The sale of commercial or other real estate held for business, trade, or investment can result in significant tax consequences that prudent taxpayers must understand to make informed decisions. Here’s a comprehensive look at why capital gains taxes apply and how you can navigate these taxes effectively.

Understanding Capital Gains Taxes

When you sell commercial real estate at a profit, the IRS requires you to pay capital gains tax on the amount by which the selling price exceeds your adjusted basis in the property. This tax applies whether the real estate is used for business, trade, or investment purposes.

Utilizing a 1031 Exchange

A 1031 Exchange, if structured correctly, allows sellers to defer gains on the sale by purchasing another qualifying property. However, it is critical to consult an attorney before selling to ensure that you qualify for the IRS’s “safe harbor” surrounding the 1031 Exchange as the rules are strict. If done correctly, significant tax savings can be achieved.

While most individuals are aware of the capital gains tax due on the sale of investment real estate, there is another higher tax that is also implicated upon sale. Owners of non-residential real estate are permitted by the Internal Revenue Code to depreciate the property on a 39-year straight-line basis. This depreciation must be recaptured upon sale if the property is sold at a profit greater than the depreciation realized. The applicable rate is capped at the individual’s current tax rate or 25%, whichever is lower. This can add a substantial burden to the tax bill of a seller who has been properly depreciating property over the period of ownership.

Structuring a Sale to Optimize Tax Savings

It is crucial to remember these tax considerations when structuring a sale. The “safe harbor” provided by a 1031 Exchange allows taxpayers to defer taxes on gains and depreciation recapture indefinitely.

Upon death, the taxpayer’s heirs may qualify for a “new basis at death” on the property. Depending on the size of the estate, the heirs will elect to proceed under the 2011 IRS rules, which permit a $5 million estate exemption in exchange for permitting heirs to take property at the current market value at the time of death. Consequently, an inheritance of a commercial property resulting from a series of 1031 exchanges would not require payment of the deferred tax gain. The heir would take the property at the fair market value at the time of death and pay only gains from that point to the sale, and the entire process of gains deferral can start anew for that new taxpayer.

By understanding these key aspects and seeking professional advice, you can make informed decisions to optimize your tax obligations when selling commercial real estate.