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Founder and Financial Advisor of DBHW Wealth Partners a leading independent wealth management and tax and accounting firm in Texas.
If you own real estate, whether through farm or ranch land, a vacation home or commercial real estate property, you are most likely familiar with tax-deferral options to help you potentially lower your tax bill. In 2023, the real estate market is favoring sellers over buyers, with limited inventory available today. A solution for real estate investors looking to sell off some of their properties, while simultaneously saving on taxes, is possible through specific tax-deferral strategies and investment vehicles.
The primary goal of tax-deferral strategies is to postpone or defer or potentially decrease capital gains tax investors would incur on the sale of a property. What is the caveat? Working with a financial professional who knows how taxation affects your overall investment portfolio can provide a lot of insight and help you understand how these strategies work. Historically, CPAs and financial advisors are seen as two separate professions, but in today's world, these two must work closely together to collaborate and maximize all available benefits so that you can keep more of what you earn.
For real estate investors looking to defer capital gains tax, here are some options you have available to you.
A 1031 exchange is a "like-kind exchange" for tax deferral that allows investors to postpone capital gains on selling a specific investment property. According to the IRS, the property you sell must be an investment property, not your primary place of residence. This is generally defined as a property that is not used for personal purposes. Think of it as swapping one property for a new property, and once the sale trigger has occurred, the clock is ticking to repurchase a "like-kind" property before 45 days have expired. For example, you could swap one rental home for another rental home -- but you cannot exchange your primary residence for commercial property, as the two have to be similar in order to qualify.
It's common for real estate to make up a portion of a certain individual's diversified portfolio. 1031 exchanges can be invested in real estate that you actively manage or could be deferred into an investment vehicle, which owns real estate and allows you to generate passive income. It's important to note that there are risks associated with this strategy like illiquidity and cost associated with fees.
These exchanges are also used as an estate planning strategy and can be seen as a tool to pass down tax-smart real estate assets to your heirs. Upon the death of the owner of a property, the heirs can receive a "step-up" in basis, meaning they can potentially avoid capital gains tax on the original or subsequent properties.
Qualified opportunity zones are economic communities identified by the Federal government needing investment and development. Tax incentives are given to real estate investors to encourage growth in these zones through qualified opportunity funds (QOF) -- also known as an investment vehicle. If you realize short-term or long-term capital gains from the current sale of an investment property, investors can reinvest gains into a QOF within 180 days. It's important to note that gains from stocks, bonds and real estate are all eligible.
If you invest the capital gains from the sale of your property into a QOF within the 180-day period, the taxes can be deferred until December 31, 2026, or the disposition of the QOF if earlier. For investors who want to hold their investment for at least 10 years, you will receive a step-up in basis, meaning you will pay no tax on the appreciation and liquidation of your QOF investment.
For investors looking to take advantage of the tax deferral, there are many requirements that must be met.
Selling your real estate investment property during a low-income year could potentially allow you to save on taxes in certain situations. When you sell a property for a profit, you are required to pay capital gains tax. However, if you know your income in a specific year will be lower than what it typically is, the same goes for the amount you pay in capital gains tax.
The overall amount you pay on taxes is determined by your combined income, and capital gains tax rates are not accessed separately. Therefore, if your income is low, it can be strategic to time your real estate sale when your overall taxable income amount is depreciated compared to higher income years.
Participating in an installment sale allows real estate investors to sell properties to a buyer and receive payments over a period of time instead of immediately receiving a lump sum payment. The buyer can reduce their overall tax burden by breaking up capital gains tax liabilities over several tax years. For installment sales to remain legal, the first installment has to be paid within one year after the tax year of the sale, and you have to record the sale on Form 6252 from the IRS.
A donor-advised fund allows clients to support qualified charities and nonprofit organizations, both now and in the future, through a charitable investment account. The amount contributed confers immediate tax benefits. This can be specifically helpful as a tax planning tool in the year that a large property sale occurs. When opening a donor-advised fund, the donor irrevocably transfers assets (cash or securities) to the respective donor-advised fund specialist.
Deferring taxes can be a beneficial short-term solution for taxpayers. Tax laws and regulations are constantly evolving, and it's critical to work with a financial advisor, CPA or real estate broker who has knowledge in the tax landscape so that you can keep more of what you earn through tax-efficient strategies.
Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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