Although the sale of real estate in the United States results in the payment of capital gains taxes, there are legal means by which real estate investors can avoid paying these taxes, which represent a fairly large percentage of the final price. Most real estate investors know that capital gains tax is one of the most significant deductions from proceeds when selling their home or other real estate.
Sharp-witted real estate investors know that there are ways to keep the money legally, which they would otherwise have to pay in the form of capital gains tax if they do not use strategies of tax deferral. Even if they only trade it for another and say it wasn’t a sale, most trades are still considered a sale unless they meet the legal requirements to fall under the exceptions . One of these ways to legally avoid paying capital gains tax is to exchange your property for another property.
You can check out the Peregrine Private Capital 1031 Exchange Facilitators and other similar sites to learn more about how to do this. Some of the legal strategies that real estate investors can use if they wish to defer or avoid paying capital gains taxes are:
Strategy 1: What is a 1031 exchange?
A 1031 exchange is a common practice in real estate investing. This occurs when a property is exchanged for another real estate investment property, usually held as an investment asset. It was given the nickname 1031 because this type of transaction is based on Section 1031 of the United States Internal Revenue Code. Real estate investors and analysts also sometimes refer to it as “like-kind” or “like-ownership” transactions.
Most real estate exchange transactions would be considered a “sale”. In a sale transaction, the seller bears the corresponding capital gains tax (CGT). Here, a 1031 exchange acts as a tax deferral strategy for real estate buyers and investors. When a property exchanged for another is considered a 1031 exchange, the seller would not have to pay any tax on the transaction.
When transactions cannot be exempt from taxes in some cases, the seller would only have to pay a limited amount of taxes. Still, there are specific conditions before a real estate investment sale can qualify for the 1031 Exchange tax deferral incentive. Here are some of those requirements:
- The real estate investor must identify within 45 days which new property or replacement property they wish to qualify as a 1031 exchange replacement for the old property that the owner has disposed of or abandoned. This period begins on the day of abandonment of the old property.
- The real estate investor must receive within 180 days the ownership of the new property identified in replacement of the old property transferred following the sale or exchange 1031.
- The new or replacement property must be of a “similar type”. This means that the new or replacement property must be similar in nature and character to the old property that was transferred or abandoned in the 1031 exchange transaction.
- A third party, acting as the qualified intermediary of the 1031 exchange transaction, should be the one who will 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 qualified third party intermediary. There can be no direct transaction between the buyer of the property and the seller of the replacement property.
The value of the replacement property must not be less than the value of the old property so that the real estate investor can take full advantage of the tax savings and benefit from this tax deferral strategy. Remember that you may be required to pay CGT if the sale is not considered a 1031 exchange. Another requirement is that the replacement properties must be located in the United States for the exchange to be considered a 1031 and can benefit from the deferral of tax obligations.
Benefits of 1031 exchanges
A 1031 exchange is one of the most common and popular tax deferral strategies used in real estate investments due to its multiple benefits. One of its apparent advantages is that property investors would not have to pay CGT each time they swap similar properties. Real estate investors can invoke the 1031 exchange as a tax deferral strategy whenever they trade or exchange their existing property/asset for another property with a much higher price or value.
In the long term, the 1031 exchange is a very effective tax deferral strategy. It allows real estate investors to grow their real estate investments over time, and they do not have to pay CGT with each transfer or exchange transaction. This incentivizes them to buy higher value or more expensive assets without being hampered by the deterrence of having to pay CGT each time they swap or trade for a more expensive property.
Strategy 2: Qualified Opportunity Zones
Another tax-deferral strategy that individual or commercial real estate investors can benefit from is investing in Qualified Opportunity Zones (QOZs). Certain land areas and specific communities within each locality are classified as QOZ. These QOZs are generally included in this classification because there are very few economic opportunities in these areas considered to be areas in economic difficulty. Therefore, real estate investors who purchase land in QOZs for investment or development purposes are generally entitled to capital gains tax incentives.
The creation of this investment opportunity or tax deferral strategy came after the enactment of the Tax Cuts and Jobs Act 2017. The purpose of passing this 2017 tax cuts legislation was to encourage large corporations, small and medium-sized businesses and even individual property investors to make long-term investments in communities and localities with little economic opportunities across the United States. The idea was to encourage companies and industries to invest in the economic development of these underdeveloped regions by granting them tax incentives if they pay long-term investments.
Property investors who wish to benefit from the capital gains incentives under the QOZ program are permitted to defer capital gains tax that should have been imposed on a sale of property if they invest in a QOZ through a qualified opportunity fund (QOF). Payment or remittance of capital gains tax would be deferred until the property purchased through the QOF investment is traded or sold, but this would only be valid until December 31, 2026, or whichever first of these two things.
Real estate investors interested in taxing capital gains on their real estate investments must meet the QOZ investment program requirements before they can become eligible for the tax deferral program.
A crucial requirement is that any capital gains tax they should have paid, but are now looking to defer, be invested within 180 days of selling the property. Another requirement is that your investment be an exchange or transaction to acquire a stake. It should not be an exchange transaction in payment of interest on the debt; otherwise, you will have to remit the capital gains taxes on the property sold.
Real estate investors interested in availing themselves of the QOZ investment program should also be aware that the tax benefit they will receive under this program will depend on how long they hold the QOF investment program. Remember the following:
- The QOF investment basis would increase by 10% of the deferred gain if you are able to hold your QOF investment for at least five years. The practical implication of this is that if you have purchased a commercial property where there is not much business, hold onto that property for at least five years if you purchased it using the money you were supposed to pay as capital gains tax from the sale of one of your properties.
- If you can do this for at least seven years and, for example, keep your shopping mall or your mini-mall, you will benefit from an additional 5% increase in the QOF investment in the deferred gain.
- If you can keep your QOF investment property for at least 10 years, the applicable QOF investment basis may be adjusted and increased up to the fair market value of the QOF investment property at the date of its sale.
Strategy 3: Installment Sales
A third tax deferral strategy available to real estate investors is to sell property in installments. This would allow the owner who sold a property on installment to defer or stagger the payment of capital gains tax on the property sold on installment because the owner has not yet received the payments.
In an installment sale, the owner is legally entitled to defer the payment and remittance of capital gains tax until future years and until the buyer has already paid the installments due, as well as interest and other charges.
This method of sale allows the owner of the property to defer the declaration of part of the income from the deposit not yet paid. This is fair and reasonable because the unpaid parts corresponding to the future installments have not yet been received by the owner who sold them.
However, the practical implication is that real estate investors can manage their tax bracket by carefully planning the accrual of income from installment payments. Therefore, they can avoid placement in the next higher bracket with a higher income tax rate.
There are several legal ways to defer or avoid paying capital gains taxes. Most resourceful real estate investors are familiar with these strategies, but some are still unaware of them, especially those new to real estate investing. Capital gains tax is triggered when the transaction or exchange is considered a sale. But U.S. tax and real estate investment laws also provide investor-friendly mechanisms that allow corporations and individual real estate investors to keep what should have been paid in capital gains tax for as long as they meet legal requirements.