Insights

How Commercial Real Estate Owners Use Effective
Tax Strategies to Mitigate and Avoid Taxes

In the 2017 tax overhaul, the deductions for real estate taxes and mortgage interest on a home were severely curtailed for homeowners. Not so for owners of commercial real estate. Favorable treatment for commercial real estate continues at multiple levels, including from income and property taxes which are fully deductible as a business expense.

The tax code continues to provide special treatment for real estate investments, including the use of depreciation, a tax strategy used in commercial real estate, where taxpayers can write down the cost of their buildings over a number of years. However, depreciation is just the start for commercial real estate owners.

Favorable treatment for commercial real estate occurs at multiple levels, starting with depreciation and moving forward to more complicated structures that allow savvy families to pass real estate worth hundreds of millions to heirs tax-free. There are myriad benefits, all legal, created specifically for commercial real estate.

The tax overhaul also allowed real estate companies to take a special deduction for qualified business income meant as an incentive for companies with a large number of employees. During the tax bill’s negotiations in Congress, an exemption was added for real estate. Instead of considering employees for the deduction, real estate companies could use a different calculation based on their assets.

Depreciation

The concept of depreciation refers to the loss of value of everything in a real estate investment, from the furniture in the lobby to the building itself. The rate at which these assets depreciate varies. For personal effects, like couches and dishwashers, their value hits zero after five to seven years. For buildings, the useful life is determined by what kind of property it is. It’s 27.5 years for multifamily residential buildings and 39 years for commercial property, like an industrial park. At the end of that time, the building would be worth zero, from a tax perspective, and the owner would have received the loss of that value in increments year after year.

When a property is sold, the seller would in theory owe tax on the difference between the depreciated value and the sale price. This is known as depreciation recapture, and it’s the point where the deferred taxes are supposed to be paid.

However, the seller can put the property into a like-kind exchange.

Like-Kind Exchanges

In addition to depreciation, a tax structure called a like-kind exchange, also known as a 1031 exchange serves as tax-deferral strategies, but in many cases, those taxes are never paid.

This tax structure allows the owner to sell one property and put that money into another property within six months. If the transaction is done properly, the property owner doesn’t pay any taxes on the gain from the sale of the original building. This tax benefit is given to investors who put their money into commercial and residential real estate, but it is not available to homeowners.

These like-kind exchanges used to be open to all kinds of assets, including art and classic cars. But in the 2017 tax act, they were restricted to just one: commercial real estate. Within that asset class, though, the types of properties that can be exchanged can vary. A storage facility could be swapped for a hotel, for example, or the air rights over an office tower could be turned into a mall.

Estate Planning

The tax code is written so that the accumulated capital gains taxes are eventually supposed to be paid. But when an individual owns the real estate, the properties can be held until death. At that point, all of the embedded capital gains are wiped out, so no capital gains tax is owed. The family inherits the properties at whatever value they were appraised at on the date of death.

Along the way, though, the owner could have refinanced the building and taken the cash out. It’s known in real estate parlance as “the harvest,” and as long as the building’s cash flow is enough to cover the debt payments, the money is tax-free.

Death and taxes are unavoidable, but real estate investors can circumvent the second part by using estate planning to significantly lower, if not eliminate, taxes on hundreds of millions of dollars of property at death.

The estate tax exemption for a married couple is $22.8 million, so generous that only a sliver of the wealthiest of the wealthy will need to worry about it. But commercial real estate is generally owned through a partnership or limited liability company, in which there is no tax at the business level and all the gains and losses flow through to the individual. They have a built-in advantage allowing owners to transfer exponentially more to heirs free of taxes.

Consider a building worth $30 million. If the owner puts it into a trust for his heirs, he can discount the value by a third or more because a fractional stake in the partnership that owns the building is worth less because it lacks control and marketability, according to the Internal Revenue Code. The buyer is likely to be just another family member.

That 30 percent discount, or $10 million, on the real estate is a benefit that someone with $30 million of Apple stock does not get. At a conservative 7 percent growth rate, the building could be worth $120 million, when other deductions are considered, in 20 years.

The owner could then swap the building for $120 million of stock, making it easier for his heirs to divide. The building would be valued at its original price for capital gains taxes, but when the owner died, all of those taxable gains would die with him. Or the owner could take a $120 million loan, and the loan and the building would cancel each out at death, resulting in no estate tax.

