OZs, DSTs, and 1031s - Tax Exit Planning for Real Estate Investors
It is April, which means that in normal years (what does that mean now anyways?) your taxes are due! In 2020 and 2021, the normal due dates were administratively extended by the IRS allowing for more time to file taxes. What has always been odd to me is the fact that April is the time when everyone thinks about “tax planning”. The problem is that tax planning generally doesn’t happen in April. This month is typically dedicated to tax compliance, which is just a fancy way of saying that you are reporting all the tax planning (or lack thereof) you did in the past year. Too many times we think of tax planning as a reactive measure, when in actuality it is a proactive measure. So, even though tax planning really doesn’t happen in April it still can if you are selling stock, real estate, bitcoin, or really any type of asset.
Tax Planning, not just for April
There are many smaller tax planning decisions that can be made throughout the year, but in general, typical annual tax planning is looking very closely at minimizing income and maximizing deduction so as to not spike income in any particular year. Some of my favorite tax planning revolves around Roth IRA conversions in low income years, however, that will be a topic for another blog. A few times in many investors lives there will be big changes, with an opportunity to sell a property for a large profit, possibly the opportunity to sell their entire portfolio in one fell swoop, or just the chance to divest from active involvement in real estate into a more passive model. When these opportunities come, this is when tax planning has to be considered early and decisions should be made before the transactions take place.
What are Opportunity Zones and how do they work?
One of the most popular strategies today for deferring income tax is the Opportunity Zone(OZ) investment. As with many items in the tax code, this is a fairly complex structure, with many abbreviations financial professionals take for granted. First of all, one unique thing about OZs is that unlike a 1031 exchange, you are only required to defer the actual capital gain. This means you are able to keep the non-gain part of the sale for any other use you desire. In most cases, the gains are reinvested in an Opportunity Zone Fund. This is an entity that is established for the purpose of investing in Opportunity Zone Businesses, which can be operating companies or real estate. For some very proficient investors, it is possible to establish your own Opportunity Zone Fund, then directly acquire property from the fund. In most cases, investors opt to invest with a sponsor of a fund, which is not unlike any other pooled investment vehicle, only that they have a mandate to specifically target investment opportunities that are in Qualified Opportunity Zone areas, which ensures that the investment will qualify for this special tax treatment. With this reinvestment of the capital gain, no taxes are due in the tax year the investment occurred. However, for most investors, the capital gain will be due in the tax year 2026. Opportunity Zone investments are targeted to provide capital flows to areas that have been designated by local and state authorities. The Opportunity Zone investment requires significant capital investment into the zone in order to qualify for the special tax benefits.
Increased Cost Basis and Ongoing Compliance with OZs
Depending on when the investment into the Opportunity Zone was made the capital gain can qualify for a 10% or 15% increase in the basis, which in turn reduces the capital gains tax due in 2026. In addition to this, if the reinvested property inside the Opportunity Zone is held for 10 years, the gains on the property will be eligible for tax-free sale treatment. Of course, this is a potentially huge benefit if the reinvestment is made into a winning property. This strategy comes with some ongoing compliance and likely increased scrutiny on an ongoing basis from the IRS. The one huge benefit of Opportunity Zone investments is that this is a strategy that can be engaged in after the fact. A taxpayer has 180 following the sale transaction to move the capital into an Opportunity Fund. For this reason, if the tax estimate a taxpayer is receiving is more than they care to stomach, they can engage in a tax saving strategy after the fact. This is only true with OZs.
Ol’ Faithful, the 1031 Exchange
As mentioned in the OZ conversation, one of the most popular strategies for real estate investors to defer taxes on the sale of property is through a 1031 exchange. This particular strategy results in all of the capital being reinvested in an identified like-kind exchange. If any cash or “Boot” is held back, a portion of the transaction will be taxable. A 1031 requires some pre-planning and engaging with professionals to appropriately account for the sale proceeds as well as identify property according to tax rules. Following a property sale, the proceeds are held by a Qualified Intermediary, and the seller has 45 days to identify appropriate replacement properties. Following the identification of replacement properties, there is an additional 180 days for replacement properties to be acquired. If this is unsuccessful, there are a few ways to solve the problem, however, it takes quick action to salvage a “failing 1031 exchange”.
Deferred Sales Trusts, an Elegant Approach to Diversification
Speaking of “failing 1031 exchanges”, one of the best rescue plans for a 1031 plan gone south is utilizing a Deferred Sales Trust, or DST. A Deferred Sales Trust is a transaction structured for a seller to create their own installment sale. Many people are familiar with Installment Sales in the context of selling real estate or a business, it is essentially where the seller agrees to provide a loan to the buyer in the form of an installment sale. This comes with some tax advantages since not all of the capital gains are recognized at the consummation of the sale, and rather they get realized as the installment sale note is repaid. In a Deferred Sales Trust, the seller of real estate, concentrated stock position, or cryptocurrency sells their holding to a specially designed trust in exchange for an installment note. The trust then proceeds to sell the holding as directed by the seller. Since the trust just purchased the asset from the seller, there would not be any tax impact for this plan. The trust is then able to diversify the proceeds from the sale into a portfolio of stocks, bonds, and/or real estate to provide sufficient returns to service the installment note. The seller then receives income from the trust over a period of time they determine with the trust. This type of a trust can be a rescue plan in a 1031 transaction because it is possible to insert the DST into the equation, but it requires specific expertise by legal and tax advisors.
The “Other DST” that moves you from active real estate investing to passive ownership
The last type of tax planning strategy to think about as you are exiting real estate is a Delaware Statutory Trust (Del Trusts), which isn’t to be confused with a Deferred Sales Trust (DST). A Del Trust is a 1031 exchange compliant vehicle which allows individuals to sell their private real estate holdings and exchange into much larger properties with a passive ownership structure. Many times the investment opportunities are for Triple Net Lease (NNN) properties, Stabilized Multifamily, or Mixed-Use properties. This allows a seller of an investment property to continue deferring taxes on their ownership and receive income from their new investment. If the goal is to defer taxes until death to receive a step-up in basis, this is a popular structure to allow a real estate investor to retire from being actively involved in ownership and management and to transition to the very desirable “mailbox money”! There are many sponsors and providers of Del Trusts, and their long-term performance is heavily dependent upon the ability of the operators to execute on their long-term investment strategy.
Plan Early and Plan Often
For those looking to do Tax Planning, 3 of the 4 tax mitigation strategies discussed here require advanced planning work. In order to optimize your tax outcome, it is best to make a plan in order to determine the path you desire to take. Sometimes the actual result ends up being different than originally planned, however, it is best to go into the sale of assets with many exit strategies. Tax planning can be incredibly powerful when done correctly, this is why there are armies of attorneys and CPAs that dedicate their careers to optimizing tax and estate planning outcomes. Fortunately for the average investor, it isn’t as hard as you might think to optimize your tax situation, and it doesn’t have to cost thousands of dollars, it only takes hiring a financial planner that understands relevant tax mitigation strategies and can apply them directly to your situation. If this is something you need, don’t hesitate to reach out to us here at RE|Focus Financial Planning.
About Daniel:
Daniel is a real estate investor, small business owner, AirBnB operator and trusted financial planner. I started RE|Focus Financial Planning, a boutique planning firm focused on working with real estate investors and retirees. As a CERTIFIED FINANCIAL PLANNER™ professional, I help successful individuals and families gain clarity on their current situation and future goals. If that sounds like you, let’s have an introductory conversation to learn more.
