Capital gains taxes are levies that the state and federal government impose on investor profits, defined as the difference between the sales price and the basis (cost or cost plus adjustments). The rate applied to the gain depends on whether the profits are from a short or long-term investment. For example, if you profit from an investment you have owned for less than a year, you will owe short-term capital gains taxes. That rate is the same as you pay for ordinary income, and it can range from ten percent all the way up to 37 percent. In contrast, if you profit from an investment you have owned for more than a year, the rate is much lower, with a maximum imposition of 20 percent.
Suppose that you are a taxpayer subject to the highest tax rates. If you receive a profit of $100,000 from selling an asset, the difference between the short and long-term capital gains tax rate is considerable: $20,000 for the long-term gain versus $37,000 for the short-term profit.
Investors can employ some tactics to defer and manage their capital gains taxes. First, let's assume that the gains are long-term. If the sold asset is an investment property, the investor can defer the recognition of the capital gain by reinvesting the sale proceeds into "like-kind" property through a 1031 exchange. For example, if you sell a residential rental that you have owned for five years and the sales price is $500,000, but your adjusted cost basis is $300,000, you have a long-term gain of $200,000. To avoid paying capital gains taxes (and any depreciation recapture), you can reinvest in a "like-kind" asset with a sales price of at least $500,000.
The IRS allows virtually any commercial real estate property to qualify as ‘like-kind” as long as you hold it for investment purposes. For example, flipping houses will not qualify, but swapping a residential rental for a self-storage operation will. The exchange is governed by rules and timelines designed to ensure that the investor doesn’t have access to the proceeds and that the replacement property has both a sales price and debt load at least equal to the relinquished asset.
It's important to note that this tactic does not eliminate the taxes due; instead, the exchange defers the taxes. If you later sell the replacement property without executing another 1031 exchange, the original taxes would be due, along with the new levy for the appreciation in the replacement property. However, the investor can sequentially perform 1031 exchanges as they continue their investment journey, deferring the taxes as they go. If the investor distributes the last property to an heir, they can effectively eliminate the accumulated obligations since the heir will receive the final asset on a stepped-up basis.
Investors can only employ 1031 exchanges for the disposition of investment real estate. However, suppose you have capital gains from selling stocks or other assets. In that case, you may want to consider reinvesting the profit into a QOZ (Qualified Opportunity Zone) Fund to defer the tax obligation. QOZ funds invest in economically distressed communities and offer tax advantages for some situations. Besides the broader inclusion of gain sources, the QOZ option only requires that you reinvest the gain instead of the entire proceeds, as is required for a successful 1031 exchange.
1031 exchanges and QOZ investments must adhere to specific timelines and other investing requirements. It's a good idea to consult a qualified investment advisor before proceeding.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.