Commercial real estate investment is about making a profit. However, the government wants a cut on the profit you make. This comes in the form of capital gain tax. Like you, the question on the lips of most commercial real estate investors is, how do I avoid capital gains tax on commercial property?
How Do I Avoid Capital Gains Tax on Commercial Property?
The best way to avoid capital gains tax on the sale of any commercial property is through a 1031 tax-deferred exchange. A 1031 tax-deferred exchange is one of the only legal ways to avoid paying taxes immediately on the sale of your commercial property. Instead, you can defer payments almost indefinitely.
Being able to reduce your tax burden or even totally avoid paying capital gain taxes in a fiscal year can be beneficial to your portfolio. You get to retain extra cash to grow your portfolio a lot faster. The government has provided the 1031 exchange and other means to allow you to make wealth to benefit the economy.
What You Should Know About the 1031 Tax-Deferred Exchange
While the 1031 tax-deferred exchange is completely legal, its execution can be tricky if you are not well-informed. There are a few things you should know to ensure that you do not get into any trouble with the government in a bid to avoid taxes. Here is a list of them:
The 1031 exchange is the primary way to legally avoid paying taxes on capital gains made on the sale of commercial property. Provided for in Section 1031 of the IRS Code, the 1031 exchange allows you to trade in the property for another one without incurring any immediate tax liability.
By taking advantage of this section of the IRS Code, you can technically defer your taxes for as long as you wish. However, you should keep in mind that you will be required to pay the deferred tax if you eventually choose to sell off a property outside of the 1031 exchange.
Type of Property
The 1031 exchange is also known as the “Like-Kind Exchange.” This is because of a particular requirement concerning the type of property that qualifies for a successful 1031 exchange. The 1031 exchange only permits tax deferral on the exchange of like-kind properties.
In other words, the replacement property must belong to a similar class to the relinquished property. This implies that:
- You can only exchange a commercial property for another
- The replacement property also has to be of equal or greater value to the relinquished property for the exchange to be successful.
Section 1031 of the IRS provides stringent requirements regarding the timeline of executing a 1031 exchange. This is perhaps the most difficult aspect of the 1031 exchange because finding a replacement property can be challenging. However, you have to follow the timeline strictly and duly to avoid any complications and punishments.
You have a total of 180 days to complete your 1031 exchange, counting from the day of the sale of the relinquished property. Within the first 45 days, you have to identify your replacement property and inform the IRS of your designation. Within the remaining time left, you have to close on the replacement property to qualify for the 1031 exchange.
To qualify for a 1031 exchange, both properties involved in the exchange have to be located in the United States.
Oftentimes, most 1031 exchanges are delayed. This means that you will need a qualified intermediary to serve as the middleman while the transaction lasts. They will also be responsible for buying the replacement property on your behalf.
Sometimes 1031 exchanges can be technical and problematic if not handled well. You should always have your 1031 exchanges handled by a team of commercial real estate investors like Si Vales Valeo Real Estate. We have vast experience in advising and handling commercial real estate transactions, including 1031 exchanges. We are your best shot if you are looking to invest in the Cincinnati MSA area.
Other Ways to Reduce Taxation on the Sale of Commercial Property
The 1031 exchange allows you to defer the payment on taxes almost indefinitely. However, there are other measures that you can take to reduce your tax burden. While they may not totally eliminate the taxes payable on capital gains, taking these measures would mean that you are required to pay fewer taxes than you would ordinarily have.
Here are some ways to reduce the capital gain taxes on the sale of property:
If you hold a property for at least two years before selling, you are eligible for significant benefits on your tax. However, only assets that were held for investment purposes and not business purposes qualify for this.
Qualified Opportunity Zones
Creation of the Tax Cuts and Jobs Act of 2017, the Opportunity Zones Program allows real estate investors to defer the capital gain taxes on the sale of their properties. The requirement for this is that the properties have to be located in any of the Qualified Opportunity Zones.
Capital losses refer to any loss made during the sale of a property. You can use capital losses to offset your gains tax basis. This means that if you sold a property at a loss in one year, you can reduce the taxable amount from the sale of another property in the same year.
How Much Capital Gains Tax Is Paid on Commercial Properties?
The tax rate on commercial properties is about 15% to 35%. However, the rates can differ based on a lot of other factors, including income bracket, duration of ownership, and marital status.
Is It Possible to Exchange One Property for Multiple Properties in a 1031 Exchange?
Yes, you are allowed to exchange multiple replacement properties for your relinquished property. That is as long as they have a total value that is higher than the relinquished property, and you can meet up with the timeline.
There is almost no one who likes to pay taxes. However, informed real estate investors can always take advantage of these options to avoid or minimize their exposure to capital gain taxes.