctly managed and minimized. These professionals can help you plan for taxes, understand potential deductions, and ensure compliance with tax laws.
Conclusion
Capital gains taxes are an important factor to consider when selling a commercial property. The tax rate you’ll pay depends on how long you’ve held the property, whether depreciation recapture applies, and whether you’re able to defer taxes through strategies like a 1031 Exchange or Opportunity Zones. By understanding these factors and working with a qualified advisor, investors can effectively manage their capital gains tax liabilities and maximize their returns.
