Top 3 Tax-Efficient Strategies for Deferring Real Estate Gains
May 6, 2024
Whether you own residential or commercial property(s), selling your real estate can be a complex process, especially when it comes to tax implications and deferral options. The good news is that the current real estate market favors sellers over buyers.
With limited inventory and sustained buyer demand, real estate investors looking to sell off some of their properties while simultaneously lowering their tax bill can benefit from certain tax-deferral strategies and investment options. By deferring capital gains taxes, sellers can potentially reduce their tax burden and reinvest in new opportunities.
Since each deferral option can affect your overall investment portfolio differently, it’s important to understand them before implementing. In this article, we will discuss three popular deferral options for sellers:
- 1031 exchanges
- Delaware Statutory Trusts
- Opportunity Zone investments
1. 1031 Exchange
A 1031 exchange, also known as a “like-kind exchange,” is named after Section 1031 of the Internal Revenue Code and allows investors to defer capital gains tax by exchanging real property held for business or investment purposes for similar real property that will also be held for business or investment purposes.
A unique benefit of a 1031 exchange is the ability to continue deferring the tax through future sales into additional 1031 exchanges. These types of transactions can be a powerful estate planning tool. If the right planning is done, the capital gains tax on the deferral will be eliminated due to the step up in basis to fair market value on the date of death. Therefore, no tax would be due on the original deferral.
It is important to note that the type of property that can be exchanged has been re-defined over time. The Tax Cuts and Jobs Act (TCJA) amended section 1031 to limit its application to exchanges of real property and “incidental property” for exchanges completed after December 2, 2020.
Generally, taxpayers must identify the replacement property within 45 days of selling the relinquished property and then acquire the replacement property within 180 days of the sale transaction or by the due date of the tax return. Additionally, these transactions require the use of a qualified intermediary to facilitate the exchange.
Taxpayers who wish to take advantage of this tax deferral exchange provision will require advice as to the following:
- Whether or not to exchange
- Whether the properties to be relinquished and acquired meet the qualified use test
- Whether the property to be acquired is like kind with the property relinquished
- How much the taxpayer must spend on replacement property to achieve a fully deferred exchange
- The timing of the identification and reinvestment period
2. Delaware Statutory Trusts (DSTs)
Delaware Statutory Trusts offer another avenue for deferring gains on real estate sales. A DST is a real estate ownership structure where multiple investors each hold an undivided fractional interest in the holdings of the trust. DSTs are considered direct property ownership for tax purposes, thus making them eligible for 1031 exchange treatment — whether it is an interest being sold or as a replacement property. This allows investors to diversify their real estate holdings and gives them the opportunity to invest in institutional-grade properties typically out of reach for most individual investors.
Similar to the 1031 transaction discussed above, taxpayers who wish to take advantage of this tax deferral method will have strict time requirements for the reinvestment of the replacement property, the determination of taxability of any proceeds received, and recognition of their new role as a passive investor rather than a managing member.
3. Opportunity Zones
Opportunity Zones, established as part of the TCJA, offer significant tax incentives for investors looking to defer capital gains from the sale of real estate. By reinvesting the proceeds from a property sale into a Qualified Opportunity Fund (QOF) within 180 days, investors can defer tax on the original gain until December 31, 2026, or until the investment is sold, whichever comes first.
In addition to the temporary deferral for recognition of realized gain until as late as December 31, 2026, any gain on subsequent appreciation is eligible for permanent exclusion, provided the qualifying investment is held for at least 10 years.
The reinvestment window for a QOF investment is the same as a 1031 exchange — 180 days from the transaction. There are instances where you are allowed additional time to reinvest if the real estate being disposed of is held in a partnership. If the partnership does not pursue a QOF, you as the partner, have 180 days from the partnership’s year-end, usually December 31, to invest your allocable share of capital gains into an OZ or June 30 of the following year.
Unlike the 1031 or DST deferral options, the deferred tax will need to be paid within the near future, and cash flow must be managed.
Your Guide Forward
Considering the benefits and limitations that each deferral option offers, Cherry Bekaert’s Real Estate & Construction group can customize a strategic plan tailored to meet your real estate goals and objectives. By combining deep industry experience and technical knowledge of key tax, accounting, transaction structuring, and compliance issues, we are uniquely positioned to provide the practical guidance and tools you need to make the right investment decision for your business.