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Commercial Real Estate Capital Gains Tax: A Comprehensive Guide for Investors

March 25, 2024

When you sell a commercial property for more than the purchase price, the profit you make is called capital gain. In commercial real estate, this profit is subject to a tax known as capital gains tax. The rate at which you’re taxed on capital gains can vary based on how long you’ve owned the property and the total amount of gain.

Understanding commercial real estate capital gains tax is essential for investors because it directly affects the net profit from the sale of a property. With smart planning and a solid grasp of how capital gains taxes work, you can maximize investment strategies, such as the 1031 exchange, to minimize your taxes and maximize your profit.

At Universal Pacific 1031 Exchange, our experienced Qualified Intermediaries with over 30 years of experience can help you defer capital gains tax through a 1031 exchange. We’re always available to help you facilitate a compliant and successful exchange and guide you throughout the process. Schedule a free consultation with us – let’s discuss how you can start your 1031 exchange.

In this article, we’ll cover the basics of capital gains tax in commercial real estate investments and provide strategies for reducing your tax burden. Having this understanding will help you maximize your investment returns while reducing tax liabilities.

What is Capital Gains Tax on Commercial Real Estate?

What is Capital Gains Tax on Commercial Real Estate?

Capital gains tax on commercial real estate refers to the tax you pay on the profit (capital gains) earned from the sale of commercial property. When you sell a commercial property or any capital asset at a higher price than the acquired price, the profit that results from the sale is known as capital gains. The income taxes levied on this profit are called capital gains taxes. 

In terms of commercial real estate, capital gains taxes apply when you sell a commercial property for a profit. It’s calculated based on the difference between the sale price of the property and its original purchase price. Also, improvements made to the investment property affect the taxes.

For example, if you purchased a house for $500,000 and sold it for $700,000, the profit on the sale would be $200,000. This profit is a capital gain and, thus, taxable. The exact amount of capital gains tax you pay varies depending on how long you’ve held the investment property and the tax laws in the jurisdiction where the property is located.

Short-term Capital Gains

Short-term capital gain is the profit you make from selling a commercial property you’ve owned for a short time, usually a year or less. Short-term capital gains tax rates are usually higher than long-term capital gains taxes. So, if you want a quick profit, be prepared to pay more taxes compared to holding onto the asset for the long term. Also, short-term capital gains tax rates are usually considered the same as ordinary income. They’re usually between 10% and 37%, depending on your taxable income and your filing status (either single, married or head of household).

Long-term Capital Gains

Long-term capital gains are the profit you realize from selling a property or an asset you’ve held for more than a year. The tax payable on this capital gain is called long-term capital gains tax. Remember, the exact tax rates and rules can vary depending on your taxable income and filing status.

  • You may qualify for a 0% long-term capital gains tax rate if your taxable income falls below $44,625 as a single filer, $89,250 as a married couple filing jointly, and $59,750 as a head of a household.
  • If your taxable income exceeds these thresholds but is below $441,450 for single filers, $496,600 for heads of households, or $496,600 for married couples filing jointly, your long-term capital gains tax bill is 15%.
  • Above the 15% income threshold, you’ll be taxed at a 20% long-term capital gains tax rate.

It’s important to note that sometimes you may have to pay both federal capital gains taxes and state capital gains taxes, depending on the state where the property is located. For instance, states like Florida, Texas, and Arizona don’t impose a state capital gains tax on the profit you make from selling a property. But in other states like California, New York, and New Jersey, you’ll have to pay state capital gain tax.

How To Calculate Capital Gains Taxes on Commercial Real Estate

How To Calculate Capital Gains Taxes on Commercial Real Estate

For commercial real estate investors, calculating capital gains taxes for a commercial property is an essential part of your tax planning. The steps include:

  1. Determine Your Basis: Start by determining your property’s basis. The basis comprises the original purchase price plus any additional costs such as closing costs, legal fees, and improvement costs.
  2. Calculate Your Gain: Next, calculate your capital gains by subtracting your basis from the price you sold the property. For example, if you bought a property for $500,000 and sold it for $700,000, your gain would be $700,000 – $500,000 = $200,000.
  3. Determine Your Holding Period: The holding period determines the tax rate apportioned to you. If you’ve held the commercial real estate for more than a year, you’ll file at the long-term capital gains tax rate. If it’s a year or less, you’ll pay short-term capital gains tax.
  4. Apply the Applicable Tax Rate: Depending on your holding period and taxable income bracket, apply the appropriate long-term capital gains tax rate or short-term capital gains tax rate.
  5. Consider Other Factors: Ensure to include any deductions, deferrals, or credits you may be qualified for. An example is the home sale exclusion for primary residences. Other deductions and benefits include mortgage interest deductions, pass-through deductions, tax credits, opportunity zones, or any other applicable state tax rules in your jurisdiction. 
  6. Calculate the Tax Owed: Multiply your gain by the applicable tax rate to determine the capital gains taxes owed. For instance, if your gain is $200,000 and the tax rate is 15%, your tax owed would be $30,000.
  7. Report the Gain: Report the capital gains on your income tax return. Use IRS Form 8949 to report the sale of the property and Schedule D to calculate the tax. For 1031 exchange transactions, use Form 8824 instead. Also, note that different states have unique capital gains tax rates and reporting requirements. As such, remember to check the rules in your state.

