How to Defer Capital Gains Without a 1031 Exchange

When an investor sells a significant asset, such as real estate or a business, they are often faced with a tax on the profit, or capital gain, realized from the sale. Deferring this tax payment is a common financial objective, as it allows an investor to reinvest the full proceeds of the sale, thereby maximizing the capital available for their next venture.

For many, the term “1031 exchange” is synonymous with tax deferral, particularly within the real estate community. This specific section of the Internal Revenue Code allows an investor to swap one investment property for another of “like-kind” while deferring the capital gains tax. While effective, the 1031 exchange comes with a rigid set of rules and tight deadlines, such as the 45-day identification period and the 180-day closing window, that can be challenging to meet. The tax code provides several alternatives that offer more flexibility and can be applied to a wider range of assets beyond just real estate.

Investing in a Qualified Opportunity Fund

A strategy from the Tax Cuts and Jobs Act of 2017 is investing in a Qualified Opportunity Fund (QOF). This program was designed to stimulate economic development in distressed communities designated as Qualified Opportunity Zones (QOZs). A QOF is an investment vehicle that pools capital to invest in these designated low-income areas, offering investors tax benefits for deferring capital gains.

The process begins when a taxpayer generates a capital gain from the sale of any appreciated asset. To initiate the deferral, the taxpayer must reinvest the amount of the gain into a QOF. This reinvestment must occur within a 180-day window that begins on the date of the sale that generated the gain.

The main benefit is the temporary deferral of the original capital gain. The tax on the reinvested gain is postponed until the QOF investment is sold or December 31, 2026, whichever comes first. The gain will be recognized in the 2026 tax year, payable in 2027, unless the investment is disposed of sooner. If an investor holds their interest in the QOF for at least 10 years, any additional capital gains generated from the appreciation of the QOF investment itself can be permanently excluded from taxation.

Utilizing an Installment Sale

An installment sale offers a method to defer capital gains by spreading the tax liability over several years. This approach is defined by the Internal Revenue Service (IRS) as a sale of property where the seller receives at least one payment after the tax year in which the sale occurs. Instead of receiving a lump-sum payment, the seller finances the purchase for the buyer, who makes payments over a predetermined period according to a promissory note.

The principle of an installment sale is that the seller recognizes the gain, and pays tax on it, as payments are received. Each payment from the buyer is composed of three parts: interest, a return of the seller’s original investment (basis), and a portion of the capital gain. This prevents the entire gain from being taxed in a single year, which could push the seller into a higher tax bracket.

To determine the taxable portion of each payment, the seller must first calculate their gross profit percentage. This is found by dividing the gross profit from the sale by the total contract price. For example, if an asset with a basis of $400,000 is sold for $1,000,000, the gross profit is $600,000, and the gross profit percentage is 60%. If the seller receives a principal payment of $100,000 in a given year, $60,000 of that payment is reported as capital gain for that year.

This method is widely applicable to sales of real estate and private businesses. However, the installment method cannot be used for the sale of inventory or for assets that are publicly traded, such as stocks and securities. The rules also require that interest be charged on the note; if the stated interest is too low, the IRS may impute a higher interest rate, which would be taxable as ordinary income to the seller.

Establishing a Charitable Remainder Trust

For individuals with philanthropic goals, a Charitable Remainder Trust (CRT) is a strategy for deferring capital gains while supporting a cause they care about. A CRT is an irrevocable, tax-exempt trust designed to provide an income stream to one or more non-charitable beneficiaries for a specified term. At the end of this term, the remaining assets in the trust are distributed to a designated charity.

The process begins when the owner of a highly appreciated asset transfers that asset into the CRT, which is not a taxable event. The donor may be eligible for an immediate partial income tax deduction, based on the present value of the remainder interest that will eventually pass to the charity. The calculation of this deduction is complex, involving factors like the trust’s term, the payout rate, and IRS-prescribed interest rates.

Once the asset is inside the trust, the trustee can sell it at its full market value. Because the CRT is a tax-exempt entity, it does not pay any capital gains tax on the sale. This allows the entire proceeds from the sale to be reinvested by the trust, generating income and growth without immediate tax erosion.

The donor, or other designated beneficiaries, then receives payments from the trust for the specified period, which can be for life or a term of up to 20 years. These distributions are taxable to the beneficiary, and the deferred capital gain is recognized gradually over many years as they receive their payments. The tax character of the income is determined by a four-tier accounting system, where payments are treated in the following order:

• Ordinary income
• Capital gains
• Tax-exempt income
• A non-taxable return of principal

Using a Deferred Sales Trust

A Deferred Sales Trust (DST) is a legal strategy that uses the principles of an installment sale to defer capital gains on the disposition of an appreciated asset. It is a proprietary structure that involves the sale of an asset to a third-party trust, specifically created for the transaction. This method offers flexibility and can be applied to a wide variety of assets, including real estate and private company stock.

The transaction unfolds in a precise sequence. First, the asset owner sells their property directly to the DST, which is managed by an independent, third-party trustee. In return for the asset, the owner receives a formal installment note from the trust, which obligates the trust to make payments to the original owner over a pre-agreed term.

Immediately after acquiring the asset, the trustee of the DST sells it to the ultimate buyer for cash at the previously negotiated price. Since the DST is the entity that makes the final sale, the trust receives the cash proceeds. The DST does not owe immediate capital gains tax because its basis in the asset is the price it “paid” via the installment note, which is equal to the sale price.

The original asset owner has successfully deferred the recognition of their capital gain. The tax is not due until the owner begins to receive principal payments from the trust on the installment note. This structure allows the owner to control the timing of their tax liability. Due to its complexity, engaging with legal and financial professionals who specialize in this type of trust is a necessary step.