None of these tax benefits work, of course, if the real estate investment is not sound.

In the 2017 tax overhaul, the deductions for real estate taxes and mortgage interest on a home were severely curtailed for homeowners. Not so for owners of commercial real estate. Favorable treatment for commercial real estate continues at multiple levels, including from income and property taxes which are fully deductible as a business expense.

The tax code continues to provide special treatment for real estate investments, including the use of depreciation, a tax strategy used in commercial real estate, where taxpayers can write down the cost of their buildings over a number of years. However, depreciation is just the start for commercial real estate owners.

Favorable treatment for commercial real estate occurs at multiple levels, starting with depreciation and moving forward to more complicated structures that allow savvy families to pass real estate worth hundreds of millions to heirs tax-free. There are myriad benefits, all legal, created specifically for commercial real estate.

The tax overhaul also allowed real estate companies to take a special deduction for qualified business income meant as an incentive for companies with a large number of employees. During the tax bill’s negotiations in Congress, an exemption was added for real estate. Instead of considering employees for the deduction, real estate companies could use a different calculation based on their assets.

Depreciation

The concept of depreciation refers to the loss of value of everything in a real estate investment, from the furniture in the lobby to the building itself. The rate at which these assets depreciate varies. For personal effects, like couches and dishwashers, their value hits zero after five to seven years. For buildings, the useful life is determined by what kind of property it is. It’s 27.5 years for multifamily residential buildings and 39 years for commercial property, like an industrial park. At the end of that time, the building would be worth zero, from a tax perspective, and the owner would have received the loss of that value in increments year after year.

When a property is sold, the seller would in theory owe tax on the difference between the depreciated value and the sale price. This is known as depreciation recapture, and it’s the point where the deferred taxes are supposed to be paid.

However, the seller can put the property into a like-kind exchange.

Like-Kind Exchanges

In addition to depreciation, a tax structure called a like-kind exchange, also known as a 1031 exchange serves as tax-deferral strategies, but in many cases, those taxes are never paid.

This tax structure allows the owner to sell one property and put that money into another property within six months. If the transaction is done properly, the property owner doesn’t pay any taxes on the gain from the sale of the original building. This tax benefit is given to investors who put their money into commercial and residential real estate, but it is not available to homeowners.

These like-kind exchanges used to be open to all kinds of assets, including art and classic cars. But in the 2017 tax act, they were restricted to just one: commercial real estate. Within that asset class, though, the types of properties that can be exchanged can vary. A storage facility could be swapped for a hotel, for example, or the air rights over an office tower could be turned into a mall.

Estate Planning

The tax code is written so that the accumulated capital gains taxes are eventually supposed to be paid. But when an individual owns the real estate, the properties can be held until death. At that point, all of the embedded capital gains are wiped out, so no capital gains tax is owed. The family inherits the properties at whatever value they were appraised at on the date of death.

Along the way, though, the owner could have refinanced the building and taken the cash out. It’s known in real estate parlance as “the harvest,” and as long as the building’s cash flow is enough to cover the debt payments, the money is tax-free.

Death and taxes are unavoidable, but real estate investors can circumvent the second part by using estate planning to significantly lower, if not eliminate, taxes on hundreds of millions of dollars of property at death.

The estate tax exemption for a married couple is $22.8 million, so generous that only a sliver of the wealthiest of the wealthy will need to worry about it. But commercial real estate is generally owned through a partnership or limited liability company, in which there is no tax at the business level and all the gains and losses flow through to the individual. They have a built-in advantage allowing owners to transfer exponentially more to heirs free of taxes.

Consider a building worth $30 million. If the owner puts it into a trust for his heirs, he can discount the value by a third or more because a fractional stake in the partnership that owns the building is worth less because it lacks control and marketability, according to the Internal Revenue Code. The buyer is likely to be just another family member.

That 30 percent discount, or $10 million, on the real estate is a benefit that someone with $30 million of Apple stock does not get. At a conservative 7 percent growth rate, the building could be worth $120 million, when other deductions are considered, in 20 years.

The owner could then swap the building for $120 million of stock, making it easier for his heirs to divide. The building would be valued at its original price for capital gains taxes, but when the owner died, all of those taxable gains would die with him. Or the owner could take a $120 million loan, and the loan and the building would cancel each out at death, resulting in no estate tax.

None of these tax benefits work, of course, if the real estate investment is not sound.