Tax Implications of Selling a Commercial Investment Property in the US
**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**
From the following article you will learn about the tax treatment of selling commercial real estate in the USA and ways to legally reduce your tax liabilities. We will discuss:
- long and short term Federal capital gains tax, its rates, and when it’s applied or not applied
- state income tax
- capital loss and how to apply it to reduce your tax liability
- depreciation recapture
- 9 legal ways to reduce your tax liability.
Note: you might also be interested in our guides on commercial real estate property tax:
- ABC’s of Commercial and Industrial Real Estate Property Taxation
- 5 Robust Commercial Property Tax Reduction Methods
Read on to learn more about proper tax planning on the sale of commercial property.
Tax Treatment of Selling a Commercial Investment Property
Federal Capital Gains Tax (CGT)
What Are Capital Gains?
Let’s not make this harder than it already is. Generally, capital gains are profits from investments sold for more than original purchase prices. They are called realized capital gains. However, when it comes to commercial real estate investment property, there’s a twist.
Unlike stocks with fixed purchase prices, original real estate prices are adjusted for tax purposes. On acquisition, a tax or cost basis (including legal fees, transfer taxes, and other closing costs) becomes part of the purchase price. Likewise, during ownership, an adjusted basis calculation often includes capital improvements (e.g., roof replacements), thereby increasing purchase costs and reducing any capital gains on future sales.
What Is Not Considered Capital Gains?
Properties qualified for capital gains are immovable investment properties — anything considered real estate, such as land, buildings, decks and pools. But there is an important caveat: proceeds from a sale of business assets aren’t considered capital gains.
A business asset is a piece of property or equipment bought primarily for business use. They may be depreciated or expensed in the purchase year under Section 179 and eventually written off.
The same is true for real estate developers in comparison with real estate investors. Proper classification has been frequently litigated. Jennifer Seaton, Partner RSM US LLP, cautions that “Decisions and actions that occur early in the acquisition phase of real estate investments can have far-reaching implications for the taxability of real estate investments.”
Any uncertainty about the following five considerations (Seaton, 2014) may portend the need for professional counsel:
- Frequency and continuity of sale.
- Nature and extent of improvements and development activities.
- Solicitation, advertising and sales activities.
- Extent and substantiality of transactions.
- Nature and purpose for holding property.
Profits from business activity are typically treated as ordinary business income rather than capital gains.
Basic Capital Gains Calculation
A simple capital gains calculation looks like this: adjusted gross proceeds from the sale of a qualified capital asset (say $200,000) minus the adjusted original purchase price of that property (say $150,000) equals a $50,000 capital gains amount. This formula applies to both short- and long-term capital gains. Yes, it gets harder from here on but that’s it, a capital gain in a nutshell.
As usual, the devil is in the detail. Let’s start with short-term gains, one of the two major categories. As you will see, tax rates skyrocket compared to long-term gains.
Short Term Capital Gains (STCG)
Definition and Explanation
Capital gains on sale of commercial immovable property held for one year or less are classified as short-term. Again, these gains on real estate sales — such as buildings and land — are calculated by subtracting adjusted sales prices from adjusted purchase prices to compute capital gains.
Short Term Capital Gains Tax Rates in 2021
Gains are taxed as ordinary income at the regular individual income tax rate. Per the IRS Tax Rate Chart below, Joint filers with $75,000 in short-term capital gains fall into the 12% rate bracket rather than a 0% tax rate shown in the next section for long-term capital gains. Clearly, the asset holding period is pivotal to your commercial real estate tax planning.
2021 Ordinary Income Tax Brackets and Rates
Here is how to start the federal tax calculation.
- If you purchased the property, determine the number of days that lapsed between purchase and sale dates.
- If the property was a gift, calculate the number of days between the date acquired by the original owner and your sale date.
- If the property was inherited, calculate the number of days between the original owner’s date of death and the sale date.
If the number of days from acquisition to sale is 365 or fewer, it’s a short-term capital gain.
Long Term Capital Gains (LTCG)
Definition and Explanation
Gains on the sale of commercial real estate property owned for more than one year are classified as long-term. Calculating these gains is covered in the What Are Capital Gains? section above. It’s no different than the short-term capital gains calculation–but for sure–tax rates are much lower. Simply subtract the property’s adjusted cost basis from the sale’s adjusted gross proceeds for capital gains, a.k.a., profits.
Long Term Capital Gains Tax Rates in 2021
Per the IRS chart below, those Joint filers with $50,000 in capital gains now fall into the 0% rather than 12% tax bracket for short-term capital gains (chart above). What a difference a day can make! No brainer it would seem unless there’s a looming financial crisis (a 20% US unemployment rate perhaps?) or other compelling reasons to sell earlier.
2021 Tax Rates on Long-Term Capital Gains
Note also at the bottom of the rate table an Additional Net Investment Income Tax that applies to Modified Adjusted Gross Income (MAGI) over certain thresholds. It’s a 3.8% surtax on high earners enjoying investment income tax breaks, i.e., deductions, credits, and other tax perks. The surtax applies to most investment sale gains above the table’s limits ($250,000 for Joint filers).
