Welcome to the second installment in our series of articles exploring tax mitigation strategies in commercial real estate. Last time we looked at the basics of depreciation for accounting and tax purposes specifically looking at the benefits of accelerated depreciation and cost segregation studies. Those tools focused on more current savings. Next, we will look at what can be done to lessen the hit when commercial real estate is sold at a gain. In this article, we will delve into two powerful tools that investors can utilize to mitigate capital gains tax: Section 1031 exchanges and Qualified Opportunity Zones (QOZs). Understanding these strategies is crucial for investors seeking to optimize their tax positions and maximize returns in the realm of commercial real estate. Additionally, we will touch upon the use of Delaware Statutory Trusts (DSTs), which are investment funds compatible with both Section 1031 exchanges and QOZ investments.
A Section 1031 exchange, often referred to as a "like-kind exchange,” allows investors to defer capital gains tax when selling a property and reinvesting the proceeds into another property of equal or greater value. This strategy is particularly valuable for those looking to diversify their portfolio or upgrade their real estate holdings without incurring immediate tax liabilities. Section 1031 of the Internal Revenue Code, established in 1921, has a long history of incentivizing investment and stimulating economic growth. Originally designed to encourage reinvestment in the economy, it allows investors to defer paying capital gains taxes on the exchange of certain types of property. Over the years, Section 1031 has undergone various amendments and interpretations, shaping its role in facilitating like-kind exchanges and influencing real estate investment strategies.
Let us consider an investor who sells a commercial property for $1 million, with a cost basis of $500,000. Without a 1031 exchange, they would owe capital gains tax on the $500,000 profit. However, by reinvesting the full $1 million into another qualifying property through a 1031 exchange, they can defer paying taxes on the gain.
· Sale Price: $1,000,000
· Cost Basis: $500,000
· Capital Gain: $1,000,000 - $500,000 = $500,000
· Potential Tax Owed (Assuming 20% capital gains tax rate): $500,000 x 20% = $100,000
With a 1031 exchange, this investor can defer paying the $100,000 in taxes and reinvest the full $1 million into a new property or properties.
Qualified Opportunity Zones (QOZs) are designated economically distressed areas where investors can receive significant tax benefits for investing in real estate and businesses. Investors can defer capital gains by reinvesting those gains into a Qualified Opportunity Fund (QOF), which then invests in projects within QOZs. The concept of Qualified Opportunity Zones (QOZs) was introduced as part of the Tax Cuts and Jobs Act of 2017, specifically in Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code. This legislation aimed to incentivize investment in economically distressed communities across the United States by offering tax benefits to investors who funnel capital gains into designated QOZs through Qualified Opportunity Funds (QOFs). The program was designed to spur economic development, job creation, and community revitalization in underserved areas while providing investors with opportunities for tax-deferred and potentially tax-free returns on their investments.
The tax benefits of investing in a Qualified Opportunity Fund (QOF) include deferred taxes on capital gains until the investment is sold or until December 31, 2026, whichever comes first. Additionally, if the investment is held for at least 5 years, there is a 10% reduction in the deferred capital gains, and if held for at least 7 years, the reduction increases to 15%. Moreover, any new gains from the QOF investment itself, if held for at least 10 years, can be tax-free.
Consider an investor with $500,000 in capital gains from a previous real estate sale. They invest this amount into a QOF focused on a Qualified Opportunity Zone project.
· Capital Gains: $500,000
· Tax Deferral: $500,000 (deferred until 2026 or when investment is sold)
· If held for 5 years: $500,000 x 10% = $50,000 reduction in capital gains
· If held for 7 years: $500,000 x 15% = $75,000 reduction in capital gains
· If held for 10 years: Any new gains from the QOF investment are tax-free
Delaware Statutory Trusts (DSTs) are investment funds that hold ownership of income-producing real estate properties. These trusts are a popular option for investors participating in 1031 exchanges or seeking to invest in QOZ projects without direct management responsibilities. Delaware Statutory Trusts (DSTs) emerged as a structured investment vehicle for real estate ownership, authorized under Delaware law. The concept gained prominence in the realm of commercial real estate investment due to its compatibility with Section 1031 of the Internal Revenue Code, which allows investors to defer capital gains taxes by reinvesting proceeds from property sales into like-kind properties. DSTs offer investors a way to pool resources and gain fractional ownership in income-producing real estate properties, providing opportunities for diversification and passive income generation.
Benefits for 1031 exchanges include tax deferral, where investors can defer paying capital gains tax on the proceeds from the sale of their original property by investing in a Delaware Statutory Trust (DST) through a 1031 exchange. Additionally, DSTs offer fractional ownership in large, institutional-grade properties, enabling investors to diversify their real estate portfolio without the need to manage individual properties. Moreover, DSTs generate regular income distributions from the properties they hold, providing investors with a passive income stream.
Let us consider an investor who sells a commercial property for $1,500,000 with a cost basis of $500,000. They plan to reinvest the proceeds into a DST through a Section 1031 exchange.
· Sale Price: $1,500,000
· Cost Basis: $500,000
· Capital Gain: $1,500,000 - $500,000 = $1,000,000
· Potential Tax Owed (Assuming 20% capital gains tax rate): $1,000,000 x 20% = $200,000
By investing the full $1,500,000 into a DST through a 1031 exchange, the investor defers paying the $200,000 in capital gains tax. They now have exposure to a diversified portfolio of income-producing properties within the DST.
Benefits for Qualified Opportunity Zones (QOZs) include tax deferral and reduction. Similar to a 1031 exchange, capital gains invested in a Delaware Statutory Trust (DST) within a QOZ can be deferred until 2026 or when the investment is sold. Additionally, investors may receive a reduction in capital gains tax if the investment is held for certain periods. Furthermore, QOZ investments offer tax-free growth, where any new gains from the QOZ investment itself, if held for at least 10 years, can be tax-free, providing significant potential for increased returns.
Let us continue with our investor who has $1,500,000 in capital gains from a previous real estate sale. They decide to invest this amount into a DST focused on a Qualified Opportunity Zone project.
· Capital Gains: $1,000,000
· Potential Tax Owed (Assuming 20% capital gains tax rate): $1,000,000 x 20% = $200,000
By investing the full $1,500,000 into a DST within a Qualified Opportunity Zone, the investor defers paying the $200,000 in capital gains tax until 2026 or when the investment is sold. If the investment is held for at least 10 years, any new gains from the QOZ investment itself can be tax-free.
In conclusion, Section 1031 exchanges, Qualified Opportunity Zones (QOZs), and Delaware Statutory Trusts (DSTs) are powerful tools for investors in commercial real estate to mitigate capital gains tax and maximize returns. By using these strategies and vehicles, investors can defer taxes, diversify their portfolios, and potentially benefit from tax-free growth.
Investors should carefully consider their specific financial situations and consult with tax advisors and financial professionals before making investment decisions. Each strategy has its own set of rules and regulations, and proper guidance can ensure optimal outcomes.
Disclaimer: The information provided in this article is for educational purposes only and should not be construed as tax or financial advice. Readers are encouraged to consult with their professionals regarding their specific tax and financial circumstances.
Chris Etterlee, CPA is the managing shareholder of Fuller, Frost & Associates, CPAs. He is an adjunct instructor in the Hull College of Business at Augusta University and the business school of Aiken Technical College. He is also the founding member of CTA Works, LLC which specializes in reporting beneficial ownership information under the Corporate Transparency Act.