Properly determining the "basis" on your commercial real estate asset is critical. It is particularly important when you are looking to determine depreciation deductions (other than for the land itself) and whether you will incur a profit or loss when you decide to sell. If not calculated properly, on a continuing basis, it could result in significantly higher capital gains taxes if you sell it at a profit, whether by traditional sale or "forced sale" (i.e., foreclosure, short sale or deed in lieu of foreclosure).
Calculating Your Basis at Time of Acquisition
The basis of your property, also called "tax basis" or "cost basis," is usually the cost or investment in your real property when acquired. (See IRC § 1012) In calculating your basis, the purchase price of your asset, which includes your down payment and amount of your mortgage, is added to the closing or settlement costs incurred with the purchase of your asset. Closing or settlement costs include title search and recordation fees, legal fees, title insurance, sales, excise and transfer taxes, abstract fees and any other agreed upon fees between buyer and seller (e.g., payment of back taxes). Be sure to exclude loan closing costs, property insurance, casualty insurance premiums, occupancy-related services or utilities prior to closing and refinance mortgage fees. (See IRS Publication 551).
Adjustments to Original Basis During Property Ownership
The basis of your real estate asset can increase or decrease due to various changes in its useful life. Thus, the "adjusted basis" of a property is its original cost basis after certain tax-allowed adjustments. (See IRC § 1016) These adjustments include costs for capital improvements (e.g., repaving a parking lot) that increase basis while depreciation deductions decrease the basis of a real estate asset. Your commercial building can be depreciated over a 39-year recovery period by allocating the basis between the actual land and the building, and then by dividing the building's basis by 39. (See IRS Publication 946).
Effect of Selling Your Real Estate Asset: Capital Gains and Recapture Taxes
The result of the above adjustments gives you your adjusted cost basis in your real estate. This is important because pursuant to IRC §1001(a), gain is computed from the sale or disposition of property by determining the amount realized minus the adjusted basis. In the case of foreclosure (deemed for income tax purposes as a property sale) on a nonrecourse loan, the owner recognizes gain or loss equivalent to the difference between the tax basis of the property transferred and the amount of the discharged debt (or fair market value if higher). Why is adjusting your basis so important then? Because the lower the adjusted basis on your real estate, the more capital gains tax you will have to pay when you sell, (or are foreclosed on) making it crucial to determine it accurately. Depending on your annual income, the current capital gains tax is either 15 or 20%.
According to Jack Rose, Chief Strategist at Breakwater Equity Partners, "Even more important to be aware of and plan for is the application of recapture taxes in the event of a sale." "If your building is sold for more than its depreciated value (the adjusted basis less all depreciation claimed during ownership), you will additionally have to pay depreciation recapture tax at a 25% maximum rate, on the difference between the building's depreciated value and its adjusted basis." (See IRC §§ 1(h)(1)(E); 1250). One should be very mindful of these types of tax ramifications and should always consult a seasoned professional to help guide your decision-making. There are other alternatives out there to avoid this huge double tax hit if you contemplate selling or face a forced sale of your commercial property.
Computing Basis and 1031 Exchanges
If you bought your real estate asset through a section 1031 tax-deferred exchange, you were allowed to defer capital gains taxes due to the exchange of your property for a like-kind or similar real estate property (e.g., an office building for a shopping mall). In this case, the basis for your old property is carried forward to the new property, subject to some time limits or the benefit will be lost. Computing the basis in a 1031 exchange can get fairly complicated and must be carefully and continuously calculated, especially when looking to sell. For example, if the original property you sold has an adjusted cost basis of $350,000 and you sold that property for $1,000,000, then $350,000 would be carried forward. If you then bought a similar property for $1,500,000, your new basis would be $850,000 (i.e., $500,000 of new money or debt plus $350,000 carried forward). This increase in value between the two properties is often referred to as "the boot." Take note, however, that calculating one's cost basis is only the first step, albeit an extremely important one, in determining ones ultimate tax ramifications, especially when calculating profit (or loss) through multiple 1031 exchanges.
In deciding whether to sell or dispose of your commercial real estate, it is important to properly calculate your cost basis so that you may logically weigh all of your options. Consulting with a reputable real estate advisory firm is always the first step in addressing all of your concerns, especially when faced with tremendous potential tax liabilities.
*Warning: This information is not intended to constitute legal, financial, or tax advice and should not be used in lieu of any professional's advice.