Understanding Tax Strategies for Real Estate Businesses: Navigate Deductions, Credits & Audit Preparedness

This article is part of BizTaxFacts, our Business Tax series on navigating taxes for self-employed individuals and small businesses. We’ll break down tax obligations and considerations, including deductions, credits, and filing across different working arrangements.

The Key to Real Estate Taxes: For businesses that deal in real estate, navigating the tax landscape is a critical component of maximizing profitability and ensuring compliance. The complexities of depreciation, entity structuring, 1031 exchanges, and passive activity rules demand expert guidance. 

This article is designed to equip real estate business owners with the knowledge to strategically manage deductions, leverage applicable credits, and minimize tax liabilities. We’ll delve into topics specific to real estate businesses, including expense management, inventory vs. capital asset distinctions, and best practices for audit preparedness, ultimately empowering you to optimize your financial outcomes.

What You Need to Know

• Maximize Deductions on Business Property: Understanding and utilizing deductions like depreciation, repairs, and mortgage interest is crucial for minimizing tax liability on rental income.
• Maintain Precise Financial Records: Accurate and detailed record-keeping is essential for supporting deductions, managing depreciation schedules, and ensuring compliance during potential audits.
• Seek Expert Tax Advice: Given the complexities of real estate business taxes, consulting a qualified tax professional is vital for accurate filings and maximizing tax savings.

Understanding Real Estate Taxes for Business Owners

Real estate taxes, also known as property taxes, are levied by local governments to fund public services such as education, infrastructure, and emergency services. As a real estate business owner, understanding these taxes is crucial for managing operating expenses and ensuring accurate financial reporting. But did you know that these taxes are typically deductible as a business expense?

Real estate taxes are often ad valorem taxes, meaning they’re based on the assessed value of the business-owned property. The tax rate varies by location, and the amount owed is typically a percentage of the property’s assessed value. For real estate businesses, these taxes are a significant operational expense that can be factored into financial planning and tax strategy.

How Property Taxes Are Calculated

Understanding the calculation of real estate taxes on business properties is crucial for accurate financial forecasting and expense management. While the process can be complex, here’s a simplified breakdown:

• Assessment: The local assessor’s office determines the assessed value of the business-owned property. This assessed value forms the basis for tax calculations and may differ from the property’s market value.
• Mil Rate: The local government establishes a mil rate, representing the amount of tax levied per $1,000 of the property’s assessed value.
• Tax Bill: The annual property tax bill for the business is typically calculated by multiplying the assessed value of the property by the applicable mil rate. This amount is a deductible business expense.

Deductions and Credits for Real Estate Businesses

Real estate businesses, including those operating rental properties, can significantly reduce their tax liability by utilizing available deductions. Key deductions include:

• Mortgage Interest: Real estate businesses can deduct mortgage interest on loans associated with business-related properties, including rental properties, without individual homeowner limitations, provided the loans are for business purposes.
• Property Taxes: Real estate businesses can deduct property taxes paid on business-owned properties, including rental properties, as a business expense, reducing taxable business income.
• Home Office Deduction: If a real estate business or professional uses a portion of their home exclusively and regularly for managing their business, including rental property operations, they may be able to deduct home office expenses.
• Cost Segregation Studies: Investing in a cost segregation study can allow real estate businesses to identify and reclassify certain property components for accelerated depreciation. This can significantly reduce taxable income by enabling faster recovery of costs for certain assets, such as interior improvements, landscaping, and electrical systems dedicated to business operations.

Local & State Taxes on Transactions

Businesses that own real estate are subject to various local and state taxes related to their property holdings and transactions. Understanding these taxes is crucial for accurate financial planning and expense management. Key taxes include:

• Property Taxes: Real estate businesses often incur annual or semi-annual property taxes on business-owned properties, which are deductible business expenses.
• Transfer Taxes: Businesses involved in property sales or transfers will pay transfer taxes, which are considered a cost of doing business.
• Documentary Stamps: Real estate businesses pay documentary stamp fees when recording deeds and other legal documents, which are also deductible business expenses.