Definition and Explanation
Capital losses occur when a qualified event such as the sale of investment property results in a loss. A loss is sustained when the original purchase price (adjusted for added costs) is greater than the sales price (adjusted for selling expenses).
To qualify as a capital loss, the property must have been held for investment and not personal use. Also, not until sold will losses be recognized. For example, if a commercial real estate investor paid an adjusted $500,000 for rental property that sold for an adjusted $475,000 two years later, the investor realized a $25,000 capital loss.
How Capital Loss Reduces the Capital Gains Tax Amount
Capital gains are netted against capital losses as outlined in the Short Term Capital Gains section above. Capital losses offset each tax year’s new capital gains, with any residual (unused) losses carried forward year-to-year until exhausted.
What to do with your capital gains, short and long-term when preparing to file your federal tax return? First, all capital gains and losses must be accounted for and netted by taking the following steps.
- Subtract any short-term losses (say $0.00) from short-term gains (say $50,000) for $50,000 in short-term net gains.
- Subtract any long-term losses ($0.00) from long-term gains ($50,000) for $50,000 in long-term net gains.
- Subtract short-term net losses ($0.00) from long-term net gains ($50,000) for $50,000 in long-term capital gains.
In 2021, for Joint filers, the $50,000 short-term capital gain falls under the 12% tax bracket for Ordinary Income (Ordinary income tax Rates chart above) while there’s no tax on the long-term capital gains (Long-term capital gains tax Rates chart above).
In addition, another tax may be imposed on property sold for more than its depreciated value. Called a Depreciation Recapture tax, it applies to commercial real estate property. The amount recaptured is taxed at a 25% rate. That calculation is covered later under the Depreciation Recapture section.
Of course, this does not end the whole short-term capital gains story. Federal tax law is legendary for its endless complexities. But be sure to take this with you: asset holding periods are pivotal to your commercial real estate tax planning.
State Capital Gains and Income Taxes
Many states impose capital gains and income taxes. However, conformity is frequently lacking, making state-by-state coverage here impractical. Some states allow taxpayers to deduct Federal income tax paid from state taxable income. Others apply special rules to capital gains income.
The table below lists rates for the 41 states that impose a capital gains tax. Rates on investment income range from North Dakota’s 2.90% to 13.3% for California. Nine states listed at the bottom have no personal income or capital gains taxes. Caution: states with no income tax may compensate with high real estate, sales, and other tax rates.
2021 State Capital Gains Rates Table
These nine states have no State income or capital gains tax:
- New Hampshire
- South Dakota
What Is Depreciation of a Property?
Depreciation is an expense. Each year as depreciable property declines in value, depreciation allows you to record losses incurred over time, thereby more closely reflecting true value. Of the two commonly used depreciation methods, straight-line produces the same expense each year ($1,000 on 10-year property with a $10,000 purchase basis) while accelerated depreciation front-loads the expense.
IRS rules for depreciation include:
- you must own the property.
- it must be a business.
- you can’t depreciate a property held mostly for personal use.
- it must have a determinable life span exceeding one year.
- it cannot be furniture.
How Does Depreciation Recapture Work?
In some instances, both capital gains on depreciable property and recaptured depreciation are taxed. Capital gains are one part of the tax calculation. A second depreciation-related portion is taxed at a higher recapture rate. When an investment property is sold for more than its depreciated value, a recapture tax of up to 25% applies.
For example, after four years your property with a $100,000 cost basis and 10-year lifespan now has an adjusted cost basis of $60,000. It sold for $65,000 and you’ve subtracted (say $1,000 in selling costs) from the sale price. Now $64,000 in adjusted sale proceeds are subtracted from the $60,000 sale value for $4,000 in depreciation recapture. The IRS will treat this recapture as ordinary income.
If there was a loss when the depreciable property sold, there’s no depreciation recapture. Also, the IRS will compare the asset’s realized gain with its depreciation expense. The smaller figure is determined to be the depreciation recapture amount.
Example of Calculating the Capital Gains Tax on Commercial Property
As an investment rather than business activity, let’s take commercial rental property bought for $550,000 in May 2010 and sold ten years later for $400,000. The land was appraised at $75,000 with recordation, legal fees, transfer tax, et al, costing $25,000. This sets the building’s adjusted cost basis at $500,000 ($550,000 paid minus the land valued at $75,000, plus $25,000 in acquisition costs). Now a $100,000 capital loss may offset any capital gains in that year. Also, a $3,000 maximum may offset ordinary income with any residual carried forward only, never to back-years.
Nonetheless, a depreciation recapture tax is due. The IRS’ depreciation period is 39 years on commercial rental property. Rounded accumulated depreciation totals $128,210 after 10 years ($500,000 divided by 39 = $12,821 x 10 years), setting the property’s depreciated value at $371,790 ($500,000 minus $128,210) on the sale date. This means you pay a 25% recapture tax on $28,210 ($400,000 sales price minus the $371,790 depreciated value).
