What is real estate? According to Merriam-Webster, the definition is simple: “property consisting of buildings and land.” The Internal Revenue Service also provides a basic definition: “Real property, also called real estate, is land and generally anything built on or attached to it.” Let’s examine different types of real property in detail.
- Commercial Real Estate
- Residential Real Estate
Residential Real Estate
A real estate transaction will undoubtedly be the largest investment an individual or couple can make during a lifetime. A real estate transaction can yield a significant return and provide substantial tax deductions. An investment in a primary residence in a city such as San Francisco (CA), San Jose (CA), Denver (CO), Portland (OR), Austin (TX), or Raleigh (NC) allows capital appreciation and foothold in the market to protect your initial investment as the market inevitability increases. According to a Realtytrac press release, in 2015, U.S. home sellers realized an average price gain since purchase of 11 percent.
As a primary residence grows in appreciation, your investment appreciates tax free. According to the IRS, an individual can protect $250,000 in market appreciation, and a couple can shield an additional $250,000, for a total of $500,000. In addition, any expenditures used to increase the value of your primary residence can also be protected from tax consequences.
As an example, if a married couple purchases a home for $500,000 and the home appreciates to $1,000,000, the $500,000 in increased value of the home would be protected from capital gains tax as long as the appreciation is rolled into the purchase of a new home. This type of investment is critical as a couple becomes a family. Families typically sell their primary residence every 13 years, according to the National Association of Home Builders.
Commercial Real Estate
Small businesses in America account for 54% of all U.S. sales, according to the Small Business Administration. As a small business grows from a single employee/entrepreneur to multiple employees and locations, it is imperative to keep expenses low. A significant expense paid by small businesses is rent. Though rent is a tax deduction, it is wasted revenue. A more prudent use of revenue is to invest in the commercial real estate where the business resides. Commercial real estate investment is an excellent way to reduce tax consequences in the form of depreciation and mortgage interest. Small-business owners can take advantage of reduced mortgage rates offered by the Small Business Administration.
Commercial real estate is also an investment and can take advantage of Internal Revenue Code Section 1031. This allows an investor to designate a new investment property to be purchased as an investment with the proceeds of the sale of the original property. This is advantageous because as a small business grows, it can purchase larger facilities to accommodate its growth. As the original investment appreciates, the capital appreciation is not subject to capital gains taxes as long as the investment is rolled into a new commercial or investment property.