Tax Reduction Strategies for Investors
Real estate is a lucrative investment. But without a strategy for tax reduction, the taxes on these properties can often blindside the unprepared investor. The IRS taxes real estate investments in primarily two ways – income from cash-flowing properties and capital gains from the sale of a real estate asset. While there are other taxes based upon unique situations, this article will explain the difference between the two most common real estate taxes and the various ways to reduce the tax burden associated with them.
Rental income from either residential property or commercial property is taxed as ordinary income. This means an investor in the 24% tax bracket will owe 24% of realized profit from the property to the IRS. Thankfully, there are ways to decrease taxable income from rental properties. We’ll discuss this in more detail below.
Capital Gains Tax
Selling an asset, such as stock or commercial real estate, incurs a special tax called capital gains tax. There are a variety of implications to understand about this tax, the most important being that upfront knowledge and a clear strategy can potentially save thousands of dollars in taxes.
Short-Term vs. Long-Term Capital Gains
The tax that a seller will be required to pay from the capital gains will be determined by the amount of time the asset was held. This is critical information in determining an investment strategy since short-term capital gains are almost always taxed at a higher rate. Short-term capital gains tax is a tax on profits from the sale of a property held for less than one year. Quite obviously, then, long-term capital gains taxes are for property held for more than one year.
Short-term and long-term capital gains taxes are both based upon the taxpayer’s income, but a considerable difference can be realized between the two.
Short-term capital gains tax is taxed at the ordinary income tax rate of the taxpayer’s tax bracket.
Long-term capital gains tax is taxed at 0%, 15%, or 20%, again depending on taxable income.
For illustrative purposes, we’ll compare the taxes on a property that sold and profited $75,000 in capital gains. We’ll assume that the property owner has an annual taxable income of $250,000 and is married, filing jointly.
2020 Capital Gains Tax Rates (Married, Filing Jointly)
Short-Term Capital Gains Rates
|Income Bracket||Tax Rate|
|$0 to $9,950||10%|
|$9,951 to $40,525||12%|
|$40,526 to $86,375||22%|
|$86,376 to $164,925||24%|
|$164,926 to $209,425||32%|
|$209,426 to $523,600||35%|
|$523,601 or more||37%|
Long-Term Capital Gains Rates
|$0 to $80,000||0%|
|$80,001 to $496,600||15%|
|$496,601 or more||20%|
Short-Term Capital Gains on Subject Property
With a $250,000 annual income, at 35% tax rate, the seller pays $26,250 in taxes.
$75,000 x .35 = $26,250
Long-Term Capital Gains on Subject Property
With a $250,000 annual income, at 15% tax rate, the seller pays $11,250 in taxes.
$75,000 x .15 = $11,250
State Taxes – Capital Gains Tax in Colorado
Keep in mind, this example does not include state taxes on capital gains. Capital gains taxes in Colorado are taxed at 4.63%, but you can deduct the amount paid in federal taxes for the total taxable capital gains for state taxes.
Before state taxes, however, the investor could realize $15,000 in additional profit simply by holding the property for more than a year.
The possibilities don’t end there. A variety of other strategies are available to reduce the taxable income on capital gains.
Tax Reduction Strategies
Knowledge is power. This is especially true when dealing with strategic moves an investor can make now that will save hundreds of thousands of dollars in the future. A tax professional and financial adviser should always be an integral part of the planning to ensure both optimal and legal tax reductions.
Some of the most common methods that can be used in a tax reduction strategy include:
- 1031 Exchanges
- Opportunity Zones
- Cost Segregation
A 1031 Exchange allows an investor to use the proceeds from a commercial property to reinvest in a new property of equal or greater value deferring all taxes on the capital gains. This method can exponentially increase an investor’s leverage, allowing the continual acquisition of higher and higher cash-flow properties.
The IRS indicates that these exchanges must be for “like-kind” properties; however, an often faulty assumption is that it must be the same type of property. This is not the case. Therefore, it is ideal to have a commercial real estate broker experienced in 1031 exchanges assist in your property search.
Be aware that there are some additional regulations based upon the type of 1031 exchange. Talk to your broker about the situation that will best fit your portfolio.
The Opportunity Zones Program is a federal incentive to encourage investment in undercapitalized communities. Capital gains can be used to invest in government-specified opportunity zones through Opportunity Funds. By investing in these designated areas, investors can defer, reduce and even eliminate certain federal capital gains taxes.
According to the Colorado Office of Economic Development & International Trade, investors can receive the following benefits when investing capital gains in opportunity zones:
- They can defer paying taxes on the original capital gain until they dispose of the investment or until 2026.
- If they hold the investment for at least five years, they will have to pay 10% fewer taxes on the original capital gain.
- If they hold the investment for at least ten years, they will not have to pay any capital gains tax on their opportunity zone investment.
For a more thorough explanation of opportunity zones in Colorado Springs, specifically, talk to one of our experienced brokers.
Cost segregation is a tax planning strategy that allows accelerated depreciation deductions on commercial properties that produce cash flow. By accelerating depreciation deductions, one can defer taxes to best fit current and future financial states.
Cost segregation depreciation is based upon separate parts of a property that depreciate at varying rates. Traditional property depreciation is taken over 27 ½ or 39 years. Cost segregation depreciates various property aspects over 5, 7, and 15 years.
Cost segregation deductions should not be taken without an extensive cost segregation study and the guidance of a tax professional. For a more detailed explanation of cost segregation for tax reduction strategies, see our article on cost segregation.
It’s important to note that with depreciation and cost segregation, there will be a special tax when the property is sold – depreciation recapture. Depreciation recapture provides the IRS the opportunity to recapture some of the taxes they were unable to collect due to previous years of depreciation tax reduction.
Depreciation recapture only occurs upon the sale of a property. The recapture amount is calculated based upon the difference between the cost basis of the property (the amount the property was purchased for) and the total amount of depreciation taken during the life of ownership.
Cost Segregation Example
For instance, if an investor purchased a property for $1,000,000 and used only the standard depreciation method for tax reduction (39 years), that property would be allowed a yearly depreciation amount of $25,641.
$1,000,000 / 39 = $25,641
If the owner held the property for 10 years and then sold the property again, the total amount of realized depreciation would be $256,410 over 10 years.
$25,641 x 10 = $256,410
To figure the capital gains associated with the sale of the property, one would need to determine the adjusted cost basis (original cost basis minus depreciation).
$1,000,000 – $256,410 = $743,590
If the property was sold for 1.2 million, the owner realized a total profit of $456,410 as the taxable income is based upon the adjusted cost basis. A capital gains tax will be required on the $200,000 over original cost basis (based upon the respective tax bracket), but the $256,410 of depreciation value will be taxed at a special depreciation tax rate of 25%.
As seen, tax implications can be complex. It’s important that both your broker and your tax professional understand your long-term goals and work in tandem to support your financial success. With the right mindset and strategy in place from the beginning, you can optimize your profit and minimize your tax liability.
At Peak Commercial Properties, we offer more than simply a brokerage service. While we do not provide legal, tax advice, we have a deep understanding of how all of these factors can work together to your greatest advantage.
Disclaimer: The information contained in this article is not intended to provide legal or tax advice. Please speak to a tax attorney, CPA, or financial adviser for professional guidance.