Capital gains occur when you sell your investment real estate at a price over what you paid. While generating profit from asset sales is great, you must also pay taxes on any recognized gain. You don’t have to pay taxes immediately—generally, you’ll pay when you file your annual tax return for the year you sell your property.
However, depending on your tax bracket and how long you own the property, this could be a significant financial burden.
Strategies to Defer Capital Gains Taxes
Any time you sell a capital asset, you always pay taxes on the profit. However, you could defer or reduce tax liabilities on the sale of investment real estate in the following ways:
1031 Exchange
Named after Section 1031 of the Internal Revenue Code, the 1031 exchange can help you defer taxes by reinvesting the proceeds from selling your investment property into a like-kind property.
The like-kind exchange is a complex process that includes the following requirements:
- A replacement property must be identified within 45 days of selling the original property.
- The entire transaction must be completed within 180 days of selling the original property.
- A Qualified Intermediary (QI) must be used to facilitate the exchange.
Failure to comply with these and other rules could void the exchange, requiring you to pay capital gains taxes and depreciation recapture.
Opportunity Zones
Opportunity Zones were established under the Tax Cuts and Jobs Act of 2017. OZs aim to boost economic development and job creation in lower-income communities. To participate, your capital gains are pooled with those of other investors in a Qualified Opportunity Fund (QOF) with monies from other investors. The QOF then funnels the money toward construction or business operations in the targeted OZ.
Participation in a QOF allows you to defer payment of capital gains taxes until the end of 2026. At that time, the Opportunity Zone program will expire (though bills have been introduced in Congress to potentially extend it). Furthermore, if you invest in a QOF before the end of 2026 (and keep your money in the fund for at least 10 years), appreciation earned during that period will be excluded from taxes when you exit the fund.
Installment Sales
An installment sale means you receive profits from a capital asset sale over time rather than in one lump sum as long as you receive at least one payment in the year following the sale. You’re taxed only on the amount you receive each year rather than the entire amount.
The process doesn’t actually defer or reduce taxes. But, it can spread the tax burden over a period of years. Money that you aren’t directing toward taxes could be reinvested.
Finding Tax Advantage Strategies
Before considering a tax-deferred approach to capital gains, check with a qualified tax advisor or financial planner who can help guide you. These experts can also explain how money saved from deferral can work for you.
While capital gains taxes are inevitable on profits, you can take steps to defer payment or spread out the burden. A tax advantage strategy can be essential to any wealth-building plan that relies on real estate or other capital assets.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
