Having an effective tax strategy is critical to your success as a multifamily investor. Otherwise, you could see a large portion of your profits consumed by an outsized tax bill.
What Investors Need To Know About Capital Gains Taxes
When it comes to investing in multifamily or commercial real estate, having an effective tax strategy is critical to your success. Otherwise, you could see a large portion of your profits consumed by an outsized tax bill.
Of all the taxes an investor may need to pay as a result of their investment, none is more important than capital gains tax. Capital gains taxes are paid whenever a taxpayer generates a profit from disposing of an asset like commercial real estate, bonds, or expensive collectibles. Capital gains taxes generally do not apply to ordinary personal and business income or the sale of an individual’s primary residence.Capital Gains Tax Rates for Commercial and Multifamily Real Estate in 2023There are two major types of capital gains taxes: short-term capital gains taxes apply to property held for less than twelve months, while long-term capital gains taxes apply to property held for more than twelve months.
This is why, in general, (at least from a tax perspective) it’s more expensive to “flip” a commercial property and sell it in 12 months or less vs. holding it for a longer period of time. Just like income taxes, capital gains tax rates vary depending upon an individual taxpayer’s income during the year in which they sell a property.2023 Long-Term Capital Gains Tax RatesFor the 2023 tax year, long-term capital gains taxes are based on your filing status and can be found in the table below:
Filing Status | No Tax | 15% Tax | 20% Tax |
|---|---|---|---|
Single | $44,625 or less | $44,626 to $492,300 | More than $492,300 |
Married (joint filing) | $89,250 or less | $89,251 to $553,850 | More than $553,850 |
Married (filing separately) | $44,625 or less | $44,626 to $276,900 | More than $276,900 |
Head of Household | $59,750 or less | $59,741 to $523,050 | More than $523,050 |
2023 Short-Term Capital Gains Tax Rates
In comparison, short-term capital gains taxes based on a taxpayer's regular bracket. You'll find those rates listed below.
First, for single filers:Income | Tax Rate |
|---|---|
Up to $11,000 | 10% |
Between $11,000 and $44,725 | 12% |
Between $44,725 and $95,375 | 22% |
Between $95,375 and $182,100 | 24% |
Between $182,100 and $231,250 | 32% |
Between $231,250 and $578,125 | 35% |
More than $578,125 | 37% |
Next, married (but filing separately) filers have the following rates in effect:
Income | Tax Rate |
|---|---|
Up to $11,000 | 10% |
Between $11,000 and $44,725 | 12% |
Between $44,725 and $95,375 | 22% |
Between $95,375 and $182,100 | 24% |
Between $182,100 and $231,250 | 32% |
Between $231,250 and $346,875 | 35% |
More than $346,875 | 37% |
If you're married and filing jointly, here are the rates for your income in 2023:
Income | Tax Rate |
|---|---|
Up to $22,000 | 10% |
Between $22,000 and $89,450 | 12% |
Between $89,450 and $190,750 | 22% |
Between $190,750 and $364,200 | 24% |
Between $364,200 and $462,500 | 32% |
Between $462,500 and $693,750 | 35% |
More than $693,750 | 37% |
And finally, if you are filing as a head of household, here are the rates:
Income | Tax Rate |
|---|---|
Up to $15,700 | 10% |
Between $15,700 and $59,850 | 12% |
Between $59,850 and $95,350 | 22% |
Between $95,350 and $182,100 | 24% |
Between $182,100 and $231,250 | 32% |
Between $231,250 and $578,100 | 35% |
More than $578,100 | 37% |
Bear in mind that using a straight percentage applied to your income is not how your calculations should be handled. For example, if your income is $250,000, your overall tax rate will not be the 35% indicated above. Instead, that 35% will apply only to each dollar earned beyond $231,250 (and similarly on down).
Capital Gains Taxes and 1031 Exchanges1031 exchanges are well-loved by multifamily and commercial real estate investors, and for a good reason; they allow an investor to defer their capital gains tax bill by “exchanging” their current property with a similar commercial property.
