It is tax time again, so we’re sharing a quick rundown on all the potential CRE and triple-net (NNN) investment depreciation and other tax opportunities for which your property may qualify.
- Straight line depreciation
- Cost segregation depreciation
- Avoidance/deferral of depreciation recapture
- Bonus depreciation
- 1031 exchange
- Capital gains tax
- Income tax
Please note that this article is not legal tax advice. It is purely informational about the different tax options. We advise you to consult your CPA or tax advisor for verification of your individual situation.
Commercial Real Estate (CRE) Depreciation
Knowing which type of depreciation will give you the most favorable internal rate of return (IRR) is important when you already own commercial real estate (CRE), and when you first purchase an investment property.
While the land your NNN building sits on doesn’t depreciate, there are numerous assets of the property that are eligible. By taking depreciation over the course of a year, you could reduce taxable income by thousands of dollars.
Straight Line Depreciation
The most straightforward way to estimate the loss of value of your NNN property over time is with straight line depreciation, or “straight line basis.” To calculate straight line depreciation, divide the difference between the commercial property’s cost and 39 years.
Cost Basis / 39 years = amount of depreciation per calendar year
Your fixed depreciation amount can be deducted each year until the property reaches the end of its useful life, i.e. the deprecation is complete, or you sell the property. All types of properties, except ground lease properties, can qualify for this type of depreciation.
Cost Segregation Depreciation (CSD)
Cost segregation depreciation (CSD) allows for nonstructural improvements such as indoor and outdoor lighting, heating and cooling systems, and parking lot and landscaping to be depreciated over five, seven, or 15 years, versus 39 years, subject to qualification.
This shortened depreciable tax life can help preserve capital, provide 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, with a CSD you can:
- adjust the timing of deductions 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) 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).
Cost segregation study. We would be remiss if we talked about cost segregation depreciation without mentioning the cost segregation study (CSS). This study will tell you if your NNN property qualifies for the maximum CSD benefit.
- A CSS is performed when buying a new building.
- It can also be performed on a building owned for many years.
- A study is also advantageous when you finish new construction or complete redevelopment or renovation of an existing building.
To satisfy the IRS’s strict CSD guidelines, your CSS must be performed by a highly accredited engineering, architecture, construction, or tax accounting specialist who will determine the cost estimates and allocations in accordance with the law. This also ensures you don’t leave any money on the table.
Be sure to work with your accountant to claim the correct type and amount of depreciation each year to maximize your IRR.
“The benefits of cost segregation, which are relatively unknown by many commercial real estate investors, can be substantial and immediate, especially in recent years with accelerated ‘bonus depreciation.’ Cost segregation is one of the biggest tax benefits available to an investor.” Jason Simon, Vice President, Westwood Net Lease Advisors
Deferral of Depreciation Recapture
Depreciation recapture is income tax on a gain from disposing of an asset that had previously provided an offset to ordinary income through depreciation. In other words, because the IRS allows you to deduct the depreciation of an asset from your ordinary income annually, you must report any gain from the disposal of the asset (up to the recomputed basis) as ordinary income, not as capital gains.
When the sale price of a property exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income.
However, in a 1031 exchange, not only can the capital gains tax be deferred, but you may also defer the depreciation recapture tax, which can provide additional savings of up to twenty-five percent.
Under the 2018 Tax Cuts and Jobs Act (TCJA), the Internal Revenue Service (IRS) bonus depreciation tax code allows business taxpayers to deduct a one-time additional depreciation for the cost of qualifying new or used business property in the year it was placed into service, not over the course of many years. If bonus depreciation is taken for leasehold improvements, for example, the expense must be depreciated 100% between September 27, 2017, and January 01, 2023, leaving no depreciation for future years. The bonus depreciation will phase out as follows:
- 2022: 100%
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
The 1031 Exchange – Capital Gains Tax Deferral
When you sell an investment property for another or trade-up to a hassle-free NNN property, you may defer federal and state capital gains taxes with a 1031 exchange. With this tax code, the money you would have thrown away paying taxes is preserved. As long as you reinvest the money in another investment property of any kind and meet the 1031 timeline, you could defer taxes indefinitely − it’s basically an interest-free loan from the government!
The 1031 exchange tax code allows you to:
- sell any “like-kind” investment property for another, the only exclusion is a primary residence.
- diversify your holdings by exchanging one property for two or three.
- relocate your investment to a growing part of town or area of the country.
- build wealth and bolster your portfolio with deferred taxes (possibly indefinitely).
After the investment and the exchange is complete, you will see a return on the tax dollars that would have been paid to the federal government.
When utilizing the 1031 exchange, the tax opportunities of the exchange plus the depreciation recapture, along with a cost-segregation study (CSS) on a new or existing building, can provide a clearer picture of your capital preservation and return over the life of the investment.
As highly experienced triple-net lease advisors and 1031 specialists, we are here to help put you in a position to maximize your CRE and NNN investment profitability. — Chris Schellin, President, Westwood Net Lease Advisors
Capital Gains Tax & CRE Income Tax
A capital gains tax is a one-time levy imposed by the federal government and some states on the profits from the sale of a property or properties. In most cases when you sell an investment property you will pay:
- a long-term capital gains tax on the asset if you’ve held it for more than one year, unless it’s used in a 1031 exchange. This is when depreciation and depreciation recapture play a role in how much tax you will pay.
- a short-term capital gains tax if you sold a property before one year of ownership.
- a potential high-income earners tax (3.8%) on capital gains, or a “net investment income tax.”
When you search for your next NNN investment, you may want to consider buying in one of eight states with no income tax, as they do not impose a capital gains tax either. Those states are Alaska, Florida, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
There are also a few states that don’t tax capital gains, even though they have a state income tax – Colorado, Nevada, and New Mexico. Montana offers a credit to offset a portion of the capital gains tax.
Income tax, on the other hand, is ongoing and paid on the rental income a property generates minus any expenses or deductions, just as if the money were coming from a salary or dividends. Depending on the type of property you own and what the lease entails, there are several variations on how this income is calculated and then taxed. Your CPA is the best source to consult when it comes to income versus deductions and your final tax rate.
To Wrap it Up – CRE Depreciation & Other Tax Opportunities Can Optimize Your NNN Investment
To optimize your investment’s profitability, it’s important to be informed of all the CRE investment tax options and how they can preserve capital and build wealth.
If you have tax questions or would like a referral to a reputable tax specialist or highly accredited CSS professional before you file your taxes, Westwood Net Lease Advisors has a vast network with established industry relationships to help you get the solutions you need. We would be happy to make a connection. Feel free to contact us today for a no-obligation conversation. 314-997-5227