Capital Gains Taxes for Multifamily and Commercial Real Estate Investors

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

There 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.

Currently, long-term capital gains taxes are:

  • 0 to $39,375: 0%

  • $39,376 to $434,5500%: $15%

  • $434,551+: 20%

In comparison, short-term capital gains taxes based on a taxpayer's regular bracket. 2019 federal income tax rates for single-filers are:

  • $0 to $9,525: 10%

  • $9,526 to $38,700: 12%

  • $38,701 to $82,500: 22%

  • $82,501 to $157,500: 24%

  • $157,501 to $200,000: 32%

  • $200,001 to $500,000: 35%

  • $500,001+: 37%

For married taxpayers, 2019 federal income taxes are:

For joint filers:

  • $0 to $19,050: 10%

  • $19,051 to $77,400: 12%

  • $77,401 to $165,000: 22%

  • $165,001 to $315,000: 24%

  • $315,001 to $400,000: 32%

  • $400,001 to $600,000: 35%

  • $600,001+: 37%

For seperate-filers:

  • $0 to $9,525: 10%

  • $9,526 to $38,700: 12%

  • $38,701 to $82,500: 22%

  • $82,501 to $157,500: 24%

  • $157,501 to $200,000: 32%

  • $200,001 to $300,000: 35%

  • $300,001+: 37%

Since the United States has a progressive tax system, taxpayers only pay the higher tax rates on their income over and above the previous tax rate. For instance, a single-filing taxpayer with a taxable income of $100,000 would only pay the 24% tax rate on their income over and above $82,500 (i.e., $17,500).

Capital Gains Taxes and 1031 Exchanges

1031 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 Tax

If 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 Program

The 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 Harvesting

While 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 Power

While 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.