Tax management is an essential component of financial planning for many taxpayers. There are several possible reasons to favor deferring taxes and more than one tool for doing so. Taxpayers may seek to defer income taxes or capital gains taxes. In each case, deferral does not equate to elimination, although it is possible to legally eradicate capital gains taxes in some cases.
How can I defer income taxes?
Taxes are levied on earned income (often from wages or self-employment) at a progressive rate. With a progressive tax system, the percentage of income payable as tax increases as the income rises. For example, for a married couple filing jointly in 2023, the first $22,000 in income is taxed at a ten percent rate. Income from $22,001 to $89,450 is taxed 12 percent, and income between $89,451 and $190,750 is subject to a 22 percent tax rate. The current maximum income tax rate is 37 percent.
One way to defer paying taxes is by delaying the income, and one tactic to achieve that is called deferred compensation. Sometimes people with high incomes have the option to push a portion of their current income forward to a future date. The logic behind this is that the person may move into a lower tax bracket in the future, usually by retiring. For example, suppose that Joe defers $100,000 in income. If Joe is presently subject to a 35 percent tax levy, he will pay $35,000 on that income today. But if he can receive the income when he has less overall income and pays 24 percent in taxes, he keeps an additional $11,000.
Another tool for deferring income tax payments is diverting the income into a tax-deferred account designated for retirement. The typical examples of these accounts include 401(k) and IRAs (Individual Retirement Accounts). Tax-deferred retirement accounts are governed by rules that limit when the taxpayer can withdraw funds and are subject to penalties if they don't abide by the applicable regulations.
In each case, the taxpayer pays the taxes when they receive the income. But, again, the motivation for deferring these income taxes is the expectation that the taxpayer can receive the income at a time when their overall tax rate is lower, thus owing less.
How can I defer capital gains taxes?
Capital gains taxes are assessed on unearned income that the investor receives from appreciation in the value of an asset like stocks or real estate. If the investor has owned the asset for less than a year, the gain is considered short-term, and the tax rate is the same as that on their ordinary income. However, if the investor holds the asset for more than a year, it is subject to the long-term capital gains rate, which is lower, and currently does not exceed 20 percent.
One common method of deferring capital gains taxes on real estate investments is to manage the disposition of investment real estate through a 1031 exchange. This section of the Internal Revenue Code allows taxpayers to defer the taxes on a long-term capital gain if they reinvest the sale proceeds into a “like-kind” property within 180 days.
The investor can defer the taxes due until they sell the new property using this method. At that time, they would owe both the deferred taxes and taxes on any new appreciation of the replacement property. However, if an investor executes sequential exchanges until they finally distribute the last property to an heir, they will effectively eliminate the accrued taxes. This result is possible because an heir receives the asset at the current (stepped-up) value and does not owe capital gains taxes. The IRS will pursue the taxpayer to pay the taxes due if it learns of an unreported sale of a replacement property. In this case, the taxpayer would owe the accumulated taxes and non-payment penalties.
Deferring capital gains taxes through a QOZ
One disadvantage to deferring taxes through a 1031 exchange is that the investor must reinvest the entire transaction proceeds rather than only the gain from the sale. If the investor pursues a QOZ (Qualified Opportunity Zone) investment, they can limit the reinvestment to the appreciation amount. Also, more types of capital gain are eligible for reinvestment in QOZ Funds, including profits from selling stocks. However, the benefits of QOZ investments created by the 2017 Tax Cuts and Jobs Act are phasing out, which limits the current utility for deferring gains.
Overall, income and capital gains taxes are deferrable by carefully applying the available tools. In many instances, the deferred taxes will be withheld, avoiding any issue with non-payment. However, taxpayers should carefully review their tax obligations when the deferral is complete to ensure they don't receive a late payment penalty.
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.
Hypothetical examples shown are for illustrative purposes only.
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.
