Very few, if any, other investments offer the tax benefits and opportunities that commercial real estate investing offers, especially triple net (NNN) lease properties. The immediate and often significant tax advantages that help build wealth set this asset class apart from stock market investments, the bond market, mutual funds, ETFs, art investments, NFTs, and many retirement plans.
So, what are the most common NNN lease investing tax benefits?
- Depreciation: Straight Line, Cost Segregation, Bonus Depreciation
- Pass-through Deduction: If you own properties through an LLC or business
- Long-term Capital Gains Tax: Typically less than income tax levies
- 1031 exchange: Defer federal capital gains tax when selling an investment property
- Opportunity Zones: Defer tax on prior gains
Please note, Westwood Net Lease Advisors is not providing legally binding tax advice. This article is informational only. Please consult with your CPA or tax advisor for verification of your individual tax situation.
NNN Tax Benefit #1. Depreciation: Straight Line, Cost Segregation, Bonus Depreciation
Straight Line Depreciation
Straight line depreciation, or “straight line basis,” is the easiest way to estimate the taxable loss of your NNN property over time. Calculate straight line depreciation by dividing the difference between the property’s cost and its expected salvage value (ESV) by the number of useful years.
- Take the cost of the property minus the land value to arrive at your total depreciation cost: $200,000,000 – $300,000 (land value)= $700,000 depreciation cost.
- Then determine the useful life of property: 39 years for commercial property.
- Divide the depreciation cost by those years for your potential annual depreciation amount: $700,000/39 years = $17,948 annual fixed depreciation amount.
You can deduct the annual fixed depreciation amount on your taxes each year until the property reaches the end of its useful life, i.e. the deprecation is complete, or you sell the property. All property types except ground lease properties can qualify for straightforward depreciation.
Cost Segregation Depreciation
Cost segregation depreciation (CSD) allows for nonstructural “leasehold” improvements, such as indoor and outdoor lighting, heating and cooling systems, and parking lot and landscaping, to be depreciated over a shorter amount of time — five, seven, or 15 years versus 39 years.
This substantially shorter depreciable tax life helps you preserve capital, realize immediate cash flow, and achieve significant tax relief on new and existing buildings. These benefits are also gained through asset reclassification and write-offs when the asset is sold. In summary, CSD allows you to:
- Adjust deduction timing to maximize tax savings.
- Swiftly depreciate expenses.
- Reduce/defer current tax liability.
- Increase cash flow for other investment opportunities or operating expenses.
- Take 100% of the adjustment (on buildings purchased after September 2017 and before December 31, 2022) in one year, i.e., bonus depreciation.
- Reclaim deductions dating back to 1987 without having to amend tax returns.
- Create an audit/paperwork trail that satisfies the IRS’s audit techniques guide (ATG).
The only way to determine if your newly purchased or existing NNN property qualifies for the maximum CSD benefit is to have engineering, architecture, construction, or tax accounting specialists perform a cost segregation study (CSS).
Chris Schellin, President of Westwood Net Lease Advisors, explains, “Cost segregation depreciation, which can be substantial and immediate, especially with bonus depreciation, offers one of the biggest tax benefits available to the triple net lease investor.”
The Internal Revenue Service (IRS) bonus depreciation tax code allows business taxpayers to deduct additional depreciation for the cost of qualifying new or used business property (excluding real property but including leasehold improvements) in the year it was placed into service. A leasehold improvement or a “qualified improvement to the property” is any improvement made to an interior portion of a nonresidential building already placed in service. A CSS can identify the potential depreciation amount.
When claiming bonus depreciation, qualifying business property can be depreciated 100% between September 27, 2017, and December 31, 2022, with the percentage phasing out over the next four years.
