Commercial real estate investments enjoy depreciation deductions during the free cash flow operating period, but depreciation recapture on the sale may offset all of that

▂▂▂▂▂▂

Depreciation during the Free Cash Flow Period

The depreciation tax deduction is a unique benefit when investing in property, whether real or personal. In addition to taxes, operating expenses, property management fees, and more, depreciation is a tax deductible expense. Depreciation deduction in the commercial sphere can even be substantial enough to entirely offset free cash flow, reducing the tax burden to zero for your investors while still giving them a healthy cash distribution.

Depreciation of the Building Only

The land under the property will not apply in your depreciation deduction. You must separate the cost of the structure(s) from the land in order to know your depreciation base. One of the easiest ways to find that breakdown is the tax assessed value on the county website. If the taxable value does not match the sale price, you can conservatively apply the same proportions of the taxable values to the sale price. Once the building value has been isolated, you can apply a straight-line depreciation on the building over 39 years for the commercial property. A cost segregation study, which attempts to identify individual items that may be depreciable over an accelerated period, may also be applicable to your property. The depreciation amount may then be deducted from the remaining free cash flow.

Often, the depreciation deduction in commercial real estate may more than offset the remaining cash flow. If the operating agreement allocates depreciation proportionally to the Limited Partners, then most, if not all, of their cash distribution can be offset by that depreciation deduction, potentially giving the investors a tax free distribution. This is not tax advice as Archway is not a tax professional, so each investor should seek their own tax counsel.

Depreciation Recapture at the time of Sale

The IRS applies a depreciation recapture law in the event of a sale of a commercial property. (There is no depreciation recapture on the sale of your own home as long as you never used any portion of it, or deducted any expenses from it, for business purposes). Depreciation recapture for commercial real estate essentially sums all the previous depreciation deductions taken on the property for the current owner and applies a tax, capped at 25% in 2022, on that sum. In effect, this depreciation recapture negates the tax benefits of depreciation during the operational phase of commercial real estate investments.

Can You Avoid Depreciation Recapture

1031 Exchange

A 1031 exchange delays the depreciation recapture tax in the same way that it delays the capital gains tax on a commercial property. As long as you place the gains from the property into another commercial property within the time frame set for by the IRS, your capital gains and depreciation recapture taxes are deferred. However, the amount you would have owed transfers into the new property. If you sell that future property and do not roll it into another 1031 exchange, then the depreciation capture tax (and capital gains tax) of not only the first property but also the second will come due. However, just as capital gains tax deferral, so too does depreciation recapture tax deferral allow investors to grow their money at a faster, compounded rate than had they paid the recapture tax at each transaction.

Inheritance and Cost Basis Step-Up

Currently there is a way to entirely avoid depreciation recapture taxes - giving property to heirs as inheritance! Once the heir inherits the property at the time of the owner’s passing, the cost basis of the property steps up, in other words, it restarts. The cost basis will become the same as the value of the building at the time of inheritance. Therefore, there is no depreciation in the building and no depreciation recapture tax. The same principle therefore applies to capital gains. At the time of inheritance, if your heirs sold the building the day after the owner’s passing, they would owe essentially zero depreciation recapture tax and zero capital gains tax, yet they would enjoy the proceeds from all the appreciation of the property during the donor’s ownership period.

Wrap Up

Depreciation deductions are strategies used by the IRS to incentivize long-term investment in real estate. The depreciation recapture tax only applies when the building is sold without being rolled over. If the property is not rolled over in a 1031 exchange, the recapture tax may offset much of the depreciation deductions taken over the ownership period. However, if the property is rolled over, then the recapture tax is deferred. That recapture tax builds, just like deferred capital gains tax, until the property is sold without a roll-over. If it is inherited at the time of the owner’s passing, the cost basis of the property is stepped-up, or reset, to match the value of the property, absolving the heirs of depreciation recapture or capital gains tax if they sold the property immediately.

Commercial real estate can be a profitable investment, despite the depreciation recapture tax, even if the properties are not rolled over. A careful review with the Manager of the investment and your tax professional can help you decide the best choice for your investment capital.