If the sale of business or investment property results in a gain, the gain is normally subject to tax in the year of the sale. However, there are opportunities to report a gain over several years, to postpone it by investing the proceeds into another property, or by simply investing the gain in a recently enacted investment vehicle. Structuring an installment sale, tax-deferred exchange, or investing in a qualified opportunity fund are all tax deferral strategies, each having their own unique requirements. The following is an overview of these strategies.
Sometimes people refer to this arrangement as a “tax-free exchange.” However, the gain is not actually tax-free; but is deferred into another property. Eventually the gain will be taxed when the new property is sold (or can be deferred again in another exchange). These arrangements are also commonly known as “1031 exchanges,” in reference to Internal Revenue Code Section 1031.
Prior to 2018, these exchanges applied to various kinds of business or investment property such as automobiles, equipment, or real estate. As a result of the new tax law, 1031 exchanges now only apply to business- or investment-related exchanges of real estate. One requirement for a tax-deferred exchange is that the transaction must involve like-kind properties. However, when it comes to real estate exchanges the rules are very liberal, and virtually any type of real estate can be exchanged for any other, regardless of whether they are improved or unimproved.
Exchange treatment is not optional; Section 1031 provides for mandatory nontaxable treatment of gains if all of the applicable requirements are met. Therefore, taxpayers who do not wish to defer gains should structure the transaction to avoid the requirements of a 1031 exchange.
Since it is difficult for an exchange of one parcel of real estate for another parcel to occur at the same time, tax law allows delayed exchanges. Among other requirements a replacement property (or properties) must be identified within 45 days and acquired within 180 days or the tax-return due date (including extensions) for the year when the original property was transferred—whichever is sooner. An exchange intermediary typically holds the proceeds from such exchanges until they can be completed.
The amount of gain that is deferred depends on the properties’ fair-market values and mortgage amounts, as well as whether you receive cash in the exchange. The rule of thumb is that the exchange is more likely to be fully tax deferred when the replacement properties have greater value and equity.
In an installment sale the seller collects the sales price over a period of time with interest. Each year the seller pays tax on the interest and the taxable portion of the principal payments received in that year, thus creating the tax deferral. For a sale to qualify as an installment sale, the seller must receive at least one payment after the year the sale occurs. Installment sales are often used for sales of real estate, businesses, or business assets; they cannot be used for the sale of publicly traded stock or securities. The installment sale provisions do not apply when the sale results in a tax loss.
Qualified Opportunity Funds
Individuals who have capital gains from the sale of a personal, investment, or business asset can temporarily defer those gains into a qualified opportunity fund (QOF). QOFs are intended to promote investments in certain economically distressed communities, or “qualified opportunity zones.” To qualify as a QOF, a fund must hold at least 90% of its assets in qualified-opportunity-zone property.
Investments in QOFs provide unique tax incentives that are designed to encourage taxpayers to participate in these funds. The following are the requirements of QOFs and related benefits.
- In order to defer the gain, it must be invested in a QOF within 180 days of the sale that resulted in the gain.
- The gain is deferred until December 31, 2026—or to the year when the taxpayer withdraws the QOF assets, if that occurs earlier.
- As the investment is an untaxed gain, the taxpayer’s initial basis in the QOF is zero; this basis lasts for five years, so any funds withdrawn from the QOF in that time are fully taxable.
- If the funds are left in the QOF for at least five years, the basis increases to 10% of the deferred gain; in other words, 10% of the original gain is tax-free.
- If the funds are left in the QOF for at least seven years, the basis increases again, to 15% of the deferred gain; thus 15% of the original gain is tax-free.
- If the funds remain in the QOF after the tax on the gain has been paid, then the basis is equal to the amount of the original deferred gain.
- If the funds are left in the QOF for at least 10 years, the taxpayer can elect to increase the basis to the property’s fair market value. With this adjustment, the appreciation of the QOF investment is not taxable.
If a taxpayer’s investment in a QOF consists of both deferred gains and other funds, it is treated as two investments. The special tax treatment described above only applies to the deferred gains; the other funds are treated as an ordinary investment.
Unlike 1031 exchanges, QOFs only require the investment of the gains (not the entire proceeds of the sale).
Consult East Coast Tax Consulting Group for Tax Deferral Strategies
Each of the above tax deferral strategies is complicated and only applies in certain situations. None of these strategies should be utilized without careful analysis to ensure their suitability. Please note that not all of the qualifications for these strategies are included in this blog.
If you have any questions about these strategies or would like to make an appointment to analyze whether these tax deferral strategies fit your situation, please call our CPAs at 561-826-9303.