Investing in real estate can be complicated, especially when it comes to selling your investment property. Taxes can take a big chunk out of your proceeds, but there are ways you can shelter your gains. One popular method used by investors to defer capital gains is the 1031 “like-kind” exchange; however, there are alternative methods to consider.
Qualified Opportunity Funds
Under the Tax Cuts and Jobs Act of 2017, the Opportunity Zone program allows investors to direct gains from the sale of assets into economically distressed federally designated areas, known as Qualified Opportunity Zones (QOZs). The program initiative is to boost economic development within lower-income communities, while at the same time, giving investors a few tax breaks.
A Qualified Opportunity Fund (QOF) is the investment vehicle used to invest in Opportunity Zones. A QOF is created by a corporation or a partnership and by filling out IRS Form 8996. The fund must invest at least 90% of its assets in designated opportunity zones to receive preferential tax treatment.
By investing unrealized gains in Opportunity Zones, the program can provide three tax benefits:
- Temporary deferral of taxes on previously earned capital gains. Existing assets with accumulated capital gains can be placed in OZs, which are not taxed until the end of 2026 or when the asset is disposed of.
- A step-up in basis of previously earned capital gains invested. After five years, the investors’ basis on the original investment increases by 10%. If invested for at least seven years, the investors’ basis on the original investment increases by 15%.
- Permanent exclusion of taxable income on new gains. For investments held for at least 10 years, investors pay no taxes on any capital gains produced through their investment in Opportunity Funds.
Delaware Statutory Trusts
Delaware Statutory Trusts (DSTs), is a real estate investment vehicle that provides investors access to commercial real estate properties which may be considerably larger than what they may be able to acquire on their own. In a DST, each investor (known as a beneficiary) owns an ownership interest in the trust, which the IRS treats as direct ownership, qualifying DSTs for a 1031 exchange.
DSTs offer a passive investment alternative in real estate and by doing a 1031 exchange via a DST, investors can defer capital gains tax liability indefinitely.
An Umbrella Partnership Real Estate Investment Trust (UPREIT) allows owners of appreciated real estate to transfer a property from individual ownership into a trust in exchange for shares in the trust. This exchange is also known as a Section 721 exchange, allowing investors to defer capital gains taxes.
A 721 exchange is similar to a 1031 exchange and allows investors to exchange appreciated real estate property for units in an operating partnership that will be converted into shares of the real estate investment trust (REIT). Capital gains are deferred until the investor sells shares of the operating partnership (OP Units), converts the OP Units to REIT shares, or the contributed property is sold by the acquiring operating partnership.
Why Consider 1031 Exchange Alternatives?
Rather than selling the real estate investment property, the main benefit of a 1031 exchange is tax deferral, freeing more capital for investment in the replacement property. However, the 1031 exchange isn’t the only option when it comes to deferring capital gains taxes. Regardless of the approach you choose, consider all of your options and speak with a legal and tax professional to find which is best for you and your situation.