The construction, development, and investment in commercial real estate (CRE) properties require financing. If an investor or a CRE developer lacks or is short in funding, they typically apply for CRE loans from numerous entities providing these loans, such as banks, independent lenders, insurance companies, and private investors. These loans typically entail five (5) to 20-year repayment terms, with the amortization timeframe longer than the loan term.
If you are new to CRE investing or development, here are some important terms you need to familiarize yourself with.
Loan-to-Value (LTV) Ratio
One consideration for CRE loans is the percentage of the loan-to-value (LTV) ratio, or the loan value measured against the property value (loan value ÷ property value x 100). Lenders favor loans with lesser LTV since these properties sustain higher stakes and, therefore, involve lesser risks.
Credit Rating and Guarantee
For almost every loan provision process, a financial record or credit rating is required of entities or individuals applying for such loans. In cases where these entities lack financial record or credit rating, the lender may require the owners of the business entity to utilize their own financial track record/credit rating, therefore providing guarantee for the loan. If the guarantee is not provided, the CRE property subject for construction/development is often identified as the only means of recovery when a loan default happens. This mechanism is referred to as a non-recourse loan.
Loan Repayment Schedules
As mentioned, commercial loans can range from five (5) to 20 years, and the amortization timeframe would typically be longer than this loan term. In this matter, a longer loan repayment timeframe equates to higher interest rates.
Debt-Service Coverage Ratio
Debt-service Coverage Ratio (DSCR) refers to the ability of a property to pay its annual mortgage fee based on its annual net operating income (NOI). This is calculated by dividing the property’s annual NOI with its annual mortgage fee (annual NOI ÷ annual mortgage rate = DSCR) to determine whether the cash flow can cover the fee. The DSCR must be more than 1, less from which indicates that the ratio is negative, implying that the annual cash flow is not enough to cover the property’s annual mortgage fees.
With all these loan provisions in place, CRE investors and developers still must deal with taxation. It is understandable why CRE investors and developers are in search of ways to ease these burdens. So, one thing to look at is tax deduction.
Now, the question: are CRE loans tax-deductible?
Let’s first get to know what tax deduction means. A tax deduction is the process of reducing an individual or organization’s tax liability by subtracting a government-validated amount from their taxable income. This government-validated amount may include annual expenses that can be deducted from an individual or organization’s gross income. Governments set tax codes to determine taxable items and tax-deductible expenses, and these include mortgage interest for investment properties. So, to answer the question: yes, CRE loans are tax-deductible. However, in this article, we look at this from a slightly different perspective.
How does this work?
An individual or business entity pays their taxes, the amount of which is determined by their annual taxable income. The higher their taxable income is, the higher their tax rate will be. Therefore, the goal is to reduce the annual taxable income.
If a person or a business entity applies for a CRE loan, the interest payments for mortgage are considered tax deductibles, or qualified reductions on an individual or organization’s income tax return. This is to be reported on the Mortgage Interest Statement. Lenders are typically required to supply this form to borrowers in the event that the property subject to mortgage is considered a real property, or a piece of land and all structures within its premises.
What happens is while you pay your full mortgage every month, this amount is tax-deductible and can still be used to deduct from your taxable income, thus reducing it. Therefore, your interest mortgage payments allow you to save a certain amount from your taxes.
For instance, your initial annual taxable income is at $100,000 and your annual mortgage interest payment is at $30,000. Your mortgage interest payment, which can be claimed as tax deduction, can be subtracted from your annual taxable income, which will then be reduced to only $70,000.
Typically, tax authorities only allow the utilization of either itemized deductions or standard deductions. This means that an individual or an organization can only choose whether to opt for their standard deductions – a fixed deduction amount you are qualified for – or for itemized deductions, which entails the enumeration of government-validated and qualified expenses which are considered tax deductibles.
Tax-deductible interest threshold
Perhaps you are wondering: how can you determine the threshold of tax-deductible interest you can avail? What/who determines this?
The answer depends on your marginal tax rate, or also referred to as your tax bracket. This is the pre-determined income tax rate based on your income. This moves as your income increases or decreases, or simply put: the higher your income is, the higher tax is deducted from you.
Now, what are the qualifications for your mortgage interest payments to be tax deductibles?
There are typically three (3) qualifications for your mortgage interest payments to be considered as tax deductibles. First, the borrower must be legally liable for the loan applied. Next, the lender and the borrower must both agree that the latter intends to repay the loan. Finally, the lender and the borrower are required to form a legit lender-borrower relationship.
All these provisions mean that you must be viable for a loan and this should be between you and a legit lender, not just from relatives or friends. Otherwise, your loan interest might not be considered deductible by tax authorities. This is because tax authorities want to secure that these loans are not only strategies for people to avoid or reduce their active income tax.
In addition, you are required to spend your loan and not just let it sit in a bank. If this happens, tax authorities will also not consider your loan repayment as deductible, even if you are actively repaying what you owe your lender.
Indeed, taxation can be complex if you are a beginner in the area but these pieces of information may now allow you to enter the loan and taxation field with the basic knowledge on how terms work.
Even after outlining all the information above, dealing with loans when investing in CRE can still seem daunting. That’s why the Leveraged CRE Investment Team at Commercial Properties, Inc. is here to help you achieve your business and investment goals. Contact us at (480) 330-8897 or send us an email at request@leveragedcre.com.
Need help on how to get started investing in commercial real estate? We got you covered! We prepared a free e-book that will serve as your guide to achieve your long-term business goals or obtain that property you’ve always been dreaming of!
Phill Tomlinson is a commercial real estate broker with Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, and owner of the Leveraged CRE Investment Team specializing in investment sales and tenant/landlord representation in the Phoenix and Scottsdale submarkets. Phill applies over 21 years of experience in the Real Estate industry helping investors and owners maximize their returns.
Bookmark www.leveragedcre.com to learn more about the Commercial Real Estate market and keep informed of relevant real estate strategies designed to maximize your income property investment results. Connect and follow Phill on Social Media at sm.leveragedcre.com/smplatform. #LeveragedCRE
DISCLAIMER: Leveraged CRE is not a law firm, and its employees are not attorneys nor are we affiliated or associated with attorneys. The information contained in this blog is general information and should not be construed as legal advice to be applied to any specific factual situation.
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