Are you looking for a way to defer capital gains taxes? A 1031 exchange may be an option – but there may be other options that may be preferable. In this blog post, we will summarize the common ways that real estate investors can defer capital gains taxes after the sale of an appreciated investment property.
First introduced in 1921, the 1031 exchange is a tax deferral technique used in the United States to postpone the payment of capital gains taxes on the sale of real estate. It allows an investor to reinvest the proceeds from the sale of one property into another, similar property, and defer paying capital gains taxes on the entire amount until the new property is sold.
The basic principle of a 1031 exchange is that an investor exchanges one investment property for another investment property of equal or greater value while deferring taxes on any taxable gain into the new property. This allows investors to increase their wealth without paying capital gains taxes.
Investors can take advantage of a 1031 exchange tax deferral each time they sell an investment property. When an investor passes, heirs or a surviving spouse can inherit the investment property at a current market value (also known as “step-up in basis”) and accumulated capital gains and depreciation related tax liabilities are reset to zero. Successor owners will be responsible for only future tax liabilities should they continue to own the property.
The 1031 Exchange is the most common type of tax deferral strategy used by individual real estate investors.
As part of the Tax Cuts and Jobs Act of 2017, a new form of tax deferral was created called the Qualified Opportunity Zone. Gains from the sale of any appreciated assets including not only real estate, but equities, artwork, collectibles, etc. can be invested in Qualified Opportunity Zone Fund. The QOZ Fund must invest in designated projects in areas throughout the US that have been deemed to in need of investment to spur economic development. QOZ Funds typically invest in ground-up development projects within the designated areas.
QOZ investments provide potential tax benefits in three areas.
While options to defer taxes via the QOZ tax deferral program are currently scheduled to expire in 2026, members of Congress have initiated efforts to extend the program.1
An installment sale is a type of sale where a buyer takes possession of the property and agrees to pay the seller over time, often making interest only payments for some period followed by a balloon payment to the seller which includes any remaining owed principal. IRS tax code M453 states that no capital gains taxes are owed by the seller in an installment sale until such time that they begin collecting principal funds from their sold property. While sellers would be obligated to pay income tax on any interest income that they receive in an installment sale, they could defer the payment of capital gains taxes into the future until they receive the principal funds from their sale.
The popularity of installment sale transactions increases as interest rates rise. Sellers may be attracted to the notion of receiving monthly interest income at higher rates than may be realized via other investments while deferring payment of capital gains taxes until principal is repaid.
In a Deferred Sales Trust or Monetized Installment Sale, an intermediary is involved who accepts purchase proceeds from a buyer and then provides funds to seller in either the form of a loan or through a stream of payments from investments that are made by the intermediary. These quasi-installment sales are structured to yield a more immediate use of sale proceeds to the seller than what some tax authorities and agencies believe is intended by current tax laws.2 3
While the 1031 exchange remains the “gold standard” of real estate tax deferral strategies, there are other options for investors seeking to defer taxes on the gains of their appreciated assets. For more information on real estate tax deferral strategies and to obtain referrals to experienced real estate tax advisors, please contact us at 866 398-1031 or visit our website at www.FGG1031.com.
2 https://blog.fgg1031.com/blog/california-tax-board-disallows-deferred-sales-trusts