Capital gains (or losses) are important to understand when it comes to capital asset investments. Understanding what they are, and how they might be taxed, can play an important part in your overall strategy.
Previous Realized blogs have outlined capital gains taxes, and how to potentially defer them. But, if you employ those strategies, how long can you defer capital gains tax on the sale of your capital asset? The answer is: It depends on the strategy you use. The 1031 exchange and Qualified Opportunity Zone program are both useful for handling taxes on capital gains. But both have different time limits when it comes to how long those taxes can be postponed.
Exchanging into perpetuity
The 1031 exchange, also known as the “like-kind” exchange, has been around for 100 years. In recent times, the process allows you to trade real estate property used for sale or investment into other real estate property, thereby deferring capital gains taxes on the sale of those assets. For how long? For as long as you want, though a typical property hold period is seven to eight years. Once that hold period is done you could technically keep exchanging into additional real estate properties, for as long as you live. And, when you pass away, your heirs won’t have to pay taxes on that capital gain.
The downside of this scenario is that the like-kind exchange process is complex, involving in-stone deadlines, assistance from a qualified intermediary, and the assumption that you’ll be able to find the right kind of exchange property. Additionally, you will have to pay taxes on the “boot,” which is any cash left over after your exchange is completed.
The 2027 tax bill
The other potentially useful tax-deferral tool is the Qualified Opportunity Zone program. Passed as part of the Tax Cuts and Jobs Act of 2017, the program encourages investors to invest their capital gains into Qualified Opportunity Funds (QOFs), which then invests those monies into federally designated, lower-income Qualified Opportunity Zones (QOZs).
The IRS and U.S. Department of the Treasury encourages investors to do this through tax-deferral advantages. Not only can you delay paying taxes on capital gains, depending on how long your gain has been held in the fund, your basis can increase by up to 15%. Furthermore, if you keep your monies in that fund for at least 10 years, you don’t pay any capital gains realized by the QOF.
Similar to the 1031 exchange, there is a deadline for that capital gain investment. Specifically, you have 180 days from the sale of your asset to reinvest that profit (though check with the IRS, which has loosened some of these deadlines, due to the coronavirus pandemic).
Unlike the 1031 exchange, the QOZ has a hard-and-fast deadline when it comes to tax payment time, which is Dec. 31, 2026. As such, you will need to pay that tax in 2027, when you file your return from the previous year. On the bright side, the basis increase means you could owe less.
Selecting a strategy
Depending on your investment strategy, capital gains tax deferral could make sense through a 1031 exchange or investment in a Qualified Opportunity Zone. These tools are not without their risks, however. To ensure you have a clear-eyed view of the pros and cons of both, talk to your financial advisor. And, depending on which strategy you use, be sure to keep an eye on the calendar.