1031 Exchange Alternatives to Defer Capital Gains

A Section 1031 exchange is a strategy in real estate that allows investors to defer paying capital gains taxes when they sell an investment property, provided they reinvest the proceeds into a “like-kind” property. This method is governed by strict rules and timelines, which can be challenging to meet. An investor has only 45 days to identify a potential replacement property and 180 days to close on the purchase after selling their original asset.

Investors often look for alternatives to a 1031 exchange for various reasons. They might be seeking to diversify their holdings, transition from the active role of a landlord to a more passive investment, or pursue different estate planning objectives. The inability to find a suitable replacement property within the mandated timeframe also prompts the search for other tax-deferral strategies.

Investing in Delaware Statutory Trusts

A Delaware Statutory Trust (DST) is a legal entity that holds ownership of one or more income-generating properties. For investors looking to complete a 1031 exchange, purchasing an interest in a DST is considered an acquisition of “like-kind” property, a position affirmed by the IRS in Revenue Ruling 2004-86. This makes it a valid method for deferring capital gains without the need to find and purchase a property directly.

The process involves an investor using the proceeds from their property sale to buy a fractional interest in a portfolio of properties owned by the trust. This completes their 1031 exchange and shifts their role to a passive investor. The day-to-day operations, including tenant relations and maintenance, are handled by a professional sponsor firm that manages the DST.

Investors in a DST receive regular income distributions from the rental revenue generated by the properties in the trust’s portfolio. Minimum investment amounts are often lower than purchasing a whole property, which can allow for diversification across multiple DSTs. The DST structure is governed by specific rules, for example, once the trust is established and fully funded, the trustee cannot acquire new properties or renegotiate existing leases.

Utilizing Qualified Opportunity Zone Funds

Investing in a Qualified Opportunity Zone (QOZ) Fund is a different approach to tax deferral. This program, established by the Tax Cuts and Jobs Act of 2017, was designed to stimulate economic development in designated communities. An investor can defer capital gains from the sale of any asset, not just real estate, by reinvesting those gains into a QOZ Fund within 180 days of the sale.

The QOZ program offers a deferral of the original capital gain. The tax on this gain is postponed until the investment in the QOZ Fund is sold or until December 31, 2026, whichever comes first. This provides immediate tax relief and allows the full amount of the gain to be put to work in a new investment.

A significant benefit is for investors who hold their QOZ Fund investment for at least 10 years. If the QOZ investment is held for this minimum period, any appreciation on the fund investment itself can be permanently tax-free. This means the investor would not owe any capital gains tax on the profits generated by the QOZ Fund when it is eventually sold.

Structuring an Installment Sale

An installment sale is a disposition of property where the seller receives at least one payment after the tax year in which the sale occurs. This method, governed by Section 453 of the Internal Revenue Code, allows a seller to defer the recognition of capital gains. Instead of paying tax on the entire gain in the year of the sale, the gain is recognized proportionally as payments are received from the buyer over the agreed-upon term.

To illustrate, consider a property with a $100,000 gain sold for $200,000, resulting in a 50% gross profit percentage. If the seller agrees to an installment plan of four equal annual payments of $50,000, the gain is spread out. Each year, the seller would recognize $25,000 of gain (50% of the $50,000 payment received), deferring the tax liability over the four-year period.

This strategy does not eliminate the capital gains tax but spreads it over time, which can be advantageous for managing annual income and tax brackets. Any depreciation recapture from the property sold must be recognized as ordinary income in the year of the sale and cannot be deferred. For large installment sales where the total of all such obligations exceeds $5 million, an interest charge may be imposed by the IRS on the deferred tax liability.

A more complex variation is the Monetized Installment Sale. In this structure, the seller enters into an installment agreement with an intermediary, who then sells the property to the final buyer. A separate lender then provides a loan to the seller, with the installment note serving as collateral, allowing the seller to receive a significant portion of the sale proceeds upfront as non-taxed loan proceeds.

Exploring Trust-Based Deferral Options

Investors with philanthropic intentions might consider a Charitable Remainder Trust (CRT) as a way to defer capital gains. In this arrangement, an investor donates a highly appreciated asset, such as real estate, to an irrevocable trust. The donor may receive an immediate partial tax deduction for the charitable contribution.

The CRT, as a tax-exempt entity, can then sell the property without incurring any capital gains tax. The proceeds from the sale are invested by the trust, which then pays an income stream to the donor or other designated beneficiaries for a specified term or for their lifetimes. At the end of the trust’s term, the remaining assets are distributed to a pre-selected charity.

Deferred Sales Trust

A different trust-based strategy is the Deferred Sales Trust (DST), which should not be confused with a Delaware Statutory Trust. A DST is a specific application of the installment sale method. The property owner sells the asset to a specially created third-party trust in exchange for a formal installment note, which details the payment terms.

The trust then sells the property to the ultimate buyer for cash. The trust holds these cash proceeds and can invest them in a diversified portfolio of assets, not just real estate. The original seller only recognizes and pays capital gains tax as they receive payments from the trust according to the installment note’s schedule.

Contributing Property to an UPREIT

An Umbrella Partnership Real Estate Investment Trust (UPREIT) offers another path for tax deferral, often referred to as a 721 Exchange. This name comes from Section 721 of the Internal Revenue Code, which governs the tax-free contribution of property to a partnership in exchange for a partnership interest. In this structure, a property owner contributes their real estate directly to a REIT’s operating partnership (OP) rather than selling it for cash.

In return for the property, the investor receives OP units, which represent an ownership interest in the operating partnership. This transaction is tax-deferred, meaning no capital gains tax is due at the time of the contribution. The investor transitions from owning a single property to holding a stake in a large, diversified portfolio of properties managed by the REIT.

The OP units provide the investor with income distributions that are equivalent to the dividends paid to the REIT’s public shareholders. A taxable event is not triggered until the investor decides to sell the OP units or convert them into publicly traded shares of the REIT. This provides both long-term tax deferral and a potential path to liquidity.

For many individual investors, accessing an UPREIT transaction involves a two-step process. First, they might use a 1031 exchange to invest in a Delaware Statutory Trust (DST). Later, when the DST sells its underlying property, the entire DST portfolio may be acquired by a REIT in a 721 exchange, giving the DST investors the option to receive OP units instead of cash.