Many people make wise investments, but it’s easy to become
entrenched in them indefinitely due to the unappealing thought
of paying capital gains taxes. It’s a bit like watching a batter at the
plate who’s always waiting for the right pitch.
Instead of waiting for the ball to come into that special zone,
keep your eye on two smart ways to take a swing at capital gains
taxes. These tax-incentivized programs, approved by the Internal
Revenue Service, can help qualified investors defer, reduce or
even eliminate their capital gains taxes on the sale of real estate
A 1031 Exchange
First up, the Section 1031 exchange. This program allows investors to sell their existing investment real estate and use the proceeds to acquire a “like-kind”
replacement property to defer
federal and state taxes.
Section 1031 exchanges
have a strict timeline. Unlike
the innings in a baseball game
that can go on seemingly forever, a replacement property
must be identified in writing
within 45 days and all replacement property must be
acquired within 180 days. It
doesn’t matter if it’s a holiday,
a weekend or the final game of
the World Series, it counts as a
calendar day. Once the 1031
exchange is complete, the taxes from an investor’s original sale
will be deferred until the sale of the replacement property, when
another exchange can be structured to continue the tax deferral
As you can imagine, it’s challenging enough to find a buyer
for investment or business real estate, let alone find a perfectly
tailored replacement property in a short window of time. The
process is much easier with a sponsored Section 1031 exchange
offering, such as a Delaware Statutory Trust (the most popular
vehicle). Through a sponsored 1031 offering, the investor benefits from the passive income-stream generated by steady rents,
while the sponsor is in charge of acquisition, asset management
and the property’s ultimate sale. Also, exchangers are able to
acquire a higher quality replacement property than they typically
are able to acquire on their own.
With Section 1031 exchanges, investors can truly swap ‘til they
drop. For example, consider a property that was purchased for
$80,000 in 1982 and is worth $800,000 today. The gain that would
have been realized in a taxable sale is deferred. For how many
innings? Until the game ultimately ends for the taxpayer on death.
But what about the taxpayer’s heirs? What happens when they
inherit the real estate? Because of the step up in tax basis on
death, the heirs will be able to sell at a later date without triggering federal or state taxes.
An Opportunity Zone Investment
Newest to tax-advantaged investments are qualified opportunity
funds. These funds invest in a qualified Opportunity Zone property. Opportunity Zones were created as part of the Tax Cuts and
Jobs Act of 2017 to incentivize the deployment of investment
capital into designated, economically-distressed communities.
Unlike a 1031 exchange, where only real estate investment
qualifies for tax deferral, a qualified opportunity fund applies to
gain from anything that would ordinarily result in taxation, including stocks, bonds, mutual funds, real estate, business assets and the
sale of a business.
With Opportunity Zone funds, investors reinvest the gains (or
any portion of the gains) within 180 days of the sale. As part of the
Opportunity Zone incentive program, these taxes are deferred
until December 31, 2026. So, if someone bought 100 shares of
Amazon stock for $3,500 in 2005 and those shares today are now
worth $190,700, an investor could reinvest the $187,200 gain in a
qualified opportunity fund and defer their tax liability.
Once someone invests in an Opportunity Zone fund, they may
defer, reduce or eliminate capital gains taxes depending on the
length of time the investment is held. There are three levels of tax
advantages that grow with time. After the investment is held for 5
years, the original capital gains taxes are reduced by 10%. At year
7, the tax basis is increased by an additional 5% to provide a 15%
deduction in capital gains tax. Once the initial investment is held
for 10 years or more, the investor permanently avoids any new
capital gains tax on their investment held in the fund. This is the
All Star game of tax deferral. ◆
Striking Out Those Capital
BY JULIA BARD
Julia Bard is Chief Operating Officer of Capital Square. The views
expressed here are the author’s own and not that of ALM. Bard can be
reached at JBard@capitalsquare1031.com.
Once someone invests in an
Opportunity Zone fund, they may
defer, reduce or eliminate capital
gains taxes depending on the length
of time the investment is held.