Tax Deferral Strategies For Real Estate Investors: A Compact Guide

Although the sale of real estate properties in the United States will incur the payment of capital gains taxes, there are legal ways by which real estate investors can avoid paying such taxes, which are quite a substantial percentage of the final price. Most real estate investors know that the capital gains tax is one of the largest deductions of the proceeds when they sell their house or other real estate property. 

Quick-witted real estate investors know there are ways to keep the money legally, which they would otherwise be obliged to remit as capital gains tax if they don’t use tax deferral strategies. Even if they only swap it for another and say it wasn’t a sale, most swaps are still considered a sale unless they meet the legal requisites to fall under the exceptions. One such way of legally avoiding the payment of capital gains tax is by swapping your real estate property with another property. 

You may check out  Peregrine Private Capital 1031 exchange facilitators and other similar sites to learn more about how to do this. Some of the legal strategies real estate investors can use if they want to defer or avoid the payment of capital gains taxes are as follows:

Strategy 1: What’s A 1031 Exchange

A 1031 exchange is a common practice in real estate investment. It happens when one property is swapped for another real estate investment property, usually held as an investment asset. It’s been given the moniker 1031 because this type of transaction is based on section 1031 of the United States Internal Revenue Code. Real estate investors and analysts also refer to it sometimes as ‘like-kind’ or ‘like-property’ transactions. 

Most real estate exchange transactions would be considered a ‘sale.’ In a sale transaction, the seller incurs the corresponding capital gains tax (CGT). Here, a 1031 exchange acts as a tax deferral strategy for real estate home buyers and investors. When a real estate property swapped for another qualifies as a 1031 exchange, the seller wouldn’t have any taxes to pay out of the transaction. 

When transactions can’t be tax-free in some instances, the seller would only have to pay a limited amount of taxes. Yet there are specific requisites before a property investment sale can qualify under the 1031 exchange tax deferral incentive. Here are some of those requisites:

• The real estate investor should identify within 45 days the new or replacement property that the investor wishes to qualify under as a 1031 exchange replacement for the old property that the property owner disposed of or gave up. That period starts on the day of relinquishing the old property.
• The real estate investor must receive within 180 days the ownership of the new property identified as a replacement for the old property disposed of as a result of the 1031 sale or exchange.
• The new or replacement property should be of a ‘like-kind.’ This means that the new or replacement property should be similar in nature and character to the old property that was disposed of or given up in the 1031 exchange transaction.
• A third party, acting as the qualified intermediary of the 1031 exchange transaction, should be the one to receive and transfer the sale proceeds to the owner of the new or replacement property. The new property will also be transferred to the real estate investor through a third-party qualified intermediary. There can be no direct transaction between the real estate buyer and the seller of the replacement property.  

The value of the replacement property shouldn’t be lower than the value of the old property so that the real estate investor can take full advantage of the tax savings and benefits from this tax deferral strategy. Remember that you might be required to pay CGT if the sale does not qualify as a 1031 exchange. Another requirement is that the replacement properties should be located within the United States for the exchange to be considered 1031 and qualify for deferral of tax obligations.

Advantages Of 1031 Exchanges

A 1031 exchange is one of the most common and popular tax deferral strategies used in real estate investments because of its multiple advantages. One of its apparent advantages is that real estate investors wouldn’t have to pay CGT every time they exchange like-kind properties. Real estate investors can invoke 1031 exchange as a tax deferral strategy whenever they exchange or swap their existing property/asset for another property with a much higher price or value. 

In the long run, the 1031 exchange is a highly effective tax deferral strategy. It enables real estate investors to grow their property investments over time, and they don’t have to pay CGT with each transfer or exchange transaction. This gives them the incentive to buy higher-value or pricier assets without being hindered by the disincentive of having to pay CGT each time they exchange or swap for a more expensive property. 

Strategy 2: Qualified Opportunity Zones

Another tax deferral strategy that individual or business property investors can avail of is investing in qualified opportunity zones (QOZs). Certain specific land areas and communities in each locality are classified as QOZs. These QOZs are typically included in this classification because there are very few economic opportunities in these areas considered economically distressed zones. Hence, real estate investors who buy lands in QOZs for investment or development purposes are usually entitled to capital gain tax incentives. 

The creation of this investment opportunity or tax deferral strategy came after the enactment of the 2017 Tax Cuts and Jobs Act. The aim of passing this 2017 tax cuts legislation was to encourage large enterprises, small and medium businesses, and even individual real estate investors to put in long-term investments in communities and localities with scant economic opportunities across the United States. The idea was to spur businesses and industries to invest in the economic development of these underdeveloped areas by giving them tax incentives if they pour in long-term investments.

Real estate investors who would like to avail of the capital gain incentives under the QOZ program are allowed to defer the capital gains tax that should have been imposed on a property sale if they invest in a QOZ through a qualified opportunity fund (QOF). The payment or remittance of the capital gains tax would be deferred until the property bought through the QOF investment is either exchanged or sold, but this would only be valid until December 31, 2026, or whichever of these two things come first.

Real estate investors interested in making the capital gains tax on their real estate investments should meet the requirements under the QOZ investment program before they can become eligible for the tax deferral program. 

One crucial requirement is that the capital gains tax they should have paid, but is now seeking to defer, should be invested within 180 days since the property was sold. Another requirement is that your investment should be an exchange or transaction to acquire an equity interest. It shouldn’t be an exchange transaction in payment of a debt interest; otherwise, you’ll have to remit the capital gains taxes of the property sold.

Real estate investors interested in availing themselves of the QOZ investment program should also be aware that the tax benefit they’ll receive under this program would depend on the amount of time they’d be holding the QOF investment program. Remember the following:

• The basis of the QOF investment would increase by 10% of the deferred gain if you’re able to hold your QOF investment for at least five years. The practical implication of this is if you bought a commercial property where there’s not a lot of business, keep such property for at least five years if you bought it using the money you were supposed to remit as capital gains tax from selling one of your properties.
• If you can do this for at least seven years and, for instance, keep your commercial arcade or mini-mall, you’ll benefit from an additional 5% increase in the QOF investment in the deferred gain.
• If you can hold on to your QOF investment property for at least 10 years, the basis for the applicable QOF investment can be adjusted and increased up to the fair market value of the QOF investment property as of the date when it’s sold.

Strategy 3: Sales On Installment

A third tax deferral strategy real estate investors can avail themselves of is selling property in installments. This would allow the property owner who sold a property on installment to defer or stagger the remittance of capital gains tax from the property sold on installment because the owner has yet to receive the payments. 

In an installment sale, the property owner is legally permitted to defer the payment and remittance of capital gains tax until the future years and until such time only that the buyer has already paid the installment amounts due, together with any interest and other charges.

This sales method allows the real estate property owner to delay the declaration of some of the income earned from the installment that hasn’t been paid yet. This is fair and reasonable because those unpaid portions corresponding to future installments have yet to be received by the property owner who sold them. 

However, the practical implication is that real estate investors can manage their income tax bracket by carefully planning the accumulation of income earned from installment payments. Hence, they can avoid placement in the next higher bracket with a higher income tax rate. 

Conclusion

There are several legal ways to defer or avoid paying capital gains taxes. Most resourceful real estate investors are aware of these strategies, but some still aren’t familiar with them, especially those who are only starting in real estate investment. The capital gains tax is triggered when the transaction or exchange is deemed a sale. But US tax and real estate investment laws also provide investor-friendly mechanisms that enable businesses and individual real estate investors to keep what should have been paid as capital gains tax as long as they meet the legal requirements.