Discover 3 amazing tax advantages of commercial real estate that help you save money and build wealth.
Tax Advantage #1: Depreciation
One of the greatest tax advantages of commercial real estate is depreciation. Depreciation is a federal income tax deduction established to offset the costs associated with the inevitable deterioration of your property over time. There are two IRS depreciation classifications; residential and commercial. Apartments and rental homes are considered residential property and are depreciated over 27.5 years. Office buildings, warehouses, hotels and retail space are classified as commercial and are depreciated over 39 years. What makes depreciation so incredible is that a house, apartment or office building does not completely deteriorate in 27.5 or even 39 years. While you may replace a roof, or replace HVAC systems, the entire structure doesn't disintegrate and you can deduct the cost of the new roof or HVAC system when you have it installed. Therefore, depreciation is a deduction without a cost!
How to Calculate Depreciation
For this example, we'll be using a 5-unit, million-dollar multifamily property:
- 85% of $1,000,000 is allocated as the value of the building, meaning the building has a value of $850,000.
- 15% of $1,000,000 is allocated to the land, which values the land at $150,000.
Since land it is not depreciable, the deductible amount is $850,000. Because the IRS allows you to depreciate the building over twenty-seven and a half years, simply divide $850,000 by 27.5 to determine the allowable yearly depreciation. In this case, you can deduct $30,909 for the next 27.5 years.
The Power of Depreciation
Why is this tax strategy a powerful tool for building wealth? Because you can write off $30,909 each year against your income. If you have a W2 job and you need a tax write off, you can invest in small commercial property and get a significant tax deduction. And not only does depreciation provide tax write offs for income, but as a commercial real estate investor, you can also write off a part of the building against your cashflow and end up not paying taxes on the property. For example, let’s say you are one of our Proteges. You’ve found a 24-Unit, $3.5 million dollar property, and because it’s a larger deal you have four investors.
- To find the depreciable value take 85% of $3.5 million which is $2.975 million.
- Divide $2.975 million by 27.5, which equals an annual deduction of $108,000.
- $108,000 divided by 5 = $21,600
Each investor in the deal has $21,600 in tax deductions per year for the next twenty-seven and a half years. So, in our example here, if each partner received $20,000 in cashflow a year, the net result will be a paper loss of $1,600 on their taxes. Their taxes will show a loss of $1,600 even though they pocketed $20,000. That's the power of depreciation.
But the tax advantages of depreciation get even better! You can accelerate the amount of depreciation you claim on your taxes by doing a cost segregation study. Instead of depreciating your buildings over 27.5 years, you can depreciate parts of a building over 5 years. This wealth building strategy has a tremendous impact. However, if you are not a real estate professional, then you are limited on what you can write-off against your income. Learn more about the benefits of achieving real estate professional status (per the IRS) here: Why Reach Real Estate Professional Status
Tax Advantage #2: Appreciation
Another advantage of commercial real estate is appreciation. If a property is well managed and profitable, it will naturally increase in value over time with the market. However, you can also force the appreciation on your commercial property by increasing the rents. As your NOI (Net Operating Income) increases, so does the value of your property. But appreciation isn’t just one of the most powerful ways to build wealth in commercial real estate, it also has great tax advantages. For example, let’s say you purchased a 12-unit apartment building for 1 million dollars.
- Your down payment was $250,000.
- Your value-add strategy is to raise the rents $150 on each unit over the next two years ($75 each year).
- After the second rent increase you are making an extra $1,800/m on the 12 units.
- $1,800 x 12 months = $21,600 per year increased income.
Now, to calculate the new value, divide your annual increase by the market cap rate. For this example, we will use a 6% cap rate.
- $21,600 annual increase divided by 6% cap rate = $360,000 added value.
The advantage here is that this added value is tax free until you sell the property. It is a tremendous advantage unique to commercial real estate; you can’t do this on a single-family home or duplex. The property must be 5-units or greater. However, this isn’t the only significant tax benefit of appreciation. Commercial investors can use appreciation to their advantage and refinance at the new value and leverage the equity with a cash out refinance.
Tax Advantage of Cash Out Refinance:
A cash out refinance is an exit strategy that allows investors to refinance their mortgage and pull equity out as cash. Again, using our 12-unit example, with a new value is $1.36 million, you can do a cash out refinance and pull some of that equity out to buy another property. In a standard cash out refinance, a lender will loan you 75% of the new value. So in this scenario, the refinance loan amount is $1,020,000. To determine how much money you will have to reinvest, we use the equation:
$1,020,000 (refinance loan amount) - $750,000 (current loan) = $270,000 (cash out amount)
In this case, you would have $270,000 cold hard cash in your pocket after refinancing that is tax free until you sell the property. You can use this money to make improvements to the property or to invest in another commercial property and build your multifamily portfolio .
Tax Advantage #3: 1031 Tax Deferred Exchange
A 1031 Tax Exchange allows investors to sell a property and defer capital gains taxes by reinvesting the profits into a larger property. This is a brilliant tax advantage every investor should be familiar with and you can learn more about a 1031 Exchange in my comprehensive case study here: 1031 Exchange Step by Step Case Study.
Often beginner real estate investors will start off with single family rentals, as is the case with many of the Proteges we mentor at Commercial Property Advisors. Over time they build equity in their rental properties, which can then be used to leverage a larger rental property using a 1031 Tax Deferred Exchange. For example, let’s say you have $300,000 in equity in your single-family rental. If you were to sell your single-family rental for $600,000, you can use the $300,000 in profits to purchase a million dollar 12-unit multifamily apartment using a 1031 Exchange and defer paying capital gains taxes until you take the profits.
But the brilliance of a 1031 Exchange isn’t just that it gives you a tax break. Not only have you traded up from just one tenant to rental income from twelve tenants, but as a commercial property owner you now benefit from the tax advantages of depreciation and appreciation:
- You will get $30,000 a year in tax deductions from depreciation. Recall from our first example, the allowable yearly depreciation for a million-dollar property is $30,909. Your single home wasn't even producing $30,000 in income!
- As owner you can implement value-add strategies like raising the rents, force the appreciation and do a cash out refinance, pull that cash out and leverage it into another commercial property.
So, a 1031 Exchange is a great way to transition from a single-family rental to commercial real estate. And while this is a great way for investors to begin in commercial real estate, it is just as effective as an exit strategy for more experienced investors.
1031 Exchange Exit Strategy
This can be demonstrated by going back to the example of the 24-unit multifamily property purchase by a Protégé and four investors. Typically, investors will hold a multifamily property for 5 years before implementing an exit strategy, during which time they will raise the rents, increase the NOI, force the appreciation, and then either do a cash out refinance and hold long-term or sell for a higher value.
In this scenario, they purchased their 24-unit for $3.5 million. Let’s speculate conservatively that the property increases in value $1 million and is worth $4.5 million by year five. Using a 1031 Exchange, our student and his partners can sell the property and roll all the tax deferred profits into a larger multifamily deal. How much larger will that property be? Well, they owed $2.625 million on the first property (25% down on $3.5 million), so after selling for $4.5 million they have $1.875 million in equity to use as a down payment. With 25% down, they can invest in a $7.5 million property.
This is a phenomenal way to scale your portfolio and create generational wealth in commercial real estate. Many of our Proteges start small and as they gain more knowledge and experience through our mentorship, they begin to build up and scale their portfolio using these 3 powerful tax advantages of commercial real estate.
If you have any questions, post a comment below or text PETER to 833-942-4516.
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