Asset Disposition and Tax Mitigation
Your Best Investment Is in Comprehensive Financial Planning
By Joe Fraser
For real estate investors, disposition of an asset is an opportunity to re-invest capital into the next project, but not without first paying taxes on your gains – with a few exceptions. Your capital gain from a recent or upcoming disposition is a good problem to have. Fortunately, there are several means of deferring and/or reducing your tax liability through strategic real estate investing, while certain legislation remains in effect. We will cover three strategies: 1031 exchanges, qualified opportunity zones, and conservation easements.
1031 Exchanges and Delaware Statutory Trusts
Most real estate investors are familiar with a 1031 exchange, which can be used to defer capital gains tax generated from a sale, so long as a) the relinquished property was held for at least 12 months and a day, b) the properties in the exchange are for investment purposes, c) the exchange agreement is put in place before close of escrow of the relinquished property, d) the replacement property is identified within 45 days and closed within 180 days, and e) the replacement property is of equal or greater value to the relinquished property, with a similar debt to equity ratio.
Fewer investors are familiar with a Delaware Statutory Trust (DST) which can qualify for a 1031 exchange. A DST can hold a single real estate asset or multiple assets. DSTs are common within multi-family, commercial triple net lease (NNN), public storage, hotels, and other asset classes. Investors can purchase shares of the DST and earn passive income in professionally managed real estate assets, without having to be the active landlord. When the DST sells in 5-7 years to an institutional buyer, you can roll your gains into the next exchange, continually deferring your taxes from one exchange to the next.
Qualified Opportunity Zones
Another way to defer tax on capital gains is by investing into a Qualified Opportunity Zone (QOZ). The hold period is longer, a minimum of 10 years, but there is greater upside potential. Where DSTs generally have modest appreciation and proceeds that are subject to tax at the time of sale, QOZ projects which are developed from the ground up are often modeled with a return of capital within the first five years which can be used to cover the deferred taxes when they become due, and 100% tax-free gains distributed at the time of sale (no sooner than 10 years) that provide for a total return ranging from 3-5x of initial capital, depending on the project.
Think about that: 100% tax-free gains. That’s the major benefit of investing in a QOZ over utilizing a 1031 exchange. QOZs can also accept capital gains from any sale, not just from sales of investment property as in the case of a 1031 exchange. If you’re selling your company or liquidating stock, a QOZ might be the right place to reinvest your capital gains. Federal legislation incentivizing development in these qualified opportunity zones can be used to your advantage to defer your capital gains tax as well as earn you long-term tax-free gains on the QOZ investment.
Conservation Easements
Other legislative incentives, such as for the conservation of privately held land, can be used to reduce your taxable income as well. Real estate in prime locations for development are valued based on the highest and best use of that property if it were to be developed, for example into a resort or a golf course community. If the owner of the property were instead to make a charitable donation by placing a conservation easement on the property, the owner receives an above-the-line tax deduction based on the value of the property at its highest and best use. A property with an initial purchase price of $1M and a highest-and-best use valuation of $5M, for example, could provide for a 5:1 tax deduction to the underlying investors in the property. In this example, investors who each put $100,000 into the initial property, can each utilize a $500,000 deduction off their taxable income after the easement has been placed on the property.
There is a lot of scrutiny from the IRS with respect to the valuation methods used by investors claiming significant deductions (sometimes up to 15x the original investment) for donations to conservation easements. Inexperienced investors and bad actors have caused there to be a lot of negative attention around the use of this deduction, and rightfully so. These are sophisticated tax strategies and not advised for everyone. It is important to work with reputable companies with a long-standing track record of success when deploying these strategies in your tax planning and investment portfolio.
Alternative investments like the ones discussed above represent a growing position in individual as well as institutional investor portfolios, as public markets continue to underperform relative to private investments with a similar risk profile. It’s not only about how much you make, but how much you keep. Accredited investors seeking diversification into alternatives should also focus on capital preservation through tax-efficient investments.
As you plan for your upcoming asset disposition, consult with you CPA or tax advisor about their experience with these strategies. Seek input from professionals who have researched the court rulings and who have successfully implemented these tax strategies on behalf of their clients.
The best investment you will ever make is in your comprehensive financial planning.
For informational purposes only. Not an offer to sell, or a solicitation of an offer to buy securities. Investing involves risk. Past performance is not indicative of future results. Speak to your financial and/or tax professional prior to investing. Securities offered through registered representatives of Benchmark Investments, LLC, Member FINRA/SIPC. Only available in states where registered representative is registered. JSP Capital Partners LLC and Benchmark Investments, LLC are separate entities.
