Tax deferment isn’t the same as tax-free or a tax credit. Tax-free means taxes aren’t owed on gains. Tax deferment means taxes are owed but at some point in the future. Depending on how taxes are deferred, the time that the tax bill comes due can vary. We’ll look at several different tax deferral methods and when taxes may be owed for each.
1031 Exchange
The 1031, like-kind exchange, is a popular tax deferment method for real estate investors. It allows them to defer taxes on gains of the relinquished property. To accomplish this, investors must follow all of the 1031 exchange rules. Otherwise, investors can be left with a surprise tax bill.
Once the 1031 is completed, taxes on the relinquished property’s gain will remain deferred until the replacement property is sold. However, an investor can continue executing 1031 exchanges. As a result, they also keep deferring their taxes on gains. This could go on until the investor passes.
Once the investor passes, heirs can inherit the property at a step-up in basis. This allows them to inherit the property at the market value at the time of the decedent's passing.
For example, a son inherits property at a market value of $500,000. The property was originally purchased or exchanged at $400,000. The son will not owe taxes on the $100,000 gain if the property is sold immediately. If the son later sells the property for $550,000, then taxes will be owed on the $50,000.
Although the son could do as the father and execute a 1031 exchange, deferring taxes on the gain.
It can be difficult to find a property that meets the like-kind restrictions. That’s where a Delaware Statutory Trust (DST) can be a useful alternative to exchanging into direct real estate. DSTs are eligible for 1031 exchange. Rather than finding a specific property that meets the like-kind criteria, the investor only needs to find a DST that meets their investment criteria. In some cases, it can be an easier way to perform a 1031 exchange.
401(k) and IRA
The 401(k) is a defined contribution plan used for retirement. These plans are set up through an employer. 401(k)s allow employers to match the employee’s contributions into the plan.
Contributions are taken directly out of the employee’s paycheck. These contributions go into the plan pre-tax. At the end of the year, 401(k) contributions can reduce an employee’s tax bill since earnings on contributions are tax-deferred.
In retirement, the employee will pay taxes at their current income tax rate on any withdrawals from the plan.
An IRA is similar to a 401(k), except contributions are not matched. An individual can also set up an IRA.
Taxes are deferred for both the 401(k) and IRA until funds are withdrawn.
Opportunity Zones
Qualified opportunity zones (QOZ) allow investors to defer taxes on gains until December 31, 2026. However, all QOZ rules must be met for the tax benefit to stick. Capital gains and qualified 1231 gains are eligible for tax deferment through QOZs.
The above gains must be:
- Recognized for federal income tax purposes before January 1, 2027
- Not from a transaction with a related person
In addition to cash (i.e., gains), non-cash property can be transferred into a qualified opportunity fund. However, non-cash property may not be 100% eligible for the opportunity zone tax benefit.
Deferring taxes generally comes with some strict requirements. Although, the deferral benefit can be well worth it. For that reason, it’s best to work with a tax advisor.
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.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
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.
