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Commercial Property Tax Primer: Everything You Need to Know

Commercial real estate property taxes are much different than the taxes on a home. There are more types of commercial property taxes to pay compared to residential property. But there are also some surprising tax advantages to owning commercial real estate.

Like death, taxes can’t be avoided, but there are some legal ways to reduce the amount of commercial property taxes paid, to have other people pay the tax for you, and to defer paying tax altogether.

The first step is to understand the different tax burdens that commercial real estate incurs.

What Are the Different Types of Taxes on Commercial Real Estate?

Taxes on commercial real estate fall into four general categories:

  1. Property
  2. Federal
  3. State and Local
  4. Rental or Sales Tax

Property

Real estate property taxes are what most people are familiar with. A property tax levy (or lien) on commercial real estate is similar to property taxes on residential property.

One of the big differences between the two asset classes is the size of the property tax bill. Commercial property taxes are based on the assessed value of the real estate. Because commercial properties are usually worth more than a home, and because they generate income, the property tax bills are higher.

Some commercial real estate lenders require the borrower to make monthly property tax payments into an accrual or escrow account, while other lenders only ask for proof that the semi-annual or annual property tax bill has been paid.

Federal

Investors who own commercial real estate that generates income need to pay federal income tax on the net income or profit, not the gross income. That means investors should expense as much as they legally can in order to reduce the amount of net income subject to taxes.

It’s important to keep in mind that security deposits received from tenants and held by the owner don’t count as income. The deposit is posted to the balance sheet, not the income statement. That’s because a deposit is held in security by the landlord and is meant to be returned to the tenant.

However, if the tenant defaults on his or her lease and the deposit isn’t returned, then the deposit becomes revenue. But then, if the deposit money is used for collections expenses or to make repairs to the vacated suite, that money then becomes an expense.

State & Local

Some states and local municipalities also tax net income on commercial property. These taxes are usually calculated in the same way as are federal taxes.

When commercial real estate investors determine tenant rental rates, they should factor in the amount of property, federal, state, and local taxes being paid. By doing this, the different taxes are effectively passed through to the tenant, reducing the out-of-pocket expense to the building owner.

Rental or Sales Tax

Many states and cities also collect a percentage of the monthly rents the investor receives from tenants. Unlike federal, state and local taxes, a rental or sales tax is a percentage based on gross income, instead of net income.

Commercial real estate leases should have a provision that allows the owner to add the rental tax being paid onto the tenant’s monthly rent – regardless if the tenant is paying a gross rent, modified gross, or a NNN lease.

For example, if the tenant’s monthly rent is $1,000 and the combined state and local rental tax is 2.5%, then the amount of monthly rent the tenant pays to the landlord is $1,000 + 2.5% or $1,025. Out of this total rent, the landlord then pays $25 to the state and city for the monthly rental or sales tax.

Note that this is only the rental or sales tax that the building owner owes. If the tenant’s business also collects sales tax from its customers, the tenant is responsible for paying the state and city directly.

How Are Commercial Property Taxes Calculated?

Of the four different types of taxes on commercial real estate – property, federal, state and local, and rental tax – property tax on commercial real estate is usually the largest and sometimes the most difficult to understand.

As property values rise, property taxes increase as well. However, the value of a property to a tax assessor isn’t the same thing as market value to the commercial real estate investor.

When determining the assessed (or calculated) value of a property, tax assessors begin by looking at recent similar property sales, improvements made to the property, and sometimes the income that the real estate is – or should be – generating.

Once the assessed value is determined, a percentage of that value is used to calculate property tax. Different parts of the municipality – entities such as the state, country, city, town or village, and the school, electric and water districts – all use property taxes to fund improvements such as new schools, roads, and infrastructure. The property tax assessor takes these different budgets into consideration when determining the tax percentage that will be levied on commercial property.

What Are Some of The Tax Advantages of Commercial Real Estate?

With all of these taxes on commercial property, why would a real estate investor even consider buying commercial real estate?

Even though there are a wide variety of commercial taxes to pay, there are also some big tax advantages in owning commercial real estate:

  • Depreciation Deduction  Even though real estate tends to rise in value over time, tax law allows real estate investors to take a percentage of the property value as a loss each year. This non-cash expense can be used to offset real cash income that the property generates.
  • Pass-Through Deductions  The new tax reform bill allows investors that hold commercial real estate in single-purpose LLCs, S Corps, or partnerships to obtain a 20% tax deduction on rental property income – including apartments, industrial, retail, and office building investments.
  • 1031 Tax Deferred Exchange – Section 1031 of the IRS code allows real estate investors to defer capital gains taxes when a property is sold, as long as the money is used to purchase new investment property.

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