Tax Planning
Capital gains tax deferral on investment property sales
One of the benefits of purchasing property as an investment is the tax benefits that can come with it – both while you own it and after you sell. Applying tax-efficient strategies will help you make the most out of your investment property.
Most such strategies require planning and preparations to be put in place, so you’ll want to do your due diligence and consult with your advisor and other professionals before you assume these strategies apply to your situation.
How to defer capital gains taxes
There are three strategies to consider if you’re seeking ways to defer capital gains taxes upon the purchase or sale of your investment property.
Qualified opportunity zones (QOZ): QOZs are economically distressed communities where new investments, under certain conditions, may be eligible for preferential tax treatment. They're designed to spawn economic development by providing incentives to individual investors or businesses putting capital into the locality. There are more than 8,700 QOZs to invest in across the United States. To get the tax deferral, you must invest through a Qualified Opportunity Fund. Once the property is sold, the seller has 180 days to invest the gains in the fund, and the investment must not be in exchange for debt interest, only equity interest.
1031 like-kind exchange: A 1031 (as they’re commonly called) is a strategy to defer taxes by reinvesting the capital in a “like-kind” property. Proceeds from the sale of a property are held in escrow by a third-party intermediary and used to buy a new property. There are several qualifications that must be met for this exchange. First, the new property must be within the United States and be of similar nature and character to the old property. It must also have a value that is equal to or greater than the old property for maximum benefit and to avoid capital gains taxes completely. The new property must be identified in writing to the intermediary within 45 days of the original property’s sale and you must close on the new property within 180 days of the sale of the original property. These exchanges must be performed without error to avoid owing taxes, so consult your financial advisor and tax professionals.
Installment sales: Another way to help maximize tax efficiency on the sale of an investment property is a payment agreement with the buyer where the buyer makes payments in installments with interest over time. This breaks up the income earned and defers taxes until later years. Installment sales start with partial payment the year following the actual sale. Typically you can get a higher selling price than you would with an all-cash sale and you’ll be collecting interest. Of course, there are some risks for extending payments over time, like risk of default on the arrangement, capital being tied up for a period of time and market and interest rate fluctuations, which could lead to lost income. But the tax benefits may outweigh these risks.
Other investment property tax strategies
There are other opportunities to make your investment property purchase or sale tax efficient. A simple strategy with less formality is to sell your property during lower income years. This will allow you to be taxed in a lower tax bracket than usual, saving on capital gains taxes.
If charitable giving is in your heart and part of your financial strategy, you could contribute to a donor advised fund (DAF). You can make a contribution and enjoy the tax break immediately but decide which nonprofits to donate to later on.
There's also an opportunity to qualify for a low-income housing tax credit (LIHTC) by developing housing targeted at lower income tenants. LIHTC gives investors a dollar-for-dollar reduction in their federal tax liability for providing financing to develop affordable housing for low-income individuals.
One of the benefits of owning investment property is flexibility when it comes to taxes. With a bit of preparation and knowledge, you can decrease your tax burden and maximize your investment. It’s wise to speak with your advisor and other professionals to determine which tax strategies make the most sense for your situation.
Sources: opportunityzones.hud.gov; irs.gov; investopedia.com; seracapital.com; forbes.com; novoco.com
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation.
Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
Donors are urged to consult their attorneys, accountants or tax advisors with respect to questions relating to the deductibility of various types of contributions to a Donor-Advised Fund for federal and state tax purposes.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of Raymond James, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
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