Among the potential benefits of commercial real estate investments, tax advantages land at the top of the list for most investors. Let’s take a closer look at the mechanisms that can lend tax efficiency to private real estate investments—and ultimately help investors keep more of what they earn.
The Perks of Pass-Through Entities
Many private real estate investments are structured as pass-through entities, such as LLCs and partnerships. This means the income, losses, and expenses of the real estate business pass through to the owners (i.e., members, partners, investors). Unlike corporations, pass-through entities are not taxed at the entity level; instead, income, deductions, and credits pass through to the members and are reported on their personal tax returns. As such, profits are taxed only once at the individual level—no double taxation. Profits or losses are reported on each member’s personal tax return and taxed at their individual rate.
If the pass-through entity incurs losses from the real estate investment, those losses can offset other forms of income on individual investors’ personal tax returns. This is especially beneficial for high-income earners.
Depreciation and Other Deductions
Real estate investors can often deduct various expenses directly related to the operation and maintenance of the investment property, including mortgage interest. Another key deduction is depreciation, which enables investors to reduce the amount of their reported taxable income without impacting cash flow. Real estate investors can depreciate the cost of their property (excluding the land) over its useful life: 27.5 years for residential properties and 39 years for commercial properties.
Investors may be able to use cost segregation to accelerate depreciation on certain components of the property (e.g., roofing or landscaping) over 5, 7, or 15 years instead of 27.5 or 39 years. This accelerated depreciation creates larger upfront tax deductions.
Real estate investors can also benefit from bonus depreciation, which allows for immediate expensing of certain property components (e.g., appliances or fixtures) in the year they are placed into service. Under the Tax Cuts and Jobs Act, bonus depreciation was initially set at 100% for qualifying property; however, this percentage is phasing out between 2023 and 2026, decreasing by 20 percentage points each year.
Special Considerations for Deductions
- Active vs. passive participation: Private real estate investment losses are generally considered passive unless an investor qualifies as a real estate professional under IRS guidelines. If so, these losses can be taken against active income.
- Basis limitations: Investors can only deduct losses to the extent of their basis. If losses (including depreciation) exceed their basis, they may not be deductible until the basis is increased, such as through additional contributions or profits.
- Depreciation recapture: When the property is sold, the IRS may impose depreciation recapture, requiring the entity (and ultimately the investors) to pay taxes on the depreciation deductions previously taken. These amounts are taxed as ordinary income, up to a maximum of 25%, rather than at the lower long-term capital gains rates. As such, planning for depreciation recapture is essential.
Opportunities to Defer Taxes
Both 1031 exchanges and Qualified Opportunity Funds offer real estate investors the chance to defer certain capital gains taxes.
A 1031 exchange—named after Section 1031 of the Internal Revenue Code—is one of the most powerful tools available to real estate investors. It allows investors to defer paying capital gains taxes on the sale of an investment property by reinvesting the proceeds into a like-kind property.
The primary benefit of a 1031 exchange is the potential to defer taxes associated with selling real estate, including federal capital gains, state income, and depreciation recapture. Unhindered by immediate tax liabilities, investors can enjoy increased buying power and greater portfolio value.
Importantly, investors can defer these taxes indefinitely—there is no predetermined date at which the taxes become due. As such, many investors complete several exchanges over the course of their lifetimes, “exchanging up” into one real estate asset after another.
Upon the taxpayer’s death, their heirs receive a huge benefit: A step-up in basis to fair market value, which potentially eliminates deferred taxes. This feature makes 1031 exchanges a very advantageous estate planning tool and has inspired the “swap ‘til you drop” mantra.
The Qualified Opportunity Zone program is an initiative designed to lift Americans out of poverty and revitalize struggling areas. The program spurs economic development and job creation in more than 8,700 census tracts by offering significant tax advantages to those investing certain eligible capital gains into Opportunity Zones through Qualified Opportunity Funds. Eligible gains may include capital gains from the sale of stocks, bonds, cryptocurrency, businesses, and other assets.
With the Opportunity Zone program, investors can defer taxes from the original asset sale through December 31, 2026, or when the investment in the Qualified Opportunity Fund is sold, whichever comes earlier. In most cases, the tax payment for the eligible gain would be due in 2027 when the taxpayer files a return. (Note: It’s possible that new legislation could extend the year-end 2026 deadline.)
If an investor holds their Opportunity Zone investment for at least 10 years, then any capital gain appreciation earned from the Opportunity Zone fund investment is not taxed upon disposition. This is the most significant tax benefit provided by the Opportunity Zone program. As it currently stands, the program won’t sunset until 2047, giving investors with long time horizons many years to let their Opportunity Zone investments grow.
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About Caliber (CaliberCos Inc.) (NASDAQ: CWD)
With more than $2.9 billion of managed assets, including estimated costs to complete assets under development, Caliber’s 16-year track record of managing and developing real estate is built on a singular goal: make money in all market conditions. Our growth is fueled by our performance and our competitive advantage: we invest in projects, strategies, and geographies that global real estate institutions do not. Integral to our competitive advantage is our in-house shared services group, which offers Caliber greater control over our real estate and visibility to future investment opportunities. There are multiple ways to participate in Caliber’s success: invest in Nasdaq-listed CaliberCos Inc. and/or invest directly in our Private Funds.
Investor Considerations
The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.
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