Investing in commercial real estate offers many unique tax benefits, primarily the ability to claim depreciation deductions on income-producing properties and defer capital gains from the sale of an investment property by completing a 1031 exchange.
Homeowners who sell their personal residences, meanwhile, enjoy a personal residence tax exemption that can shelter as much as $500,000 of sales profits from taxation for married couples. Savvy investors use these strategic benefits to reduce their taxable income, which in turn reduces their tax burden.
These examples of tax shelters apply to real estate, but there are others, including tax-deferred retirement accounts (401ks) and tax-sheltered annuities (403b). In this article we’ll take a look at how investors can calculate a baseline tax shelter on their real property assets.
Three Common Tax Shelters in Real Estate
Direct property ownership provides some substantial tax deductions that can shelter your capital from taxation. Here are three ways you can create a tax shelter on your investment capital.
This is one of the most important real estate tax deductions. Depreciation is an annual decrease in the overall value of your asset as a result of daily usage of the property. The IRS allows a 39-year depreciation window for commercial assets purchased after 1993. Each year, investors are allowed to deduct 1/39th of the costs incurred acquiring and improving their commercial investment assets.
For example, if you owned a commercial property that was acquired for an all-in cost of $10 million, you would be able to deduct 1/39th of that cost, or roughly $256,410, each year. If you held the asset for 10 years, you would be able to deduct more than $2.5 million through depreciation. This significant tax deduction could substantially lower your annual income and drop you into a lower tax bracket, thus sheltering more of your money from taxation.
Investors can take the depreciation deduction for the full basis of their investment. Here’s how to figure your depreciation deduction for commercial properties:
- Find your basis by taking the total cost of the asset and subtracting the value of the land
- Divide your basis by 1/39th. That’s your annual depreciation deduction.
Depreciation deductions also can be taken for residential rentals in service after 1986, and multi-family properties. The “useful life” of these assets is 27.5 years, so the depreciation deduction is 1/27.5 of your adjusted basis.
Investors who sell investment properties often complete 1031 exchanges to shelter their capital gains from taxation. Here’s how the process works:
Investors can defer capital gains, depreciation recapture, and Affordable Care Act taxes on their sale proceeds if they reinvest the funds into like-kind assets. Although the taxes are only deferred, investors can keep swapping investment properties until their death. If they bequeath their real property interests to their heirs, those heirs can receive a one-time step-up in basis that could potentially offset the original deferred tax liability.
Long-Term Versus Short-Term Gains
The length of time you’ve held an investment asset can have huge tax implications when you divest it for a profit.
Long-term capital gains are taxed at much lower rates -- 0, 15, or 20 percent -- than short-term capital gains, which are taxed as ordinary income (as high as 37 percent in 2021).
Simply holding an investment for longer than one year could provide you with a significant tax shelter.
The Bottom Line
Tax shelters can help you minimize both current and future tax liabilities, which preserves your capital and maximizes its leverage. Your trusted financial experts can help you tap into these tax shelters and others to protect and potentially grow your investment wealth.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.