There can be significant advantages to owning investment real estate, including reducing taxable income with business expenses, depreciation, and amortization. Unfortunately, what the IRS gives, it also eventually takes back.
In this article, we’ll discuss capital gains tax, how to calculate potential capital gains tax liability, and ways commercial real estate investors can minimize the impact of tax on capital gains.
What is a capital gain?
When a capital asset such as investment real estate is sold at a higher price than its adjusted basis the result is a taxable capital gain. There are three important terms to understand about capital gains tax:
- A capital asset includes shares of a stock, a business, or real estate.
- Adjusted basis is the original price of the asset, including commissions and improvement costs, less depreciation.
- Long-term capital gains come from assets that are held for more than one year, while short-term capital gains are from assets held one year or less.
How are capital gains taxed?
Capital gains are taxed at both the state and federal level.
Short-term gains for assets held less than one year are taxed as ordinary income. The tax rate for long-term capital gains is much lower (up to 20%), depending on income and filing status.
Realized has put together an interactive Capital Gain Tax Rates by State that provides the current combined state & federal top marginal tax rates on capital gains to make understanding state-level capital gains rates less complicated.
How to calculate capital gains
Calculating your capital gains tax on commercial real estate isn’t a simple matter of subtracting your acquisition price from your sales price. You first need to figure out your cost basis and net proceeds, and also factor in depreciation recapture taxes over the holding period of the investment.
Here’s an example of how to calculate capital gains tax for an investment property with the variables provided below:
- Purchase price: $1,000,000
- Sales price: $1,200,000
- Depreciation: $200,000
First, you must figure your taxes for depreciation recapture. This amount will be imposed on the gain due to depreciable property, and will typically be taxed at a flat rate of 25%. In this case, that number will be $200,000 taxed at a 25% tax rate, or $50,000.
Next, you will figure your federal capital gains. This amount will be calculated off of your gain due to the appreciation of the property, and will be taxed at a rate of 0%, 15%, or 20%. Using the uppermost tax rate, you will be liable for $40,000 of capital gains ($200,000 X 20%)
In total, you will be liable for $90,000 in capital gains tax if you’re in the upper-most tax bracket, not including the state tax rate or the Section 1411 Medicare Surtax (if applicable).
Ways to minimize & avoid paying capital gains tax
The Office of Tax Analysis at the U.S. Department of the Treasury tracks the amount of taxes paid on capital gains. In 2014, the most recent reporting year available from the Office, Americans paid more than $139 billion in capital gains tax. That’s just over 4% of the nation’s GDP.
If you sell commercial real estate and have a capital gains tax liability, one option is to pay the tax. However, just because other real estate investors choose to pay capital gains tax, it doesn’t mean that you have to.
Here are three of the best ways to minimize and even avoid paying tax on capital gains:
#1 Conduct a Section 1031 tax-deferred exchange
Section 1031 of the Internal Revenue Code allows real estate investors to relinquish or sell one property, acquire or buy another like-kind property, and defer paying capital gains.
There are specific rules to follow when conducting a 1031 exchange. Investors hire a Qualified Intermediary (QI) as a third-party facilitator to ensure the process follows IRS rules, and the transaction remains tax-free.
#2 Invest in a DST or TIC
Delaware Statutory Trusts (DST) and Tenant-In-Common (TIC) properties are two proportional ownership structures recognized by the IRS for use in a 1031 exchange.
Under a DST, each investor holds title to real property through a beneficial interest in the trust, which qualifies as real property ownership. A TIC investment is real estate that is co-owned with other investors as a tenancy in common.
#3 Invest in a Qualified Opportunity Zone
The Tax Cuts and Jobs Act of 2017 created Opportunity Zones, where new investment is eligible for preferential tax treatment. There are over 8,700 Qualified Opportunity Zones (QOZ) in all 50 states and four U.S. territories. The U.S. Department of the Treasury Community Development Financial Institutions Fund (CDFI) has compiled a visual map of the census tracts designated as QOZs.
Tax benefits of investing unrealized capital gains in Opportunity Zones are:
- Temporary deferral of taxes on previously earned capital gains through 2026 or when the asset is sold
- Basis step-up of previously earned capital gains tax invested between 10% and 15% for investments held for at least seven years
- Permanent exclusion of taxable income on new gains on investments held at least 10 years
Important things to remember about capital gains tax
Capital gains tax can significantly reduce the profitability of a commercial real estate investment. Fortunately, there are several things investors can do to minimize and defer potential capital gains tax liability:
- 1031 tax-deferred exchange to reinvest sales proceeds in a like-kind property
- Delaware Statutory Trust and TICs investments to passively own income-producing real estate
- Qualified Opportunity Zones allow for the deferral of capital gain tax, basis step-up, and exclusion of any tax on new gains
Capital gains tax law can be complicated. That’s why it’s important to work with a specialist like Realized, who has a proven track record of helping real estate investors to defer capital gains with 1031 exchanges.
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.
There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities.
Investing is not suitable for all investors due to its speculative nature. All investors must be “accredited investors” and/or “qualified purchasers” as defined in the securities laws before they can invest in the Fund.
Realized does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
IRS CIRCULAR 230
To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. Federal tax advice contained in this communication, unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing, or recommending to another party any matters addressed herein.
