Before you buy or sell commercial real estate, it’s essential to grasp the tax issues and challenges that could eat into your profit. Often, timing your deal correctly is the best way to defer taxes. Here are some important tax issues to consider when diving into the world of commercial real estate.
What’s your basis?
You can’t figure out the profit you make from any deal and mitigate capital gains taxes until you understand the cost of your investment. In tax speak, this is called your tax or cost “basis.” Your cost basis is the price of your purchase (down payment and mortgage), plus some closing costs, including legal and recording fees, title insurance, surveys, transfer taxes, and any money your seller owes that you agree to pay, like back taxes, repairs, and commissions.
Not everything you pay connected to the purchase of commercial real estate is considered part of your cost basis. Most of these exclusions are attached to the cost of your mortgage, including credit report costs, points, mortgage insurance premiums, required appraisal fees, and loan assumption fees.
Your cost basis isn’t carved in stone. The basis can go up or down during the course of your ownership of a property; this is called an “adjusted basis.” If you make capital improvements, your basis will increase; if you depreciate an income-producing property, the cost basis can decrease.
How do you calculate capital gains?
The capital gains you realize on a commercial real estate deal are determined by subtracting the adjusted cost basis of the property from the amount you realize on the sale. Profit on the sale is taxable, which is why it’s so important that you calculate your adjusted cost basis correctly. Mistakes can cost you a pile of money in capital gains taxes.
What is a 1031 exchange?
A 1031 tax-deferred exchange is an Internal Revenue Service (IRS) tax break that lets you defer (not eliminate!) capital gains taxes until you’re finished buying and selling similar properties used for similar purposes, like exchanging a shopping mall for an office building. The adjusted cost basis of your old properties is carried forward to your new properties, possibly over and over again until the music stops and you halt or delay any new purchases. That’s when you pay the piper, in this case, the IRS.
Here’s where timing is crucial. In a 1031 exchange, once you sell a property, you have only a limited time to identify a new, like property (within 45 days) and close on the purchase (typically within 180 days). Get the timing wrong, and taxes become due.
Calculating cost, timing a new purchase, and figuring capital gains taxes can be tricky. Give us a call, and we’ll help you make the most of your commercial real estate deals and pay the least taxes.