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Deferral of Gains on Real Estate Investments

By Paul J. Carroll, CFP®March 21, 2023October 19th, 2023Videos


I’ve previously talked about investment real estate as an investment asset class. Of course, the challenge already identified is that when you sell investment real estate, you now must recapture depreciation and you’ll be also taxed on capital gains. Are there strategies to defer gains or maybe even eliminate them on the sale of your property?

The short answer is yes. There are three primary strategies available. One is the 1031 exchange, the second is a qualified opportunity zone, and the third is the installment sale.
Now, in the last video we talked about the simplest one – your personal residence. If you own a personal residence for more than a certain amount of time and lived in it two out of five years, the sale of that property, if you’re an individual, you can roll over $250,000 of capital gain, if you’re married, $500,000 of capital gain into your next property.

I’m going to talk about installment sales first. As an investor, installment sales is not an indefinite deferral of capital gains. It’s a strategy where, as you receive payments for your property, pro rota portion out payment is a capital gain. And so you’re staggering the realization of gain over the period of the installment sale.

For those investors who carry their own note, who are also investing in the mortgage essentially, installment sales can be very useful.

1031 exchange allows for the sale and reinvestment of gains without paying capital gains tax on that sale. Those gains are rolled into the next property. How does it work? Well, you sell the property, and you’re supposed to ID a replacement property within 45 days. So you’ve got a warehouse, you sell it, you’ve got million dollars in gains you don’t want to pay tax on. You find another property, and there are constraints and rules as to the identification of that property within 45 days. You now have 180 days from the time of sale to purchase that property, to close and make the payment.

In essence, the IRS treats it as the same property, but just different. What I mean by that is all the gains and all the depreciation rolls into the new property. You’ve deferred those gains. It’s a great strategy. You may have a reason to get a bigger property or there might be a reason you need to sell the old property. Maybe your neighborhood’s going down.

The pros of the strategy, of course, a tax deferral, continued real estate diversification through holdings and flexibility. You save taxes, you get to keep the cash. You can invest more money for future growth. However, there are cons and the first and foremost is, it’s complex with very strict rules. You’ve got a limited timeframe to act. You’ve got limited options.

Deferring taxes usually is a good thing, but not always. If you’re in a lower tax bracket now than you think you will be down the road, maybe you should just pay the taxes, unless you’re going to use the ultimate tax strategy and that is deferring gains until you die. And assuming you are below the estate tax exemption, well, you got to step up in basis and you never pay the tax. Invest, borrow and die is a fairly well-known strategy used by the ultra-rich to avoid paying taxes, the only catch being, of course, you do have to actually die. Fortunately, none of us get out alive in the end.

There are firms that help with this 1031 exchange process and we’ve partnered with one or two. They do a wonderful job at making it easy. They still don’t take over the responsibility for the identification, financing, and closing of the new property, but they make it work and they keep you within the confines of the law.

But I always warn people – don’t let the tax tail wag the dog. Sometimes the net benefit of tax deferral isn’t that great. The tax bill may not even be that. It may be a $15,000 bill. Okay, that’s nice. We’ve rolled over 15 into a new property. We may not want to do that. Maybe we didn’t want the constraint. Maybe there are other reasons including and not limited to this is a low tax bracket year and we’re just not going to pay much tax on it. Why defer to another year when you may pay 15, 20, 50, a hundred percent more tax on the same game? So be careful not to let the tax tail wag the dog.

In the next video, we’re going to talk about workarounds to further improve in the 1031 exchange. Sometimes you can’t find a great alternative property, but there’s a way to deal with that. If you need more information and would like to talk about this in greater detail, please feel free to call or email me.

We wish you the best of real estate investing success.

Correction: In the video I inadvertently included personal residences in the rollover of capital gains.  It is more correctly described as an exclusion assuming ownership and usage tests are met (re. Tax Cuts and Jobs Act of 2017 – IRS).


Founder & CEO at Avion Wealth

Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.