Capital Gains Tax Considerations

Real estate businesses must carefully consider capital gains tax when selling business-owned properties. Key aspects to understand include:

• Taxable Event: Capital gains tax applies to the profit generated from the sale of business-owned real estate assets, such as investment properties or development/resale properties.
• Gain Calculation: The taxable gain is determined by subtracting the business’s basis in the property (original purchase price, improvements, transaction costs) from the sale price.
• Tax Rate: The applicable capital gains tax rate depends on the business’s tax bracket and the holding period of the asset.
• Strategic Planning: Effective tax planning is crucial to minimize or defer capital gains tax liability, impacting the overall profitability of real estate transactions.

Tax Liens & Foreclosures: A Business Risk

Businesses that own or manage real estate must understand the serious consequences of tax liens and potential foreclosures on their properties. A tax lien, a legal claim filed by the government for unpaid property taxes, significantly damages a business’s financial standing. This damage manifests as a reduced ability to sell, refinance, secure loans, or attract investors, ultimately jeopardizing business operations and growth. Prompt action is crucial to mitigate these financial risks.

Year-End Tax Planning: Stay Ahead

Real estate businesses should prioritize year-end tax planning to optimize financial outcomes. Key considerations include:

• Depreciation Optimization: Review and strategize depreciation deductions for business properties.
• Expense Review: Ensure all deductible business expenses (property taxes, repairs, etc.) are documented.
• 1031 Exchange Strategy: Plan 1031 exchanges for potential capital gains deferral.
• Entity Review: Evaluate the business’s legal entity for optimal tax efficiency.

Your Real Estate Tax Questions Answered

Q: Can a real estate business deduct property taxes on its owned properties?

Yes, real estate businesses can deduct property taxes paid on business-owned properties as a business expense. There are generally no dollar limits, provided the properties are used for business purposes.

Q: How does the IRS classify different types of business-owned properties?

For tax purposes, businesses distinguish between properties held for sale (inventory), properties held for rental income, and properties held for development. Each category has distinct tax treatments, especially regarding depreciation and capital gains.

Q: Can a real estate business deduct mortgage interest on business loans?

Yes, real estate businesses can deduct mortgage interest paid on loans used to acquire, develop, or improve business properties. These deductions are treated as business expenses, with specific rules and limitations that apply depending on the type of property and the nature of the business.

Q: How long should real estate businesses retain tax records?

Like all businesses, real estate businesses should retain tax records for at least seven years, and potentially longer, depending on the type of transaction and potential audit risks. Consult with a tax professional for specific guidance.

Q: How are property taxes treated for rental property businesses?

Property taxes on rental properties can be deductible as a business expense. This reduces the business’s taxable rental income.

Q: What is a 1031 exchange and how does it benefit real estate businesses?

A 1031 exchange, or like-kind exchange, allows real estate businesses to defer capital gains taxes when exchanging one business-owned investment property for another “like-kind” property. This is a crucial tool for tax planning and reinvestment. However, 1031 exchanges are complex and have many specific requirements. It is recommended to discuss your 1031 exchange strategy with a tax expert. 

Optimize Your Real Estate Business Tax Filing

Mastering real estate taxes can be complex, especially as a business owner. But with the right guidance, you can navigate the process with confidence. Remember to keep accurate records, track expenses, and stay up-to-date on tax laws and regulations. Don’t miss out on deductions and credits you’re eligible for – consult with a tax professional or use TurboTax Live Business to help you confidently handle your real estate business taxes and ensure you capitalize on all applicable deductions and credits.

​With TurboTax Live Business, get unlimited expert help while you do your taxes, or let a tax expert file completely for you, start to finish. Get direct access to small business tax experts who are up to date with the latest federal, state and local taxes. Small business owners get access to unlimited, year-round advice and answers at no extra cost, maximize credits and deductions, and a 100% Accurate, Expert Approved guarantee.