NNN Tax Benefit #2. Pass-through Deduction: If You Own Properties Through an LLC or Business Entity
In 2018, the Tax Cuts and Jobs Act created a tax deduction called the Qualified Business Income (QBI) deduction (Section 199A). To qualify for the QBI tax code and claim as much as a 20% deduction on your income, your business must be a pass-through entity, such as an LLC or sole proprietorship, and meet certain guidelines as outlined by the IRS. This large federal tax deduction began in 2018 for income tax returns filed in 2019 and has an ending date of December 31, 2025.
NNN Tax Benefit #3. Long-term Capital Gains Tax is Typically Less than Income Tax
When you sell commercial real estate, profits from the sale are usually taxed as capital gains rather than “income.” Capital gains taxes are levied by the government at a special tax rate based on various factors: short-term or long-term gain, annual income bracket, and filing status. Typically, long-term capital gains are taxed by the IRS at 0, 15, or 20%, while short-term gains on an asset held for less than a year are typically taxed on a taxpayer’s ordinary tax bracket, from 10 to 37%.
In addition to federal capital gains tax, there are also state capital gains taxes and/or state income taxes to consider. Many states calculate capital gains taxes and income taxes differently, and some do not impose them at all, so be sure to understand the regulations of the state in which you file taxes (not necessarily the state where your CRE investment is) to minimize your capital gains tax bill.
And let’s not forget about the 1031 exchange which allows complete deferral of the federal capital gains tax, potentially indefinitely.
NNN Tax Benefit #4. 1031 Exchange: Defer Capital Gains Tax When Selling an Investment Property
When you decide to sell your NNN lease property, if the sale price exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income. There is also a capital gains tax levied by the IRS and possibly the state in which you file taxes.
However, when you use a 1031 exchange to trade into a different investment property, not only can you defer 100% of the federal capital gains tax, possibly indefinitely, but you may also defer the depreciation recapture tax, which can provide an additional savings of 25%, freeing up a significant amount of capital to reinvest.
Depending on your investment strategy, you could choose to exchange investment properties indefinitely as there is no limit to how many times you can use the tax code in a lifetime. The 1031 exchange is a smart way to build wealth by acquiring increasingly profitable commercial real estate while avoiding capital gains taxes.
NNN Tax Benefit #5. Opportunity Zones: Defer Tax on Prior Gains
The Tax Cuts and Jobs Act of 2017 created the Opportunity Zones program, which is another way to defer paying federal capital gains taxes on prior gains from the sale of investment properties.
The IRS defines an Opportunity Zone (OZ) as an economically distressed, low-income US community deemed ripe for economic redevelopment. These investments, under certain conditions, may be eligible for preferential tax treatment, such as the deferral of capital gains taxes until December 31, 2026, provided you reinvest capital from a 1031 exchange, stock cash-out, or the sale of a business into a Qualified Opportunity Fund (QOF).
Qualified Opportunity Funds are investment vehicles in which you must place at least 90% of your assets in qualified investment properties located in one or more of the nation’s 8,700 Qualified Opportunity Zones. This program is designed to incentivize investors to invest in these communities long-term and improve the quality of life for those who live there.
Therefore, if you were to keep the QOF for ten years, you could be eligible for an increase in the basis of the investment equal to its fair market value on the date the investment is sold or exchanged, essentially resetting the basis and deferring capital gains tax once again.
To Wrap it Up — When it Comes to NNN Lease Investing, Tax Strategy is Key
When it comes to NNN lease investing, a tax strategy is key. Whether you decide to form an Investment LLC, perform a CSS for cost segregation depreciation, trade an underperforming property for a higher-value property using a 1031 exchange, or defer taxes by investing in an Opportunity Zone, when utilized correctly, the IRS’s tax codes can help you build wealth and keep your money working for you.
When you work with a Westwood Net Lease Advisor to purchase your next triple net property or use a 1031 exchange, we start the process by getting to know you and performing a risk tolerance assessment. This includes tax education and an exit strategy, so you know where you’re going and what you’ll get out of it before you invest your hard-earned money. Questions? Contact us today for a no-obligation conversation about triple net lease investing using tax benefits. Our buyer services are free. 314-997-5227