Very few business opportunities allow investors to build wealth without paying taxes and subsequently pay reduced taxes when the time finally comes to settle up with Uncle Sam. Commercial real estate ownership is a prime exception. There are not many wealthy individuals that are not involved in the commercial real estate. They are not in real estate because they are wealthy. In many cases, they are wealthy because they are in real estate.
While most real estate entrepreneurs know there are a number of ways to make money investing in commercial real estate, two of the most common are rental income and appreciation. When applied properly, both of these wealth building tools will result in little or no taxes until the property is sold.
Assume a doctor in Fort Bend purchases a small professional building for $1,000,000.00 and then leases space in the building to a couple of other doctors for a total of $10,000 per month (or $120,000 per year). Assume the monthly out-of-pocket expenses for the building averaged $8,333 per month (or $100,000 per year). This would include the mortgage payment, repairs, and maintenance, management fees, etc. Although this investment would generate a positive cash flow, it most likely would result in a tax loss. The reason for this is when the doctor files the activity for the building on his annual tax return, depreciation rules allow him to recoup the purchase price of his investment over time through annual tax deductions. In other words, the depreciation is counted as a non-cash expense. When it is combined with the other property ownership expenses, it is very likely that the total expenses would exceed the amount of income received on the property. In some situations, this tax loss can be used to offset other W-2 income.
A second wealth-building component in this example is the appreciation of the property itself.
Historically, real estate values have increased over time. Let’s assume that over a three-year period the doctor’s professional building increased in value to $1,200,000.00 and the monthly mortgage payments had reduced the outstanding debt to $950,000.00. The doctor would have increased his net worth by $250,000.00. Another huge benefit of this scenario is that when the property is eventually sold to tum that equity into cash, the majority of the gain is taxed as long-term capital gain that has preferential tax treatment. Currently, the maximum long-term capital gain rate is 15%. Compare this to an additional $250,000 in income that the doctor might have earned from operating his practice. Odds are, the doctor would be paying taxes at more than double that rate on the additional income.
All commercial real estate investors need to know about a 1031, or like kind, exchange. A 1031 exchange allows an investor to sell a property at a gain and then roll that gain into a like-kind property without any tax consequences. The gain generated by the first transaction is deferred into the new property. In other words an investor would owe no capital gains tax on the sale of a property using a 1031 exchange. If the investor later sold the acquired property, the taxes would be due at that time. It is important to note that “like kind” doesn’t mean that an office property must be exchanged for an office property. It means that real estate must be exchanged for real estate. You could not exchange real estate for personal property (i.e. an airplane) and defer capital gains tax. An investor contemplating a 1031 exchange must declare that he is doing the 1031 exchange at the time the sale closes on the first property.