However, there are a few rules that must be followed: the new property must cost at least as much as the original one, and personal residences are not eligible. In addition, investors need not already have a new property lined up immediately; they can utilize something called a reverse 1031 exchange in order to put off purchasing the exchange property for 180 days (additional time may be allowed in some scenarios, but that’s beyond the scope of this article). The 1031 exchange also generally allows borrowers to put off paying their depreciation recapture taxes, though they will still have to pay them at some point.Another Important Consideration: Depreciation Deductions and Depreciation Recapture TaxIf you own a commercial or multifamily property, that property will naturally age, require repairs, and inherently become less valuable (i.e., depreciate) over time. Fortunately, the federal government allows you to take property depreciation deductions against your income taxes to represent this loss in value. Multifamily properties are generally depreciated over 27.5 years, while purely commercial properties are typically depreciated over 39 years.
However, when an investor sells a property will still need to pay taxes on any depreciation deductions they have taken (but only if they sell the property for a higher amount than the depreciated value). This referred to as the depreciation recapture tax (technically referred to as a Section 1250 gain and taxed at 25%). For example, if an investor buys a $1 million apartment building and takes $200,000 in depreciation deductions against their federal income taxes, they will be required to pay taxes on that $200,000 upon the sale of the property (but not if they sell it for less than $800,000).Investors should also know that they can generally take accelerated depreciation deductions via ordering a cost segregation study, which identifies parts of a property (i.e., carpeting, insulation, etc.) that can be depreciated over a shorter period (i.e., 5 or 15 years). In addition, a temporary provision of the Tax Cuts and Jobs Act of 2017 allows investors to take an even larger depreciation deduction in the first year that they own a property (bonus depreciation). It’s important to realize that these accelerated deductions will still be subject to depreciation recapture later on.Capital Gains Taxes and The Opportunity Zones ProgramThe Tax Cuts and Jobs Act of 2017 authorized a new tax incentive program, referred to the Opportunity Zones program, which allows multifamily and commercial real estate investors to defer their capital gains taxes until December 31st, 2026 by reinvesting their assets into a Qualified Opportunity Fund (QOF). The program is designed to revitalize the lowest-income census tracts in the U.S. by encouraging additional investments in these areas.
While deferring capital gains taxes for up to 7 years is great, the program offers some additional incentives; those who keep their money in a QOF for at least 5 years before to December 31, 2026 are permitted to take 10% reduction in their capital gains tax basis, while those who keep their money in a QOF for at least 7 years before to December 31, 2026, are permitted to take 15% reduction in their capital gains tax basis (meaning they would need to invest prior to December 31, 2019.)Capital Gains and Tax Loss HarvestingWhile 1031 exchanges and Opportunity Zones are great ways to defer and/or reduce your capital gains tax bill, they’re the only ways to do so. If you have an investment that you can sell at a loss (including art and collectibles), you can utilize that loss to offset your capital gains taxes. This is referred to as tax-loss harvesting. For instance, if you sell an apartment building and generate a taxable profit of $200,000, but you sell a separate investment at a $100,000 loss, this would reduce your capital gains tax bill to $100,000.
When It Comes to Capital Gains Taxes, Knowlege is PowerWhile investing in commercial or multifamily property can be incredibly rewarding, it isn’t always a simple process. Being aware of potential expenses (like capital gains taxes) early on in the process is the best way to ensure they won’t totally eat up your profits. So, whether you want to engage in a 1031 exchange, invest in an Opportunity Fund, take advantage of tax-loss harvesting, or adopt another strategy entirely, remember that, when it comes to real estate taxes, the more you know, the more money you can save.
Frequently Asked Questions
What are the capital gains tax implications for multifamily and commercial real estate investors?
Capital gains taxes are paid whenever a taxpayer generates a profit from disposing of an asset like commercial real estate, bonds, or expensive collectibles. Capital gains taxes generally do not apply to ordinary personal and business income or the sale of an individual’s primary residence.
