Striking Out Those Capital Gains Taxes

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 investments.

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 indefinitely.

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.

Julia Bard is Chief Operations 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.