Understanding Capital Gains Tax
Start Your Application and Unlock the Power of Choice$5.6M offered by a Bank$1.2M offered by a Bank$2M offered by an Agency$1.4M offered by a Credit UnionClick Here to Get Quotes!Capital gains taxes are paid whenever a taxpayer generates a profit from disposing of an asset like commercial real estate, bonds, or expensive collectibles. Capital gains taxes generally do not apply to ordinary personal and business income or the sale of an individual’s primary residence.
Capital Gains Taxes and 1031 Exchanges
1031 Exchanges, which allow an investor to defer their capital gains tax bill by “exchanging” their current property with a similar commercial property, are greatly appreciated by multifamily investors. However, a 1031 is not without a few rules that must be adhered to: the new property must cost at least as much as the original one, and personal residences are not eligible. Investors are not required to already have a new property lined up immediately for the exchange to take place; instead, they can utilize something called a reverse 1031 exchange. This allows a delay in purchasing the exchange property for a period of 180 days (additional time may be allowed in some scenarios). The 1031 exchange also generally allows borrowers to delay paying depreciation recapture taxes, though they will still be required to pay them at some point.
Related Questions
What are the tax implications of capital gains on commercial real estate investments?
When an individual profits from selling an asset, such as stock in a company, commercial real estate, or other investments, a capital gain has occurred. Instead of paying ordinary income tax, an individual generally must pay a special tax rate on these gains, known as the capital gains tax. However, this depends on how long the asset has been held.
Short-term investments (held for one year or less) are taxed at the investor’s ordinary income tax rate, while long-term investments (held for more than one year) are taxed at a lower rate. The exact rate depends on the investor’s income level and filing status. A map of the U.S. with tax rates for individual states can be found here.
In addition to federal tax considerations, investors may also have to pay state capital gains taxes or state income taxes, if they reside in a state with an income tax. Different states will calculate an investor’s capital gains tax burden in different ways, so it’s essential to understand your state’s tax regulations if you want to minimize your capital gains tax bill.
Commercial real estate investors can also take advantage of the 1031 exchange and the Opportunity Zones program to defer capital gains taxes. A 1031 exchange allows investors to defer capital gains taxes by using proceeds from an investment property to purchase a “like kind” property. The Opportunity Zones program allows investors to defer paying capital gains taxes until December 31, 2026, provided that they invest in an Qualified Opportunity Fund. Additional benefits are provided by those who invest before December 31, 2019.
When an investor sells a property that they have used to take depreciation deductions, they will have to pay taxes on those deductions. This is known as depreciation recapture taxes.
Overall, understanding the impact of capital gains taxes-- and how to minimize that impact, is essential if you want to maximize the profitability of your commercial real estate investment.
How can I minimize capital gains taxes on commercial real estate investments?
There are several ways to minimize capital gains taxes on commercial real estate investments. One way is to get creative with your income, such as taking a smaller salary for tax benefits. Another way is to engage in a 1031 exchange, which allows you to defer taxes on the sale of a property by reinvesting the proceeds into a similar property. You can also defer taxes by investing in the Opportunity Zones program. Additionally, you can utilize tax-loss harvesting, which involves selling an investment at a loss to offset your capital gains taxes. For example, if you sell an apartment building and generate a taxable profit of $200,000, but you sell a separate investment at a $100,000 loss, this would reduce your capital gains tax bill to $100,000.
What are the differences between long-term and short-term capital gains taxes on commercial real estate investments?
Long-term capital gains taxes are generally defined as gains on assets held for more than one year, while short-term capital gains are generally defined as gains on assets held for less than one year. In 2019, long term capital gains taxes are:
Taxable Income Tax Rate $0 to $39,375 0% $39,376 to $434,5500% 15% $434,551+ 20% In contrast, short term capital gains taxes are taxed at a taxpayer's ordinary tax bracket. Federal income tax rates for 2019 for single filers are:
Taxable Income Tax Rate $0 to $9,525 10% $9,526 to $38,700 12% $38,701 to $82,500 22% $82,501 to $157,500 24% $157,501 to $200,000 32% $200,001 to $500,000 35% $500,001+ 37% In 2019, income taxes for married couples filing jointly are:
Taxable Income Tax Rate $0 to $19,050 10% $19,051 to $77,400 12% $77,401 to $165,000 22% $165,001 to $315,000 24% $315,001 to $400,000 32% $400,001 to $600,000 35% $600,001+ 37% In comparison, income taxes for married couples filing separately are:
Taxable Income Tax Rate $0 to $9,525 10% $9,526 to $38,700 12% $38,701 to $82,500 What are the tax benefits of investing in commercial real estate?
Investing in commercial real estate can offer a variety of tax benefits, such as accelerated depreciation, mortgage interest deductions, and reduced tax burdens for beneficiaries. For instance, if an investor buys a commercial property for $3 million, and its value increases to $4.5 million before the investor passes away, the investor’s beneficiaries will only need to pay taxes on the $1.5 million that the property has appreciated, not the entire $4.5 million sale price. Additionally, borrowers can deduct any interest they pay on a commercial mortgage off of their federal income taxes. For instance, if a commercial real estate borrower pays $10,000/month in mortgage payments, $2,000 of which is interest, they would be able to take a mortgage interest tax deduction of approximately $24,000 for that year. Source
What are the best strategies for reducing capital gains taxes on commercial real estate investments?
The best strategies for reducing capital gains taxes on commercial real estate investments include 1031 exchanges, investing in Opportunity Zones, and tax-loss harvesting.
A 1031 exchange allows investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar property. This can be a great way to defer taxes and reinvest in a more profitable property.
Investing in Opportunity Zones is another way to reduce capital gains taxes. Opportunity Zones are designated areas that offer tax incentives to investors who invest in them. By investing in an Opportunity Zone, investors can reduce their capital gains taxes and benefit from the tax incentives offered by the program.
Finally, tax-loss harvesting is a strategy that can be used to reduce capital gains taxes. Tax-loss harvesting involves selling investments at a loss in order to offset capital gains taxes. For example, if an investor sells an apartment building and generates a taxable profit of $200,000, but they sell a separate investment at a $100,000 loss, this would reduce their capital gains tax bill to $100,000.