Real estate is a proven way to build wealth. One of its greatest advantages is the ability to reduce taxes through specific strategies. For commercial real estate investors, understanding these tax benefits is essential.
This blog explains key strategies, such as depreciation, 1031 exchanges, interest deductions, and cost segregation studies. It also shows how to use these tools to grow wealth over time, with examples relevant to the North Carolina commercial real estate market.
Understanding Depreciation and How It Reduces Taxable Income
Depreciation allows you to spread the cost of a property over its useful life, reducing your taxable income each year.
What is Depreciation?
- Reflects wear and tear on a property over time.
- Only the building’s value qualifies for depreciation, not the land.
- IRS classifies depreciation over fixed periods:
- Residential properties: 27.5 years.
- Commercial properties: 39 years.
Why is Depreciation Beneficial?
- A non-cash expense that reduces taxable income without impacting cash flow.
- Shields a portion of your rental income from taxes.
- Even properties generating strong income can show little or no taxable profit.
For Example:
A $3M commercial property in Raleigh:
- The land value is $500,000 (non-depreciable).
- The building value is $2.5M.
- Depreciation deduction: $2.5M ÷ 39 years = $64,100 per year.
Additional Depreciation Benefits
- Bonus Depreciation: This lets you deduct a large portion of certain assets in the first year.
- Section 179 Deductions: These are useful for equipment and improvements such as HVAC systems.
- Depreciation recapture occurs if you sell the property, but strategies such as 1031 exchanges can help mitigate it.
By understanding depreciation, investors can significantly reduce their annual tax burdens.
The Power of 1031 Exchanges: Deferring Capital Gains Taxes
A 1031 exchange is one of the most powerful tools for real estate investors to preserve wealth and reinvest capital.
What is a 1031 Exchange?
- Allows you to sell one investment property and reinvest in another without paying capital gains taxes immediately.
- Applies to “like-kind” properties (e.g., selling a commercial property and buying another).
- Postpones tax liability, freeing up funds for reinvestment.
Benefits of 1031 Exchanges
- Tax Deferral: Defer capital gains taxes, which can range from 15-20% federally (plus state taxes).
- Portfolio Growth: Reinvest the full sale proceeds into higher-value properties.
- Leverage: Trade up to properties with greater income potential or appreciation.
For Example:
An investor in Charlotte sells a warehouse for $2M:
- Capital gains tax on $1M profit could be $200,000.
- By using a 1031 exchange, they reinvest the entire $2M into a $3M shopping center in Asheville.
Rules to Keep in Mind
- 45-Day Rule: Identify potential replacement properties within 45 days of selling the original property.
- 180-Day Rule: Complete the transaction within 180 days.
- Qualified Intermediary: A neutral third party must manage the exchange.
Common Uses
- Transition from older properties to newer, more profitable ones.
- Consolidate smaller properties into a single, larger asset.
- Diversify into different markets, such as growing areas like Winston-Salem and High Point..
Interest Deductions: Lowering Your Tax Burden on Loans
Interest deductions help offset the cost of borrowing by reducing taxable income.
What Can You Deduct?
- Mortgage interest on loans used to purchase, build, or improve real estate.
- Interest on lines of credit tied to property expenses.
- Points are paid at closing to secure a loan.
Benefits of Interest Deductions
- Reduces taxable income, especially in the early years of ownership when interest payments are high.
- Improves cash flow, allowing investors to reinvest savings.
- Makes borrowing more affordable.
For Example:
A developer in Greensboro secures a $2M loan:
The annual interest paid is $100,000.
The $100,000 deduction reduces taxable income by the same amount, lowering the overall tax liability.
Additional Tax-Saving Deductions
- Property taxes.
- Operating expenses, including utilities, insurance, and repairs.
- Legal and professional fees, such as property management or consulting services.
Important Considerations
- Interest deductions apply only to loans directly tied to income-generating properties.
- Ensure proper documentation of loan expenses to avoid IRS challenges.
By using interest deductions, investors can better manage costs and retain more of their profits.
Cost Segregation Studies: Accelerating Depreciation Benefits
Cost segregation allows investors to speed up depreciation on specific components of a property.
How Does Cost Segregation Work?
- Identifies parts of a property that qualify for shorter depreciation timelines.
- E.g., flooring, lighting, HVAC, and landscaping.
- Instead of depreciating over 39 years, some items can be depreciated over 5, 7, or 15 years.
Benefits of Cost Segregation
- Larger Deductions Early: Higher deductions in the early years reduce taxable income.
- Increased Cash Flow: More money upfront to reinvest or pay down debt.
- Strategic Tax Planning: Helps align deductions with high-income years.
For Example:
An investor purchases a $5M office building in Durham:
A cost segregation study identifies $1.5M in components eligible for 5- and 15-year depreciation.
Annual deductions increase from $128,000 to over $300,000 for the first five years.
Who Should Use Cost Segregation?
- Owners of commercial properties valued at $500,000 or more.
- Investors planning significant renovations or upgrades.
- Those looking to offset income from multiple properties.
Key Considerations
- Hire a certified cost segregation expert for a detailed study.
- Be aware of depreciation recapture taxes if you sell the property without using a 1031 exchange.
By accelerating deductions, cost segregation helps investors maximize their tax savings early in ownership.
Leveraging Tax Benefits to Build Long-Term Wealth
Combining tax strategies can help investors grow their portfolios and build wealth over time.
Key Strategies to Combine
- Depreciation: Use annual deductions to shield rental income from taxes.
- 1031 Exchanges: Reinvest proceeds into higher-value properties without losing capital to taxes.
- Interest Deductions: Lower the cost of borrowing to improve cash flow.
- Cost Segregation: Maximize upfront deductions to free up funds.
Benefits of Strategic Tax Planning
- Retain more profits for reinvestment.
- Scale your portfolio faster by reinvesting tax savings.
- Diversify investments across different markets, such as Charlotte, Raleigh, and Asheville.
Local Opportunities in North Carolina
The Piedmont Triad and surrounding areas in North Carolina offer promising opportunities for commercial real estate investors:
- Winston-Salem and Greensboro: Thriving job markets and increasing demand for office and industrial spaces, driven by business growth and urban revitalization.
- High Point: A hub for furniture and design, with opportunities in industrial, retail, and mixed-use developments.
- Salisbury: Growing interest in logistics and industrial properties due to its strategic location near major transportation corridors.
Tax benefits such as depreciation, 1031 exchanges, interest deductions, and cost segregation are essential tools for commercial real estate investors. They reduce taxable income, boost cash flow, and create opportunities for long-term wealth building.
By working with experienced professionals such as DeLille | Field, you can navigate complex tax laws and maximize your savings. Ready to unlock the full potential of your real estate investments? Contact DeLille | Field today to learn more about tailored tax strategies!