Remember, tax laws and rates can change, and there may be additional factors or deductions that can affect your calculation, such as state taxes. It’s always recommended to consult with a tax professional or qualified intermediary who specializes in commercial real estate to ensure you’re calculating your capital gains taxes accurately and taking advantage of any possible tax benefits or deductions.

Example Calculation of Capital Gains Tax 

Assume you purchased a shopping complex for $500,000 and spent $100,000 on improvements and claimed $50,000 in depreciation.

  • Your adjusted basis: $500,000 + $100,000 – $50,000

Say you sell the property for $800,000 with a spelling expense of $20,000, your selling price for tax purposes is $780,000.

  • Capital Gain = Selling price – $Adjusted Basis
  • Capital gains = $780,000 – $550,000 = $230,000

Assume your tax rate is 15%. Capital gains taxes = $230,000 x 15% = $34,500 

Strategies to Defer Capital Gains Taxes on Commercial Properties

Strategies to Defer Capital Gains Taxes on Commercial Properties

To avoid or minimize capital gains taxes, you need to understand the tax code and plan strategically. There are various strategies you can employ to reduce the tax burden when you decide to sell a commercial property. Such strategies include:

1. 1031 Exchange

A 1031 exchange, also known as a like-kind exchange, allows you to defer paying capital gains taxes by reinvesting the proceeds from the sale of a property into another “like-kind” property. Effectively deferring capital gains taxes using this strategy requires that you adhere to the IRS requirements for 1031 exchanges. For instance, the IRS requires that both properties must be like-kind, must be used for investment or business purposes, and the transactions must be completed within the IRS timeline for 1031 exchanges.

2. Installment Sales

An installment sale allows the seller to spread the receipt of proceeds over several years, potentially lowering the tax bracket and reducing the overall tax rate on the gain. By receiving the payment in installments, you can defer the capital gains taxes over the period the payments are received, rather than paying all at once. Note that you must also adhere to the IRS regulations for installment sales to qualify.

3. Opportunity Zones

Opportunity Zones are economically distressed communities where new investments may be eligible for preferential tax treatment under certain conditions. By reinvesting capital gains into a Qualified Opportunity Fund (QOF) that invests in these zones, you can defer and potentially reduce your capital gains taxes.

According to the IRS, if you keep your money in a QOF investment for at least five years, you’ll receive a 10% reduction in your capital gains taxes. Likewise, holding it for at least seven years gives a 15% reduction. If you hold the investment for at least ten years, the capital gains from the investment in the zone can be tax-free. Also, ensure that the QOF has met the specified eligibility conditions before investing your money. One of these conditions includes investing at least 90% of its assets in Qualified Opportunity Zone property.

4. Conversion to Primary Residence

Under certain circumstances, converting a commercial property into your primary residence can allow you to take advantage of the Section 121 exclusion for capital gains on the sale of primary residences. Individuals can exclude up to $250,000 of gain from their income, and married couples can exclude up to $500,000. However, this strategy requires living in the property for at least two of the five years before the sale and is subject to other limitations.

5. Tax Harvesting

This strategy involves offsetting capital gains with capital losses. If you have other investments that have lost value, selling them to realize a loss can offset the gains from your commercial real estate property. This can be a complex strategy and requires careful timing and consideration of tax implications.

6. Charitable Trusts

Using a Charitable Remainder Trust (CRT) allows the property owner to donate the property to a trust, sell the property tax-free through the trust, and then receive income from the trust for a set number of years. Upon the termination of the trust, the remainder of the assets go to the designated charity. This can provide immediate tax benefits and income, along with fulfilling philanthropic goals.

The Impact of Recent Legislation on Commercial Real Estate Capital Gains

The Impact of Recent Legislation on Commercial Real Estate Capital Gains

The Biden administration has proposed changes to the taxation of individuals, decedents, and noncorporate entities. In April 2021, President Biden announced the proposed “American Families Plan,” which was followed by detailed guidance from the Treasury in May 2021. Although the legislation has not been passed yet, it can impact commercial real estate capital gains if implemented.

President Biden proposed raising the top capital gains tax rate from 20% to 39.6% for individuals earning more than $1 million annually. Sadly for high-income earners, this would effectively double their tax rate on capital gains.

In addition, as per the present tax law, a property’s cost basis steps up to its fair market value upon the death of the owner. This reduces the potential capital gains tax liability for heirs. However, the proposed changes would eliminate this step-up in the basis for gains above $1 million. This can increase tax liabilities for heirs.

Conclusion

Understanding capital gains taxes and their calculations helps you make informed investment decisions and fine-tune your financial plans to minimize tax liabilities and maximize returns. With the strategies covered in this blog, especially the 1031 exchange, you can defer capital gains taxes on commercial real estate sales and have more capital available for investments.

To ensure that you comply with the current tax laws while maximizing the tax benefits of the 1031 exchange, consult with our qualified intermediary.

Michael Bergman, the CEO of Universal Pacific Exchange is a licensed CPA professional who specializes in helping investors reduce commercial real estate tax liability through strategic 1031 exchanges in California.

Schedule a free 1031 exchange consultation with us today and take the first step towards reducing your tax burdens.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.