There are few industries that the tax code is more favorable to than commercial real estate. As a result, the strategic use of tax incentives can mean the difference between good and exceptional returns on an investment through the power of compounding. While many investors focus solely on appreciation and cash flow, professional investors understand that commercial real estate tax strategy is where real wealth is built over time.
At Alakai Capital, we’ve helped investors strategically leverage tax incentives across 70+ transactions including the successful implementation of 10+ Cost Segregation studies and more than two dozen 1031 transactions. This guide reveals some of the tools we’ve used to structure investments to maximize tax advantages while building long-term wealth.
Note: The vast majority of real estate tax strategies are not tax avoidance or tax free strategies, but are rather tax deferral strategies. Thus, the benefit of the strategies relies on the productivity of those funds being deferred. If the funds being deferred are reinvested and making a positive return, then the strategies can be extremely beneficial towards long term wealth creation.
Key Tax Benefits Every Commercial Real Estate Investor Should Know
Commercial real estate offers unique tax advantages unavailable in most other investment classes:
1) Straight-Line Depreciation: Your Built-In Tax Shelter
Depreciation allows investors to deduct the replacement cost of a property over time on an owner’s tax return, even as it appreciates in value. The IRS considers commercial real estate to have a 39-year depreciable lifespan, meaning you can write off approximately 2.56% of the building’s value annually with straight line depreciation (relative to “Cost Seg” which we’ll touch on further down in the article).
How depreciation works in practice:
- You deduct a percentage of the property’s value each year, reducing taxable income for that year. The theory is that property’s age and becomes obsolete over time, so a portion should be depreciated each year as the property’s useful life shrinks.
- Even if a property’s value increases over time, depreciation still applies and is only relevant to the investment/development cost at acquisition or construction.
- This “paper loss” can offset rental income for that year, lowering your overall tax burden for the year.
- This depreciation is deferred until sale of the property, at which time your cost basis is lower on the property, therefore increasing your potential capital gains.
2) Cost Segregation: Accelerating Depreciation Benefits
Straight-line depreciation is powerful, but cost segregation supercharges this benefit by separating out and identifying components of your property that qualify for shorter depreciation schedules:
- 5-year property (certain equipment and fixtures)
- 7-year property (furniture and carpeting)
- 15-year property (land improvements)
This approach front-loads depreciation deductions, creating larger tax savings in the early years of ownership when they provide the most value (dollar today is worth more than a dollar tomorrow). Generally speaking for this strategy, an investor hires a Cost Segregation Engineer to visit the property and put together a schedule of the various equipment and finishes that qualify for shorter depreciation timelines. This can provide significant tax savings in the first few years of ownership, allowing an investor to re-invest the funds that would have gone to the IRS in the form of income tax.
3) 1031 Exchanges: Compounding Wealth Tax-Free
The 1031 exchange is perhaps the most powerful wealth-building tool in real estate investing. This provision allows investors to defer capital gains taxes when selling a property by reinvesting proceeds into another “like-kind” real estate asset.
Key 1031 exchange requirements:
- You must have a 1031 intermediary identified prior to closing, and all proceeds from the sale must go through the 1031 intermediary, never entering your business or personal account.
- You must identify the replacement properties within 45 days of sale
- There are two rules that define how many properties you can identify and invest in:
- 200% Rule: In a 1031 exchange, you can identify up to three replacement properties without any value restrictions, or more than three as long as their total value doesn’t exceed 200% of the relinquished property’s value.
- 95% Rule: If you identify more than three properties and exceed the 200% value threshold, you must acquire at least 95% of the total identified properties within the 45-day identification period.
- The acquisition(s) must close within 180 days.
- All proceeds must be reinvested to defer 100% of tax liability (any proceeds not reinvested will be taxed as the portion of the capital gains, thus exposing all funds not reinvested to capital gains.)
The capital gains tax rate varies based on how long an investment has been held as well as an investors personal tax rate. Following are the ways your capital gains tax can vary:
Investment Hold Time
If an investment is held less than 12 months, the short term capital gains tax is the same rate as an investors personal income tax rate. Thus, for shorter term investments, 1031’s can create significant benefits allowing an investor to re-invest 35%+ or more of the proceeds.
If an investment is held for 12 months and 1 day, it qualifies for long-term capital gains, which at the federal level is 15% for anyone making less than $533,400 and 20% for those making over the same amount.
Certain states have additional Capital Gains taxes. The tax is charged based on the state the investment is located in – thus if you’re a Florida based investor who is investing in California, you’ll be exposed to California capital gains taxes.
Pro Tip: As long as the whole investment time horizon is longer than 12 months, it qualifies for long term capital gains. Thus, if an investor sells the first property at 6 months, and 1031’s into a second property that they then sell at 7 months (13 month total investment cycle) the capital gains for both will be at long term capital gains rates.
The power of this strategy compounds over time and can create a significantly different growth trajectory of wealth.
Example: You buy a property for $1MM with 50% equity ($500k) and sell it for $1.5MM six months later, you’ll have $500k of short term capital gains exposure (at 35% tax bracket that’s $175k of taxes). If you as the investor pay the gains and reinvest the proceeds, you’ll have $175k less to reinvest. Let’s assume the property you reinvest in is making a 10% return, the investor who utilized the 1031 tax deferral structure will make an additional $17,500 each year on the investment. This additional return is each year, so over a 10+/- year time horizon the difference between the investor that utilizes the tax strategy and the one that doesn’t can be significant. It should be clear, deferring taxes throughout the wealth-building journey can create a significantly different outcome for an investor over their lifetime.