Investors can take advantage of a 1031 exchange, invest in an Opportunity Fund, take advantage of tax-loss harvesting, or adopt another strategy entirely to reduce their capital gains tax burden. For more information, please visit IRS Tax Topic 409.
What strategies can multifamily and commercial real estate investors use to minimize their capital gains taxes?
Multifamily and commercial real estate investors can use a few strategies to minimize their capital gains taxes. One option is to engage in a 1031 exchange, which allows investors to defer capital gains taxes when they exchange one property for another. Another option is to invest in an Opportunity Fund, which allows investors to defer capital gains taxes when they invest in certain designated areas. Additionally, investors can take advantage of tax-loss harvesting, which allows them to offset their capital gains taxes by selling investments at a loss.
What are the differences between capital gains taxes for multifamily and commercial real estate investments?
Capital gains taxes are paid whenever a taxpayer generates a profit from disposing of an asset like commercial real estate, bonds, or expensive collectibles. Capital gains taxes generally do not apply to ordinary personal and business income or the sale of an individual’s primary residence.
When it comes to capital gains taxes, investors can take advantage of strategies like 1031 exchanges, investing in Opportunity Funds, and tax-loss harvesting. 1031 exchanges allow investors to defer capital gains taxes when they exchange one property for another. Opportunity Funds allow investors to defer capital gains taxes when they invest in certain low-income communities. Tax-loss harvesting allows investors to offset capital gains taxes by selling investments that have lost value.
It is important for investors to be aware of potential expenses like capital gains taxes early on in the process in order to ensure they won’t totally eat up their profits. The more knowledge investors have about capital gains taxes, the more money they can save.
Are there any tax credits available for multifamily and commercial real estate investors?
Yes, there are tax credits available for multifamily and commercial real estate investors. The Low Income Housing Tax Credit (LIHTC) program is a federal tax credit designed to encourage private businesses to invest in affordable housing. It can be used for multifamily apartment developments, as well as mixed-use projects. Additionally, the Historic Tax Credit (HTC) program offers a tax credit based on the percentage of eligible expenses used to rehabilitate a historic building for commercial use. The New Markets Tax Credit Program provides a tax credit for commercial development in low-income areas. It's important to consult with an experienced tax professional to understand how each of these tax benefits may work for you. Source and Source
What are the tax implications of selling a multifamily or commercial real estate investment?
When it comes to selling a multifamily or commercial real estate investment, the primary tax implication is capital gains tax. Capital gains taxes are paid whenever a taxpayer generates a profit from disposing of an asset like commercial real estate, bonds, or expensive collectibles. Capital gains taxes generally do not apply to ordinary personal and business income or the sale of an individual’s primary residence.
There are several strategies investors can use to reduce their capital gains tax burden, such as engaging in a 1031 exchange, investing in an Opportunity Fund, taking advantage of tax-loss harvesting, or adopting another strategy entirely. It is important to be aware of potential expenses (like capital gains taxes) early on in the process to ensure they won’t totally eat up your profits.
Are there any tax deductions available for multifamily and commercial real estate investors?
Yes, multifamily and commercial real estate investors can take advantage of tax deductions. These include mortgage interest costs, property repairs, maintenance costs, certain property management expenses, and many other operating expenses. Additionally, investors can deduct the cost of real estate investment related seminars, conferences, conventions, and other similar education events. However, general property improvements, such as renovations or new furnishings, must be depreciated over the regular life of the property.
Investors can also take accelerated depreciation deductions via ordering a cost segregation study, which identifies parts of a property (i.e., carpeting, insulation, etc.) that can be depreciated over a shorter period (i.e., 5 or 15 years). In addition, a temporary provision of the Tax Cuts and Jobs Act of 2017 allows investors to take an even larger depreciation deduction in the first year that they own a property (bonus depreciation). It’s important to realize that these accelerated deductions will still be subject to depreciation recapture later on.