What is Tax Treatment of Commercial Real Estate Income?
One of the major benefits of a commercial real estate (CRE) investment is the tax treatment of the income produced by it. But for those not accustomed to the terms and accounting concepts used to describe the tax implications of CRE, the exact mechanics of these benefits can be confusing. To understand how it all works, it’s important to start with the basic accounting concepts behind a property’s profit and loss statement.
Commercial Property Expense Deductions
At its core, the premise behind real estate investing is simple: an investor purchases a property that produces “X” amount of income from tenant leases and costs “Y” amount of dollars to operate. If the income is more than the expenses (including debt service), the property produces positive cash flow, which is taxed. For example, if a property produces $500,000 in income and $300,000 in expenses, the remaining $200,000 is considered taxable income.
Given this framework, commercial property owners are incentivized to maximize the amount of deductible expenses they take, which in turn minimizes the property’s tax liability. One of the ways this is done is through an accounting concept known as “depreciation.” Because commercial properties are physical structures that deteriorate over time, Internal Revenue Service (IRS) rules allow the property owner to deduct a portion of the property’s value each tax year to account for this fact. We use an advanced strategy known as “Cost Segregation” to maximize the amount of allowable depreciation annually, which serves to minimize the property’s tax liability each year.
Depreciation isn’t the only allowable expense deduction for commercial rental properties; other options include property tax, management fees, utilities, insurance, mortgage interest, and marketing costs. And any money that is left after these items are paid can be distributed to the commercial real estate investors who provided equity in the deal. The legal structure of a typical commercial real estate transaction is optimized to maximize the tax advantages behind this transfer.
Typical Commercial Real Estate Deal Structure
In a typical commercial real estate transaction, the lead investor creates a Limited Liability Corporation (LLC) and uses it to purchase the target property. To raise equity for the investment, shares of the LLC are sold to investors in return for a percentage of the income and profits produced by the underlying property. Legally, the LLC is a “pass through entity”, which means it is not taxed at the corporate level. Income and expenses “pass through” it and go to the investors who are taxed on a personal level. Here’s how it works:
At the end of each tax year, the property’s rental income and expenses are tallied to determine the amount of money that is available to be distributed to the investor(s). These funds are distributed according to each investor’s percentage of ownership. To document this for an individual tax return, each investor is issued a document called a “K-1” which details the contributions made and income received from the LLC that year. This information is added to each individual’s tax return and used to calculate his or her final tax bill. To illustrate this point, the following example should be helpful.
Assume that an LLC is formed with two investors who each own 50 percent, and together they use the LLC to purchase a small multifamily property. At the end of the first year of ownership, the property has produced $100,000 in gross income and booked $70,000 in operating expenses (which includes a $10,000 depreciation deduction and all loan payments). The resulting income of $30,000 is available to be distributed to investors. So in this case, $15,000 is sent to each investor because they each own half of the LLC. This income is added to the individual investor’s tax return and will be used to calculate their total income tax liability (based on the prevailing income tax rate at that time) after tax deductions.
Treatment of Capital Gains
Income isn’t the only source of return for a commercial real estate property. If the supply and demand characteristics of the local market are favorable, the property will increase in value. For example, if a property is purchased for $1MM and sold for $1.25MM, the investor will book a $250,000 “gain” on the property. This gain is subject to “capital gains tax” and is included on the same K-1 statement to LLC investors when the transaction is finalized. At present, long term capital gains tax rates (for assets held for more than one year) are 0%, 15%, or 20%, depending on an individual’s filing status, tax bracket, and taxable income. As a result, if the gain is large, the associated tax bill can be large, as well.