Tax Planning for Real Estate Capital Gains

Many investors have built their wealth through investment real estate. It can provide several tax benefits to investors, as well as cash flow potential and long-term appreciation. But now you’ve sold the property and you are facing a significant capital gain. Luckily, there are options available to defer the realization of capital gains from the sale of investment real estate: the 1031 like-kind exchange, Delaware Statutory Trusts and Qualified Opportunity Zone Funds. In this article, we will compare and contrast these vehicles so you can make an informed decision regarding the most suitable investment strategy for your specific financial goals.

Investing the proceeds from the sale of investment real estate requires careful consideration to maximize returns and minimize tax liabilities.

1031 Like-Kind Exchange

1031 like-kind exchanges have long been utilized as a powerful tax strategy for real estate investors, providing an avenue to defer capital gains taxes and preserve investment gains. Under Section 1031 of the Internal Revenue Code, individuals and businesses can exchange one investment property for another of "like-kind" without triggering immediate tax liabilities on the capital gains.¹

One of the primary benefits of engaging in a 1031 like-kind exchange is the potential deferral of capital gains taxes. By reinvesting the proceeds from the sale of an investment property into a like-kind replacement property, investors can defer paying taxes on the capital gains until a future date. This deferral enables individuals to preserve a larger portion of their investment gains and keep funds working in the real estate market, potentially generating further growth and income. Moreover, investors can continually defer taxes by participating in successive 1031 exchanges, allowing for the compounding of investment gains over time.

A 1031 like-kind exchange is not without its potential limitations and requirements. To qualify for tax deferral, the replacement property must be of "like-kind," which generally means it must be a similar type of property used for business or investment purposes. You must also hire a Qualified Intermediary to hold the proceeds of the sale during the transaction and there are strict timeframes to follow. Potential replacement properties must be identified within 45 days of the sale and the acquisition of the replacement property must be completed within 180 days. These time constraints can add pressure to the exchange process and limit the available options. Additionally, any cash or other non-like-kind property received during the exchange may be subject to immediate taxation, reducing the potential tax benefits.

1031 like-kind exchanges allow real estate investors to defer capital gains. Investors can reinvest proceeds into like-kind replacement investment property. Strict timeframes and qualification requirements must be followed.

Qualified Opportunity Zone Fund

An Opportunity Zone is a designated geographic area that has been identified by the government as needing economic revitalization. The Tax Cuts and Jobs Act of 2017 established 8,746 of these zones spread across the United States.² Qualified Opportunity Zone Funds then emerged as an intriguing investment opportunity, offering significant tax incentives for individuals looking to invest in economically distressed communities. A Qualified Opportunity Zone Fund allows investors to deploy capital gains from other investments into these zones, providing potential tax advantages and the opportunity to support community development.

By reinvesting capital gains into an Opportunity Zone Fund within 180 days of the sale transaction, investors can defer paying taxes on those gains until December 31, 2026, or until they sell their investment, whichever occurs earlier. If investors hold their investment in the Opportunity Zone Fund for at least ten years, any appreciation in the Opportunity Zone Fund is tax-free.²

It is important to consider potential disadvantages or pitfalls associated with Opportunity Zone Funds. One challenge is the complexity of the tax regulations and compliance requirements. Navigating the intricacies of the Opportunity Zone program and ensuring compliance with the various rules and deadlines can be challenging for investors. Additionally, investing in economically distressed areas carries inherent risks, such as uncertain market conditions and potential lack of infrastructure or demand for new projects.

Opportunity zones offer potential tax advantages and support community development in designated economically distressed areas. Investors can defer paying capital gains taxes until December 31, 2026. Thorough due diligence and professional consultation is necessary due to the complex tax regulations and investment risks.

Delaware Statutory Trust

A Delaware Statutory Trust is a legal entity formed under Delaware state law that enables individuals and organizations to own and manage real estate assets. A primary advantage of this vehicle is the ability to diversify investment portfolios and gain access to institutional-grade properties. By pooling funds with other investors, a Delaware Statutory Trust allows individuals to invest in properties that would otherwise be financially out of reach. By using professional asset managers to handle property management and maintenance, it offers passive income potential while relieving investors of the burdensome responsibilities associated with active property ownership.

A Delaware Statutory Trust provides tax advantages through the deferral of capital gains taxes. It can offer passive income potential as professional managers handle property management and maintenance. A Delaware Statutory Trust can also enable investors to diversify their portfolio and access institutional-grade real estate properties.

Investors can utilize a 1031 like-kind exchange from the sale of their investment property into a Delaware Statutory Trust, allowing for the deferral of capital gains taxes. This tax benefit, coupled with the potential for regular income distributions and diversification, makes this an attractive option for those seeking to optimize their tax planning and generate passive income, while maintaining exposure to investment real estate.

Since a Delaware Statutory Trust is managed by professional asset managers, investors have limited input in property management decisions. It typically has a predetermined investment period, meaning investors may have limited liquidity during that time. As with any real estate investment, risks such as market fluctuations, vacancies, and unforeseen expenses can impact the overall returns.

Investing the proceeds from the sale of investment real estate requires careful evaluation of options. With expert guidance, you can optimize tax advantages and diversification while mitigating risk and tax liabilities. Consult with your tax, legal, and financial professionals.Conclusion

When deciding where to invest the proceeds from the sale of investment real estate, investors should carefully weigh the differences, advantages, and disadvantages of the available options. The 1031 like-kind exchange provides tax deferral and portfolio diversification, while a Delaware Statutory Trust offers passive investing and diversification benefits. A Qualified Opportunity Zone Fund, on the other hand, provides tax incentives for investing in economically distressed areas.

It is important for investors to consult with tax professionals, financial advisors, and legal professionals to assess their unique circumstances and make well-informed decisions. By doing so, investors can maximize the benefits of their investment while minimizing potential risks and tax liabilities.

Preparing to Sell Real Estate?

Speak with a Comerica Advisor. Our experienced team will help you analyze your tax-saving options and prepare a strategy. Contact your Comerica Relationship Manager or request to speak with a Comerica Professional.

¹Cornell Law School Legal Information Institute: 26 U.S. Code § 1031 - Exchange of real property held for productive use or investment | U.S. Code | US Law | LII / Legal Information Institute (cornell.edu)
²Opportunity Zones” - Internal Revenue Service: Opportunity Zones | Internal Revenue Service (irs.gov)