It’s a pleasant surprise when you find out that the business property you’ve owned for years has appreciated significantly. But don’t be surprised by the amount of taxes you could owe when you sell it. This article will help you better understand the tax implications of selling commercial property, and the ways by which you can minimize capital gains taxes.
What Is Capital Gains Tax?
According to the capital gains tax definition, capital gains tax is the amount levied on any increase in an asset’s value from the time of acquisition to the time of sale. The formula is simple in concept:
Sales Price – Initial Purchase Price = Capital Gain
But the formula must be adjusted by an accountant to comply with current tax codes. The tax on the capital gain is paid by the owner of the commercial real estate.
Short Term vs Long Term Capital Gains Tax
The capital gain on real estate held less than one year is subject to a short term capital gains tax. For real estate held more than one year, the gain is subject to a long-term capital gains tax.
Short term capital gains taxes are taxed (in 2019) according to your tax bracket. For a single filer:
$0 – $9,525—10%
$9,526 – $38,700—12%
$38,701 – $82,500—22%
$82,501 – $157,500—24%
$157,501 – $200,000—32%
$500,001 and above: 37%
Long term capital gains are taxed (in 2019):
0 – $39,375: 0%
$39,376 – $434,5500%: $15%
$434,551 and above: 20%
As you can see from the tables, taxes are less for long term capital gains. Most financial planners would advise holding assets until they become long term capital gains. This Forbes article on long term and short term gains will help to better understand tax deductions.
State Taxes on Capital Gains
The following states have no state capital gains taxes:
- New Hampshire
- South Dakota
The following states have some type of special treatment of capital gains income:
- New Jersey
- New Mexico
- New York
- North Dakota
- South Carolina
California has the highest capital gains tax rate (13.3% in 2019), followed by Minnesota, Oregon, Iowa, New Jersey, and Vermont (at 9% or higher).
For a better understanding of state taxes on capital gains see this helpful post by CBPP.
Net Investment Income Tax
The net investment income tax went into effect on January 1, 2013, as a way of helping to pay for the Affordable Care Act. The tax is a 3.8% surtax on a portion of your Modified Adjusted Gross Income (MAGI).
It targets higher income earners with significant investment income. Trusts and estates with whose adjusted gross income exceeds the starting point of the highest tax bracket are also subject to the tax. The overview on The Balance explains what this tax is and how to calculate it in more detail.
A commercial real estate owner is permitted to depreciate a commercial building over time, to lessen taxable income. This depreciation can be deducted as a loss on their tax return. But if the building is sold, and the sales price is higher than the depreciated value, the increase is treated as a capital gain to be taxed.
When the property is sold, the taxes deducted as depreciation must be recaptured (paid back)—if it sells for more than its depreciated value. Here is a comprehensive explanation of adding depreciation back by Huffpost.
What Reduces Capital Gains Tax
Selling at a Loss
Sometimes, opportunities in commercial real estate don’t turn out as planned. As an example, that old apartment building you gutted and restored seemed like the right decision at the time. But if the city’s primary employer shutters its factory, you may own a building that’s not worth what you have in it.
A depreciated property is often sold to a cash commercial property buyer. This kind of transaction is different from a traditional sale through a broker. This in-depth guide to selling commercial real estate by Property Cashin—North America’s largest platform for off-market commercial properties, explains how it works in detail.
When a property sells for less than its true cost basis, you don’t pay capital gains tax. In contrast, the resulting capital loss reduces taxable income. Report any such loss on Schedule D of your Form 1040. And this loss will offset an equivalent capital gain on any other investment property sold.
Capital gains tax can be deferred by doing a 1031 exchange of like-kind property. As an example, if you sell an office building, you can qualify for an exchange with the purchase of another office building of equal or greater value. But you aren’t eligible if you purchase a warehouse.
Additionally, the new property must be located within 45 days of the original property’s date of sale. And the new property closing must be completed within 180 days of the date of sale.
For other details to help with the pre-sale planning of a 1031 exchange, check with your accountant.
Tax laws have historically favored long-term investments over short-term investments. While no one can predict future changes to tax laws, holding real estate investments over one year (at least) is usually the best tax strategy, regarding capital gains taxes.
You cannot shelter capital gains from your current year’s taxes with a Roth IRA. But a Roth IRA has tax advantages when you retire.
You can defer capital gains taxes by contributing to a traditional IRA or a 401k—up to the full allowable contribution. But the value of the IRA and 401k is taxable when either account is liquidated.
Using a tax-advantaged retirement plan to shelter a capital gain from taxes has a limited benefit, because of small contribution limits.
Opportunity Zones were created through the Tax Cut and Jobs Act of 2017. Certain rural and urban areas that were historically capital-deprived, but had growth potential, were designated as Opportunity Zones. Capital gains invested in these areas are deferred until the end of 2026. If the gains are held in a Qualified Opportunity Fund for at least seven years, taxes are reduced by up to 15%. Gains held for ten years or longer become exempt from capital gains taxes.
There are four types of charitable trusts:
- Charitable lead annuity trust
- Charitable lead unitrust
- Charitable remainder annuity trust
- Charitable remainder unitrust
These trusts have in common:
- Capital gains can be deferred for contributions.
- The trusts benefits a chosen charity at the end of the trust’s term (number of years or grantor’s death).
- A fixed amount is paid to the beneficiary annually with an annuity trust. And a variable amount is paid to the beneficiary with a unitrust.
The differences between the types of trusts are beyond the scope of this article. An experienced estate planning attorney should be consulted when deciding which type of charitable trust will work best for your situation.