If you recently sold commercial property or a rental property—or if you are planning to sell in the near future—you will want to minimize your capital gains taxes. There are a couple ways to avoid paying these taxes immediately:
Both of these methods can be effective solutions to help you defer your capital gains taxes on any profits made from real estate sales.
A Section 1031 exchange allows you to sell your property and invest all the proceeds in another like-kind replacement property of equal or greater value. You are essentially “exchanging” your gains for another investment and therefore capital gains taxes can be avoided on the sale.
A qualified opportunity zone fund doesn’t require you to purchase another property. Instead, the gains from your sale are invested into a qualified corporation, partnership or LLC that pools money from investors like you. These funds are invested back into property located in areas that the government has designated as “qualified opportunity zones.” Most of these funds are invested in real estate for areas where they are looking to spur economic growth or recovery.
When deciding between a 1031 exchange vs. qualified opportunity fund, it may depend on your financial goals and personal priorities. The right answer will be different for every investor.
If your goal is to hold onto the replacement property until you die (in order for it to be transferred to your heirs), a Section 1031 exchange is generally preferable. Your heirs will ultimately receive the property at a stepped-up basis relative to its current market value. They will be able to sell the property immediately, likely free of capital gains taxes because it was acquired and sold at current market value.
If you sell our 1031 replacement property before death, you will pay the capital gains tax based on the difference between the original property’s basis and the replacement property’s sale amount. This can really add up, which why this option makes the most sense if you plan to pass the property onto your heirs.
A qualified opportunity fund only provides tax deferral for up to four years. If you sell your property in 2022, your investment in this fund will require you pay your deferred capital gains tax as part of your 2026 tax return. However, you will not pay any tax on the fund’s appreciation if you hold it for at least 10 years. Your long-term financial gains may offset your tax liabilities on the original property sale.
A qualified opportunity fund offers more liquidity and can reduce the headaches and responsibilities that come with ownership of commercial or rental property (property taxes, upkeep, etc.). You will only need to invest your capital gains from the first sale into the fun. Compare this to a 1031 exchange, which requires you to re-invest the entire proceeds of the sale into the replacement property.
Both of these options can be viable for investment and commercial property owners who wish to defer their capital gains taxes on sales. There are other solutions to consider, as well, which is why it pays to work with an experienced financial advisor who can guide you through your options and develop a sound financial plan.
To talk with one of our knowledgeable financial specialists at Illumination Wealth, contact us today and schedule an introductory consultation.