4) Bonus Depreciation & Cost Segregation
In 2017 the Tax Cut and Jobs Act (TCJA) was passed, providing another layer of tax deferral for real estate investments, bonus depreciation. The rules allowed bonus depreciation on all equipment deemed to have a 5, 7 or 15 year life per the following schedule based on when a property was purchased:
- 100% between September 27, 2017 and January 1, 2023
- 80% in 2023
- 60% in 2024
- 40% in 2025
- 20% in 2026
- 0%in 2027
This additional layer of tax benefits provides immediate write-off of significant portions of qualified improvement property during the first year of ownership of a commercial real estate investment. Even as phase-down occurs, investors can still take substantial upfront deductions:
There has been talks of reinstating the TCJA bonus depreciation schedule over the last year but no bill has been proposed as of yet.
Interested in tax-advantaged commercial real estate investments? Explore Alakai Capital’s current opportunitiesor contact us to discuss how our tax-efficient approach can enhance your portfolio.
Advanced Tax Strategies for Sophisticated Investors
Beyond basic tax benefits, sophisticated commercial real estate investors can leverage additional strategies:
1) Real Estate Professional Tax Status
This powerful designation allows qualifying investors to deduct real estate losses against other forms of income, including W-2 wages, business income, and investment gains.
Requirements to qualify:
- 750+ hours annually in real estate activities
- More than 50% of your total working hours in real estate
- Material participation in real estate operations
For high-net-worth individuals or couples where one spouse can meet these requirements, this status can provide substantial tax savings by sheltering other income streams. Many investors will have a spouse manage a residential rental property or airbnb just enough to qualify, allowing the couple to recoup the benefits on their larger commercial real estate investments.
2) Opportunity Zone Investments
The Tax Cuts and Jobs Act created Opportunity Zones to stimulate investment in economically distressed communities:
Key benefits:
- Defer capital gains tax on invested funds until 2026
- Reduce original capital gains tax by up to 10% with 5-year hold
- Eliminate taxes on appreciation if held for 10+ years
When strategically selected, Opportunity Zone investments can deliver strong returns while providing exceptional tax benefits. This is one of the few areas in the tax code that taxes are actually forgiven.
3) Estate Planning Advantages
Commercial real estate offers significant estate planning benefits:
Step-Up in Basis:
- Heirs receive property at current market value, not original purchase price
- Eliminates capital gains tax on appreciation that occurred during your lifetime
- Creates tax-efficient transfer of generational wealth
Strategic Entity Structures:
- Family Limited Partnerships (FLPs) and LLCs allow fractional ownership transfers
- Discount valuation opportunities for estate tax purposes (illiquidity and partial ownership discounts)
- Maintain control while transferring economic benefits to heirs
Alakai Capital’s Tax-Focused Approach
Our tax optimization strategy isn’t theoretical—it’s implemented across our entire portfolio.
Key components of implementation include:
1) Expert Team Coordination
We coordinate specialists for maximum benefit:
- Cost segregation engineers
- Tax attorneys
- CPAs experienced in real estate
- 1031 exchange qualified intermediaries
2) Documentation and Substantiation
Proper documentation ensures tax positions are defensible:
- Detailed cost segregation studies
- Contemporaneous records of improvement costs
- Time tracking for real estate professional qualification
- Entity formation and operating documentation
Common Tax Mistakes to Avoid in Commercial Real Estate
Many investors leave significant money on the table through preventable tax mistakes:
1) Overlooking Cost Segregation Studies
Many investors fail to conduct proper cost segregation analysis, missing out on accelerated depreciation benefits that could save thousands in the early years of ownership.
2) Missing 1031 Exchange Deadlines
Strict timelines govern 1031 exchanges. Missing either the 45-day identification or 180-day closing deadlines can invalidate the entire exchange, triggering immediate tax liability.
3) Improper Entity Structures
Using the wrong entity structure or ownership arrangement can limit available tax benefits and create unnecessary liabilities.
4) Insufficient Documentation
The IRS requires substantiation for claimed deductions. Without proper documentation, valuable tax benefits may be disallowed under audit.
5) Failure to Plan Exit Strategies
Many investors make tax-inefficient exit decisions because they didn’t plan their exit strategy from the beginning of the investment.
The Alakai Capital Tax Philosophy
Our approach to tax planning reflects our core investment principles:
1) Legally Maximize Every Available Benefit
We pursue all legitimate tax advantages available under the tax code. While we never promote artificial tax shelters, we ensure no legal benefit slips by without consideration.
2) Long-Term Perspective
We focus on after-tax wealth creation over a long term time horizon, not just immediate tax savings. Deferred taxes today reinvested can provide significant long-term value tomorrow.
3) Integrated Business Planning
Tax considerations inform our acquisition, improvement, and disposition decisions—they never drive the decisions, but they are variables considered with all decisions.
Tax Planning as a Wealth-Building Tool
You don’t need to be a CPA to leverage tax strategy effectively—but you do need to understand the key tools and ask the right questions and have the right experts on your team. The most successful investors look at tax planning as part of their overall investment framework—not as an afterthought.
If you’re building a portfolio, it pays to align with professionals who approach each acquisition, improvement, and exit with tax efficiency in mind. With proper planning, the tax code becomes an asset—not a liability.
At Alakai Capital, we believe that what you keep matters more than what you make. Our tax-optimized approach to commercial real estate investing helps accredited investors and family office partners maximize after-tax returns while building long-term wealth.
For accredited investors and family offices interested in tax-advantaged commercial real estate opportunities, we invite you to explore our current offerings.
Nick Jones is the founder and CEO of Alakai Capital, with over 20 years of experience in commercial real estate management, investment, development, and brokerage. He has overseen more than 70 commercial investments including the successful implementation of 10+ Cost Segregation studies and more than two dozen 1031 transactions.