Depreciation And 1031 Exchange Rules Combine To Push Commercial Real Estate Investments To The Top

Nov 21, 2016

When purchasing commercial real estate investments, do you know what the different advantages are over stocks, bonds, gold, commodities and other forms of return on your equity?

Consider this.

If you earn passive income through a stock, you will pay standard tax bracket rate (up to a high of 39% plus state tax) and take the normally limited deductions away from your present gross income. With commercial real estate investments, you may be able to first subtract the depreciation of the buildings – not land – by as much as a third or more.

Subtraction on the depreciation depends on the rate of time you schedule for present set up of depreciation with your CPA at the beginning, such as accelerated (15 years) depreciation schedule or a standard schedule of 27.5 years or 39.5 years. This will depend on the different types of real estate that the IRS allows you to take off per year.

Let’s take, for example, aggressive investors who earn high amounts of money when they’re younger want to try and deduct as fast as they can in the first 15 years. The reason behind why they do this is because their tax bracket currently is very high, and they expect it to decrease as they slow down and get older.

By dividing the building into parts, like the roof, HVAC, floor, parking lot, elevator and other components, they are can state the remaining life of each of these parts. Aggressive investors are doing this in less time to write off for tax purposes than the building itself. They then end up with less tax to pay each year at the beginning of the investment. Some investors want the same write-off over 27.5 years for residential like apartments versus 39.5 years for commercial buildings, retail, office, warehouses.

consider commercial real estate investment costs


Let’s say you are earning a net cash flow of $100,000 a year from an investment property. You take off the depreciation over 15 years, the building and land cost $900,000 with $800,000 value for the building itself and the land was valued at $100,000 what is your taxable cash flow result?

You would pay tax on approximately $47,000 of income based on 15 years instead of $100,000 not counting the other deductions like the real estate tax, repair expenses and interest on a loan you may have. This end tax is based then on your tax bracket affecting your net income and eventual payment to IRS a year.

Using other methods of depreciation like 27.5 years (apartments) gives you results that are a far cry from the fast track method in taxable income to pay a year. This would result in taxes on approximately $64,000 a year in taxable income but stretch out over 27.5 years not 15 years. If your tax bracket was 39%, this could increase your tax per year to the IRS as much as $7000 more using 27.5 versus 15 years is the point.

Always check with a CPA to make sure your tax consequences are correctly calculated. You also need a professional specialist to correctly value the component part depreciation schedule in setting up the initial depreciation for the building and its parts.

Another thing to remember when selling your commercial real estate investment is that the IRS wants a recapture of the savings you had over many years with the depreciation you already took to save yearly taxes. It is presently 25% of the total depreciation over many years and can be very significant, but it can be delayed for years.

The 1031 Exchange rule allows the real estate investor to purchase another property of equal value that you may trade into to delay your taxes. You must identify another property within 45 days. After starting the exchange process, you have 180 days in total to close the deal.

1031 Exchange costs

Currently, you need to meet many rules that are set up to accomplish this goal.

However, professionals like Westwood can help guide you through the process quite easy. We can make sure you do things correctly along with a good Buyer’s Agent.

By doing this tax strategy, the selling party can delay taxes for a longer period of time.

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