If you’re new to commercial real estate investing or considering selling a rental property but fear the tax implications, this article will help you better understand income tax and capital gains tax and the difference between them. (Please note, Westwood Net Lease Advisors is not giving legal or tax advice – this article is for information purposes only. Please consult your CPA or tax attorney for verification of your individual situation).
Quick Definition of Income Tax & Capital Gains Tax
In short, income tax is ongoing and paid on the rental income a property generates minus any expenses or deductions, just as if the money was coming from a salary or dividends.
A capital gains tax, on the other hand, is imposed one time – when you sell an investment property. The IRS taxes the profits from the sale when those profits are not rolled into another like-kind property in a 1031 exchange.
Let’s expound on these two taxes in a bit more detail so you feel informed as you move forward with your net-lease investment decision.
What is Rental-Property Income Tax?
Rental income is taxed as ordinary income, defined by the IRS as “any payment received for the use or occupation of a property.” 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. Some examples of rental income include, but are not limited to:
- Rent payments you receive from tenants.
- Advanced payments of rent, such as first and last month’s rents, in the year received.
- The portion of the security deposit you intend to keep, unless you return 100% of the deposit.
- Services or repairs performed by tenants in place of monetary rent payments.
- Any fees in addition to rent, like a pro-rata share of CAM or utilities.
Possible Income Tax Deductions
Although there are typically no landlord expense deductions with an absolute NNN lease property, your CPA can determine if you are a candidate for cost-segregation depreciation and/or line-item depreciation deductions, qualified business income (QBI) and mortgage interest deductions, possible Section 199A Safe Harbor deductions (as of 2020), depreciation recapture, and other tax opportunities.
There are also seven states with no income tax and two others that have more reasonable dividend taxes, so if you live in or own property in any of these states, it may be possible to save on state income taxes.
When it comes time to calculate your actual annual income and claim deductions against the income tax on rent received from a CRE property, your best resource will be a reputable CPA.
What is Capital Gains Tax?
Selling a property? You need to know about this tax before you sell. A capital gains tax is a levy on the profits from the sale of a property or properties. When selling an investment property, if the profits are not re-invested, the capital gains tax could amount to a significant tax bill.
However, under Section 1031 of the Internal Revenue Code, a 1031 exchange allows you to invest profits from the sale of one or more investment properties into one or more like-kind properties within 180 days, and defer the capital gains tax – potentially indefinitely.
Keep in mind, you must legally identify the property with your Qualified Intermediary within 45 days from the sale of your original property. As a result, it is best to start a dialogue with a buyer’s broker for your 1031 a few months in advance. A 1031 exchange is a great option to relinquish heavy, high-maintenance or under-performing properties for low or no-maintenance NNN investments and preserve capital.
Let’s Not Forget Deprecation Recapture Tax
Another tax that may pertain to you when you sell your investment property is the depreciation recapture tax.
When you claim property depreciation on your tax return for your current investment property, it reduces your annual income that would be subject to taxes. Then, when you sell the property, the IRS wants that money back. Therefore, when the sale price of a property exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income that’s then taxed using ordinary income tax rates.
The good news here is that in a 1031 exchange, not only can you defer the capital gains tax, you may also defer the depreciation recapture tax, which can provide additional tax savings.
To Wrap it Up – Understanding Income Tax, Capital Gains Tax, & Tax Opportunities
As you can see, when it comes to investment properties, there are many income tax and capital gains tax variables and opportunities. We have simplified the information for this article but want you to feel comfortable enough with the terminology to have a working knowledge of these tax codes and feel prepared for your property search or property sale.
When dealing with the ins-and-outs of tax codes and buying/exchanging commercial properties, a buyer’s advisor and a reputable CPA will be your best resources. Westwood Net Lease Advisors specialize in triple-net lease 1031 exchanges. To learn more, contact us today for your free consultation. 314-997-5227