Selling an investment property can be exciting–until you realize how much of your hard-earned profits you’ll lose to capital gains taxes. For years, the 1031 exchange has been a reliable way for real estate investors to defer capital gains taxes and maximize their reinvestment opportunities. However, the 1031 exchange is not without its limitations and drawbacks.
Fortunately for you, there are other options. Opportunity Zone Investing and Deferred Sales Trusts are alternatives to the 1031 exchange that might better fit your investing needs and desires. In this article, we will go over the pros and cons of each investment option. Whether you are new to real estate investing or looking to break free from the restrictions of a 1031 exchange, these capital gains tax strategies could be a game changer.
Opportunity Zone Investing
The Opportunity Zone tax break was created in 2017 as a part of the Tax Cuts and Job Act (TCJA), which was signed into law by President Trump. The objective behind the TCJA is to encourage investment in underserved or economically declining areas. Governors of each state were given the power to designate struggling geographic areas as Opportunity Zones.
Investors can receive tax benefits for investing capital gains in these Opportunity Zones. The neighborhoods identified benefit from increased investment, and the investors offset the risk of purchasing property in economically depressed areas with significant tax benefits. Ideally, everyone benefits.
Tax Benefits of Opportunity Zone Investing
- When you sell a property and reinvest into a Qualified Opportunity Fund (QOF), you are eligible to defer the capital gains taxes on your gain until December 31, 2026.
- The longer you hold your investment in an Opportunity Zone, the greater the tax benefit. Investors who keep their funds in a QOF for at least five years are entitled to a 10% capital gains exclusion.
- Investors holding their funds in a QOF for seven years receive a 15% exclusion of capital gains.
- If you hold your investment in a QOF for at least 10 years, you will no longer owe any capital gains taxes on the revenue from your investment. Any gains from your Opportunity Zone Investment will be completely tax-free.
How to Take Advantage of Opportunity Zone Investing
To take advantage of the tax benefits of Opportunity Zones, you can’t just buy a property in a designated zone. Instead, you must invest in a Qualified Opportunity Fund (QOF). These funds pool resources from multiple investors and are managed by experienced developers or investment firms who use the fund to build new properties, buy real estate, or improve current properties.
The requirement to invest in a QOF is both an advantage and a disadvantage. On one hand, you aren’t restricted by the like-kind or time requirements of a 1031 exchange. You do not have to search for the perfect property to reinvest in, and you don’t have the stress of trying to close a sale within 180 days.
On the other hand, if you are a hands-on investor wanting to be involved and make decisions, it might not be the best option. You won’t get to handpick a business or property to reinvest in, and the fate of your investment lies in the Opportunity Zone as a whole.
Additionally, the money you invest must come from the capital gains earned by selling another asset, such as stocks, property, or a business. The tax benefits will only apply to reinvested capital gains. While this investment allows you to avoid capital gains taxes on your Opportunity Zone Investment, you will still have to pay taxes on your original capital gains after 2026.
Because you have to hold your investment for at least 10 years to maximize the full tax benefits, and because Opportunity Zone Funds are almost always invested in real estate development, it will likely take years before you see a positive return on your investment. This isn’t necessarily a bad thing, but it does mean that Opportunity Zones are not the best investment for someone who needs cash flow or wants to access their principal in the near future.
Investing in a Deferred Sales Trust
A Deferred Sales Trust is a relatively unknown yet powerful capital gains tax deferral strategy. While many investors and even tax professionals are not familiar with it, it has been around for over 20 years and has been tested and proven in nearly every financial market.
A Deferred Sales Trust (DST) is a flexible alternative to a 1031 exchange or an Opportunity Zone Investment that lets an investor defer their capital gains taxes from the sale of almost any asset. In contrast with other investment strategies, you can set up a DST to allow for a steady cash flow customized to your needs.
How to Take Advantage of a Deferred Sales Trust
A Deferred Sales Trust falls under the IRS tax code section regulating installment sales. Here’s how it works: instead of selling your asset (property, stocks, art, Bitcoin) directly to a buyer, you sell to an independent third-party trust that gives you a promissory note in return. The trust sells your asset to the buyer and takes receipt of the proceeds. Since you haven’t received any principal from the sale or realized any capital gains, you don’t immediately owe any capital gains taxes. Based on the terms of the promissory note, which you determine before the sale, the trust will reinvest your capital gains, and you’ll receive regular installments of your profits. You will only owe capital gains taxes on the portion of your proceeds that you receive each year.
Tax Benefits of a Deferred Sale Trust
- Using a DST allows you to reinvest 100% of your capital gains rather than the roughly 70% – 80% (percentage varies from state to state) you would have left after paying capital gains taxes. This will enable you to maximize your investments and end up with more money in your pocket.
- If you choose to reinvest all of your proceeds and take interest-only payments, you can maintain a 100% deferral of your initial capital gains. You will only owe income taxes on the interest payments you receive each year.
- If you need a more consistent cash flow, you can structure the sale so that you receive regular payments. This allows you to defer much of the capital gains taxes while giving you the freedom and flexibility of a dependable cash flow.
- You can use a Deferred Sales Trust on the sale of nearly any asset–a business, investment properties, a primary residence, stocks, cryptocurrency, or art and collectibles. Accordingly, the trust can reinvest your profits into any combination of investment vehicles. This gives you the option of diversifying your investments and reducing your risk.
If you are getting ready to sell a highly appreciated property but feel trapped by capital gains taxes and wary of a 1031 exchange, know there are viable and powerful alternatives. Opportunity Zone Investments and Deferred Sales Trusts both provide significant tax benefits without many of the restrictions and drawbacks of a 1031 exchange. Consult with your tax advisor or a qualified Deferred Sales Trust trustee to determine which strategy will serve you best.