Tax deferral is one of the aspects of real estate investing that make it a powerful wealth building vehicle. Tax is ultimately due at some point of time. However, the ability to defer such liability carries the power of the time value of money, i.e. the proceeds one would otherwise pay in tax can be deployed towards cash flowing investments generating returns in the interim.
As usual, before exploring any tax deferral strategy you must consult with your CPA and tax advisor to determine the most optimal path for you.
In today’s snippet we reveal some of the most commonly used strategies and provide a high level comparative chart in the end.
1031 Exchange
1031 is a section within the IRS code that ultimately allows one to defer the qualifying gains from sale of a property. However, for that deferral to be recognized, the investor must follow a few strict guidelines.
- A qualified intermediary must be engaged. And one should also involve his/her CPA.
- One has 45 days to identify a replacement property from the day one closes on the sale of the relinquished property and 180 days to close on the replacement property. The 180 day clock starts ticking from the sale date or the due date of the tax return for the tax year during which the relinquished property was sold.
- The exchange must be like for like, i.e. real estate for real estate, not real estate into an LLC owning RE (in some states exchanging mineral rights into real estate might be eligible).
- The qualifying property must be held for investment – intent matters.
- The replacement property must be of equal or greater value. There are specific reinvestment requirements to follow.
- The exchange MUST be set up BEFORE the sale of the relinquished property (before the PSA is signed).
- Typical exit is a sale of the property or 1031 exchange into another property, which 1031 exchange process can continue indefinitely until one passes away at which point the property passes on to one’s heirs on a step up tax basis.
Delaware Statutory Trusts
Delaware Statutory Trust (not to be confused with Deferred Sale Trust) became popular since 2004 and represents another tax deferral vehicle. It represents fractional ownership in a Trust that owns the underlying real estate.
- The Trust holds title to real property (most common investments are multifamily or NNN leased retail or office but may include other commercial real estate like self- storage, senior living, retail, etc.)
- DSTs typically obtain low LTV (50% + or -) non-recourse financing
- Can close within five days from submission of subscription documents
- The typical investments are safer well maintained low capex need assets. Given the lower risk, returns are also lower.
- Close in 5 days from submission of subscription docs
- No K1 is issued at year end – only an operating statement with your prorata ownership share, which document your CPA can input into Schedule E of your tax return
- Only available to accredited investors
- You relinquish control to the DST sponsor/operator who will operate the property. As such, DST investments are considered passive in nature.
- No future contributions of capital are allowed – e.g. for capex so the sponsor must raise upfront and estimate well. And even then, no heavy capex is allowed, only routine and typical repair and maintenance.
- No refinance or re-borrow of new funds and no new investors are allowed, i.e. no new capital infusions post close.
- Excess cash must be distributed.
- No 1031 exchange into another DST is allowed as it is no longer like for like – may be able to sell your share to other DST trustees
- Typical exits include a sale to a REIT, institutional buyers, high net worth 1031 exchange buyers, or a Sec 721 exchange into a REIT.
- Key players – your CPA, DST sponsor/operator, licensed broker dealers selling the DST, provides immediate access to properties to 1031 exchange into
- Potential to diversify into various properties
- Small min amount of $100K
Deferred Sales Trusts
The Deferred Sales trust is a form of installment sale. One would sell the property to a trust (managed by a third party on the seller’s behalf), which then sells the property to the final buyer.
- The trust then pays you the proceeds from sale over an extended period of time (up to 20 or more years).
- Only the installments are taxed, which allows you to spread out the tax liability over time.
- Excess funds not yet distributed can be invested in other low risk investments or treasuries, generating additional income.
- Ensure you are working with an experienced professional in that matter – tax & legal – to set it up properly.
- The set up and maintenance fees could be significant. As such (and as with any other major ticket decision), a cost (set up and maintenance fees) vs. the benefit (tax savings over time) should help one assess this option.
Tenant In Common (TIC)
This vehicle offers the ability to 1031 exchange a property into a syndication. However, the syndication must have the TIC structure set up ahead of time. Not all sponsors offer that structure as it requires additional set up from a legal standpoint. Such set up, if not done correctly could also trigger a tax liability and void the 1031 exchange altogether. It can also result in complications around voting power, control, fees, and profit splits. For that reason many sponsors would have minimum required investment amounts that start at $500M-$1MM in order to accept 1031 exchange investors.
Opportunity Zones (OZs)
Investments in OZ are typically in distressed zones or communities who would benefit from investment in the region. As such, these investments enjoy a preferred tax treatment.
- The gain (or entire sale proceeds) can be invested in an OZ fund and therefore deferred until the OZ project is sold
- No intermediary is required
- Per the IRS: “Gains that may be deferred are called “eligible gains.” They include both capital gains and qualified 1231 gains, but only gains that would be recognized for federal income tax purposes before January 1, 2027, and that are not from a transaction with a related person. For you to obtain this deferral, the amount of the eligible gain must be timely invested in a QOF in exchange for an equity interest in the QOF (qualifying investment). Once you have done this, you can claim the deferral on your federal income tax return for the taxable year in which the gain would be recognized if you do not defer it.”
- You may defer the gain in whole or in part
- A taxpayer has 180 days from the date of the sale or exchange of appreciated property to invest the realized capital gain dollars into a Qualified Opportunity Fund
- The 180-day period during which to invest in a Qualified OZ Fund begins on the day the installment payment is received, even if the installment sale giving rise to the gain took place prior to December 2017.
- If your installment sale took place after 2017, if you elect installment treatment for your sale, you have two options for how to defer gain detailed here (https://www.wellsfargo.com/the-private-bank/insights/planning/wpu-qualified-opportunity-zones/ )
- The deferral expires on December 31, 2026, at which point of time the gains will be taxable.
- Only the portion of the investment attributable to the capital gain will be eligible for the exemption from tax on further appreciation of the Opportunity Zone investment,
- There is no requirement for like kind property.
- Step up OZ benefits are no longer applicable unless the OZ is extended
Other
There are a few other vehicles one can utilize such as foundations, charitable remainder trusts, spendthrift trusts, and installment sales/seller finance.
Which option is the best really depends on one’s personal situation and goals around timing, comfort with relinquishing control, desired deferral timelines. As such you should always discuss such events with your tax advisor and CPA.
Sources:
Lifetime tax Free Wealth by Dave Foster
An Introduction To DST Properties For 1031 Exchange Investors by Dwight Kay
Wells Fargo Private Bank publication 10-2022
Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.