As the year draws to a close, a lot of business owners will be meeting with their accountants and financial advisors to assess their tax situation for the year. And, upon seeing Uncle Sam’s projected take, will scurry to make last-minute investments to reduce their tax burden. One investment that could significantly lighten their load is commercial real estate, and the savings can go well beyond property depreciation.
Most savvy investors are already familiar with the tax benefits that come with depreciation. The IRS allows depreciation of a building over a 39-year schedule (called the recovery period), essentially covering the wear and tear on the structure. Keep in mind that land never depreciates, so it cannot be calculated into the schedule.
That means if you own a commercial property that’s worth $1.25 million and the land that it sits on accounts for $250,000 of that figure, you could depreciate the remaining $1 million at $25,641 per year for 39 years.
But depreciation isn’t the only way to use commercial property investments to reduce your taxes. Lesser-known 1031 exchanges (also called like-kind exchanges) offer an excellent means to step up your investments without increasing your tax liability.
Usually, when you sell or swap commercial property, the sales are taxable as are the capital gains. But when it falls into the 1031 category, you could pay no tax at all. Instead it’s viewed as changing the form of your investment and thereby delays any taxes—even if you have a profit on each swap—until you ultimately sell the property outright.
If timing for a trade doesn’t align, you can also do a delayed exchange. With a delayed exchange, you have a third party hold the proceeds after you sell one building while you look for a replacement property or properties. You’ll need to specifically identify your replacement property in writing to that third party within 45 days of the sale of the first property and then complete the purchase of the new property within six months of the first closing date.
In a 1031 exchange, you must never be in possession of the cash resulting from the initial transaction or it’s no longer considered a swap. And if after you close on your new property, you have money left over (called “boot”), that money is taxable as a capital gain.
It works the same way when mortgage loans are involved. If you trade in a property with $500,000 mortgage for a property with a $300,000 mortgage, you’ll be required to pay capital gains tax on the difference.
Property that is held for productive use in business or as an investment qualify for a 1031 exchange. Real property that is purchased with the intent to sell does not qualify (no flipping allowed), nor does residential property in most cases.
Exchange transactions can be complicated and a lot of rules apply. To make certain your exchange works for you, be sure to consult with your tax advisor and an experienced commercial Realtor. Those professionals can also help you identify the requisite third party in case of a delayed exchange.
Closing fees and taxes are usually covered in the exchange. Other costs, such as security deposits, application fees and mortgage insurance are not. And you can expect to pay anywhere from $400 to $1,000 for a third-party facilitator for a delayed exchange.
When you consider capital gains tax runs anywhere from 10 percent to 39.6 percent, 1031 exchanges can save you significant money on your 2016 taxes.
Reprinted with permission from River Valley Business Report.