How to Avoid Capital Gains Tax on the Sale of Commercial Property

Selling commercial property can result in substantial capital gains tax liabilities, significantly impacting the financial outcome of such transactions. For investors and business owners, employing strategies to mitigate or defer these taxes is essential to maximize returns and maintain liquidity.

Adjusting the Property’s Cost Basis

One way to manage capital gains tax when selling commercial property is by adjusting the property’s cost basis—the property’s original value for tax purposes, adjusted over time. Increasing the cost basis can reduce taxable gain upon sale. This can be achieved through capital improvements, such as renovations or upgrades to systems like HVAC or plumbing, which add value or prolong the property’s life. Keeping detailed records and receipts of these improvements is crucial, as the IRS requires these costs to be capitalized and added to the cost basis.

Casualty losses, including damage from natural disasters, may also adjust the cost basis under specific IRS guidelines. Additionally, legal fees incurred during acquisition or sale can be included in the cost basis, further reducing the taxable gain.

Depreciation Recapture Considerations

When selling commercial property, depreciation recapture is a critical factor. The IRS requires sellers to pay taxes on depreciation deductions previously claimed. Depreciation allocates the cost of tangible assets over their useful life, reducing taxable income during ownership. However, upon sale, the cumulative depreciation is taxed at a rate of up to 25% under Internal Revenue Code Section 1250.

For example, if a property purchased for $1 million has $300,000 in claimed depreciation and sells for $1.5 million, $300,000 of the gain is subject to depreciation recapture. Strategies to mitigate this tax include spreading out the sale through installment payments or using a like-kind exchange under Section 1031, which can defer both capital gains and depreciation recapture taxes. However, recent tax reforms have tightened eligibility for such exchanges, requiring careful planning.

Using 1031 Exchanges

A 1031 exchange allows investors to defer capital gains taxes by reinvesting proceeds from a sold property into a “like-kind” property. This strategy enables investors to maintain liquidity while upgrading or diversifying their real estate portfolio.

“Like-kind” properties encompass a broad range of real estate types, such as selling an office building and reinvesting in a multifamily complex, provided both are held for business or investment purposes. To qualify, the new property must be of equal or greater value, and the exchange must adhere to strict timelines: a 45-day identification period and a 180-day closing period.

Compliance requires meticulous planning and documentation. A qualified intermediary is essential to hold the funds between sales and purchases, ensuring the investor does not take possession of the proceeds. Any deviation from IRS timelines can result in disqualification and immediate taxation of the gains.

Redirecting Gains into Qualified Opportunity Funds

Qualified Opportunity Funds (QOFs), established under the Tax Cuts and Jobs Act of 2017, provide a way to defer capital gains taxes while fostering economic development in designated Opportunity Zones. Investors can reinvest unrealized capital gains into these funds and defer taxes on the reinvested amount until December 31, 2026, or the sale of the investment, whichever comes first. If held for at least ten years, any appreciation on the QOF investment itself is excluded from capital gains taxation.

To qualify, investors must reinvest gains within 180 days of the sale and comply with asset allocation requirements within the fund. This strategy not only defers taxes but also supports economic growth in distressed communities.

Installment Sale Arrangements

Installment sales allow sellers to manage tax liabilities by spreading payments over multiple years. Under Section 453 of the Internal Revenue Code, this approach defers capital gains tax until payments are received, potentially lowering overall tax liability.

The seller and buyer agree on a payment schedule, which includes interest on the balance. Each payment consists of a return of principal, taxable gain, and interest income. For instance, a property sold for $1 million with a $400,000 taxable gain, structured over five years, allows the seller to report a portion of the gain annually.

However, installment sales carry risks, such as buyer default or challenges recovering the balance. Depreciation recapture must still be paid in the year of sale and cannot be deferred. Consulting a tax advisor ensures compliance and helps optimize this strategy.

Structuring Ownership Entities

The ownership structure of commercial property significantly affects the tax implications of its sale. Strategically using entities like limited liability companies (LLCs), partnerships, or real estate investment trusts (REITs) can reduce or defer capital gains tax while enhancing asset protection.

LLCs and partnerships are popular due to pass-through taxation, where gains are passed directly to owners, avoiding corporate-level taxation. The allocation of gains among partners or members must align with the entity’s operating agreement and comply with IRS rules.

REITs offer another avenue for tax deferral through share exchanges. Contributing a property to a REIT in exchange for shares can qualify as a tax-deferred exchange under Section 721 of the Internal Revenue Code. This defers capital gains tax until the REIT shares are sold. REITs also provide liquidity and diversification, making them an attractive option for transitioning from direct property ownership.