The Stock Market Vs. Commercial Real Estate

Commercial Real Estate Gives You More Influence Over Returns

 

Investing in the stock market is sometimes compared to gambling. While not entirely accurate, there’s an important truth in the comparison: both the casino and the stock market are environments in which money is put at stake, with very little possibility to individually influence one’s end results in terms of profits or losses.

 

Along with reducing your annual fees and charges as much as possible, another long-term goal of any investor’s career should be to reduce their taxes as much as possible.

 

Commercial real estate investing carries several important tax advantages that don’t apply to stocks, bonds, mutual funds, and other similar asset classes. Let’s briefly review them.

 

1. Depreciation

 

The IRS has set the official “useful life” of a commercial property at 39 years, so depreciation on the asset is based on that figure. For every year that you own it, you can write off 1/39th of its total price as a deduction for depreciation.

 

Depreciation is an especially valuable tax benefit, because it’s what’s known as a non-cash expense. This means that you accrue valuable tax savings on an annual basis, but haven’t technically paid anything to get them.

 

You will eventually have to pay taxes on the sum total of money that you previously wrote off for depreciation when you sell the property. This is known as the depreciation recapture tax.  But it’s still an overall benefit, because the depreciation recapture tax rate tends to be lower than income tax rates and other varieties.

 

2. 1031 Exchange

 

Even though you can’t completely avoid the depreciation recapture tax, you can defer it using what’s called a 1031 exchange. In commercial real estate investing, a 1031 exchange allows you to defer paying capital gains taxes and depreciation recapture taxes when you sell your investment property.

 

There are some caveats to this to be aware of though. The IRS only allows 1031 exchanges if you use the proceeds from the sale of your property to invest in the same type of asset (also called a “like-kind investment”). Additionally, there is a time limit of 180 days to engage in a 1031 exchange from the date you sold your original property.

 

Many investors will purchase and sell a property, then use the profits to upgrade to a larger and more profitable investment. In the real estate industry, this is known as “trading up”.

 

When the IRS finally does charge you capital gains taxes and the depreciation recapture tax upon the sale of your property, it will be based on the smaller, original property. Investors can do this multiple times, meaning the cumulative effect on your profits can be quite large if you invest strategically across time.

 

3. Interest Expense

 

Most commercial real estate deals are financed through loans. When you purchase a commercial property, you’re able to write off the annual total of the mortgage interest on your loan against your earned income.

 

This can result in substantial savings during tax season, especially during the early phases of your loan repayment.

 

4. Your Beneficiaries Will Receive Tax Benefits

 

In addition to the tax benefits listed above, commercial real estate confers tax benefits on your beneficiaries if you happen to leave your real estate investments to your descendents or other beneficiaries in your will.

 

If someone inherits and then sells your property after your death, they will be able to engage in a 1031 exchange if they wish, enabling them to defer capital gains and depreciation recapture taxes.

 

Also, if you pass down your commercial property, your heirs will get what’s known as a “step-up” basis. This means that when they finally choose to sell, they’ll only pay capital gains taxes on the value of the investment when they inherited it.

 

If you leave your commercial real estate to others in your will, a “step-up” basis can be very profitable if the property appreciates between the time of being bequeathed and sold.