As the saying goes, timing is everything. And like most strategic business decisions, the timing with which you finalize your tax plans can determine how effective they will be. If you sell real estate investments at a profit and generate capital gains, here are three tax deferral strategies to use at year-end.
Strategy 1: 1031 Like-Kind Exchange
A 1031 exchange can be used to defer capital gains tax on a property sale. When you dispose of a property and generate a capital gain, you can defer tax by reinvesting in a like-kind real estate investment property. However, these capital gains taxes are only deferred and need to be paid in the future when they’re realized.
Certain rules must be followed for a property investment sale and purchase to qualify as a 1031 exchange:
- The replacement (new investment) property must be identified within 45 days after the sale or exchange of the relinquished (disposed) property.
- The new investment property needs to be received within 180 days of the sale of the disposed property.
- For the exchange to be valid, any reinvestments have to be made on like-kind property. This means the properties being exchanged should be similar in nature and character.
- The sale proceeds and property need to be transferred through a third party known as a qualified intermediary. There can be no direct exchange between the seller and the buyer.
If you want to take full advantage of this tax-deferral strategy, the value of the replacement property should not be lower than the value of the disposed property. You may also be required to pay taxes on any proceeds from a property sale that is not a like-kind exchange.
Your replacement properties should be located within the United States to qualify as a 1031 like-kind exchange for tax deferral benefits.
Strategy 2: Qualified Opportunity Zones
Investing through a qualified opportunity zone (QOZ) is another tax deferral strategy for individual or business property investors. If you invest in communities that are economically distressed and have been classified as QOZs, you might be able to take advantage of capital gain tax incentives.
This investment opportunity came about through the 2017 Tax Cuts and Jobs Act to encourage economic development in low-income zones through long-term capital investments. You can defer eligible capital gain tax on a property sale by investing in a QOZ through a qualified opportunity fund (QOF). The deferral is in effect until the QOF investment is sold or exchanged or on Dec. 31, 2026, whichever comes first.
For capital gains to become eligible for tax deferral through the QOZ investment program, you need to meet certain requirements. The capital gains must be invested within 180 days of the sale of the disposed property. Also, your investment needs to be an exchange for equity interest and not debt interest.
Additionally, the tax benefit depends on the time period for which you hold the QOF investment. For example:
- If you hold your QOF investment for at least five years, the basis of the QOF investment increases by 10% of the deferred gain.
- If the QOF investment is held r for at least seven years, the basis of the QOF investment increases by an additional 5% of the deferred gain.
- If held for at least 10 years, the basis can be adjusted to its fair market value on the date it is sold or exchanged.
Strategy 3: Installment Sales
Another option to defer or stagger capital gains tax from property sale could be through an installment sale. In an installment sale, you can defer capital gains until future years when the buyer of your property makes the installment payments plus any interest. This allows you to delay income earned, thereby managing your income tax bracket by deferring taxes until later years.
An installment sale is valid when at least partial payment is received by the next year following the sale. An average installment sale payment consists of interest income, gain on the sale and a return of adjusted basis in the property.
Any tax deferral methods you decide to use need to be analyzed and well planned. Because these tax vehicles can get quite complex, you might need experienced tax experts to make it a seamless process.
James Moore’s real estate and tax teams have helped individuals and businesses plan out the best tax strategies for years. Be proactive with your year-end tax planning and take advantage of the investment deadline extensions by speaking to an expert at James Moore to learn more.
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