All but thirteen states and some localities impose the transfer tax, either on the buyer or seller. It is assessed on real property when ownership of the property is exchanged between parties and is included in the closing costs paid during the commercial property transaction.
How to File Taxes After the Sale
For form 1040 filers, ordinary income from investment property sales is reported on Form 8949 and Schedule D along with filing capital gains taxes.
Income from sales of assets used by dealers in their trade or business are reported on Form 4797, including the depreciation recapture tax.
The nine states listed above have no income tax. Most states with the tax generally conform with IRS’ definitions and treatments.
9 Ways to Avoid or Minimize Capital Gains Tax on Selling a Commercial Investment Property
In this section we will give you a basic understanding of what methods of reducing your capital gains tax obligations exist. To learn about how they work in more detail, read our guide 9 Ways to Avoid or Minimize Capital Gains Tax on Commercial Real Estate.
#1 Deduct Capital Losses
Until exhausted, capital losses offset capital gains. For example:
- In 2016, your $40,000 capital loss offsets a $14,000 gain, along with a $3,000 offset of ordinary income.
- With no capital gains the following two years, $6,000 offsets ordinary income.
- In 2019, $10,000 in capital gains and $3,000 in ordinary income are offset.
- Now $4,000 in capital losses are left for future use.
#2 1031 Tax-Deferred Exchange
In like-kind property exchange, investors may defer paying capital gains, depreciation recapture, and income taxes on investment real estate property when it’s sold solely to reinvest the proceeds in another investment property.
Most often these exchanges are delayed (Starker or forward exchange), requiring sale proceeds be held by qualified intermediaries until reinvesting them in another property. There are also reverse exchanges (replacement property is acquired before the relinquished property is sold) and simultaneous exchanges (investors swap each other’s properties at the same closing, no qualified intermediary required).
Flipped property doesn’t qualify for a 1031 exchange. Any cash received to compensate the property value difference (boot) is taxed. There are other many important rules for this type of transaction to be valid.
If you are considering a 1031 exchange, take a look at our directory of top-rated 1031 exchange companies (qualified intermediaries) serving your area.
#3 1033 Tax-Deferred Exchange
Much like Section 1031, realized gain from an involuntary conversion (e.g., loss to casualty or condemnation) can be deferred if the owner acquires similar replacement property.
However, some Section 1031 restrictions don’t apply: no 45-day deadline for identifying a replacement; insurance proceeds need not be held until the replacement property is acquired; and no qualified intermediary (QI) is required.
#4 Section 721 Tax-Deferred Exchange
A Section 721 Exchange or UPREIT allows investors to exchange investment property for Real Estate Investment Trust (REIT) shares or an Operating Partnership without triggering a taxable event.
No replacement property is required, and sale proceeds may have already been given to the REIT. As with Sections 1031 and 1033, investors’ goals typically include tax deferral, diversification, and estate planning.
#5 Section 453: Installment Sale Tax Deferral
Under Section 453, tax deferrals are permitted in one of these cases:
- when accepting a carry back promissory or installment note on disposition. As a seller you defer capital gains income tax recognition until principal payments are received.
- periodic annuity payments are received. Deferred capital gains amounts are recognized pro rata on principal payments as received.
Important: depreciation recapture is not deferred.
#6 Opportunity Zones
Selected by state governors in 2018, Qualified Opportunity Zones (QOZs) were created in all fifty states and six territories to revitalize economically distressed communities. Incentives included allowing income taxes on reinvested capital gains proceeds to be deferred and reduced. Held for 10 years, a permanent income tax exclusion applies to capital gains earned post-investment; depreciation recaptures go untaxed; and 15% of the original gain goes untaxed after 7 years.
#7 Hold the Property for More than a Year
Called long-term, such properties may qualify for significant capital gains tax benefits (see the What Are Capital Gains? section of this guide). If so, real estate sale profits are taxed at long-term rates starting at $40,000 applied at 0%, 15% or 20% rates depending upon your taxable income and filing status. Conversely, short-term rates start at $10,000 and tops out at 37%.
#8 Charitable Remainder Trusts
Appreciated assets may be transferred to Charitable Remainder Trusts (CRT) tax free for a specific term. Since CRTs are tax-exempt, the trustee (or yourself as trustee) may sell these assets, thereby allowing proceeds to compound tax free.
All the while you receive periodic distributions, initially as ordinary income. Despite that when the trust ends, 10% stays with it and is used for charity, tax savings often dwarf that loss.
#9 Retirement Plans with Tax Advantages
Traditional plans include:
- Annuities — only the earnings portion of this income stream is taxed.
- IRAs and 401(k) — tax on contributions are deferred while distributions after 59½ are taxed as ordinary income.
- Roth IRA — when held 5+ years, there’s no tax on withdrawals after 59½.
- Non-retirement brokerage accounts — investments with long-term gains taxed at low rates on distribution.