What Is a Deferred Gain on Sale and How Does It Work?
Understand the concept of a deferred gain, a tax strategy that allows you to postpone tax on profits from a sale by meeting specific IRS requirements.
When an asset is sold for a profit, the gain is subject to tax in the year of the sale. A deferred gain allows the seller to postpone paying taxes on that profit, shifting the obligation to a later tax period. The ability to defer a gain is not automatic and is only permitted under specific circumstances outlined in the tax code.
It is important to distinguish deferral from exclusion. Deferral pushes the tax payment to a future year, while an exclusion permanently removes the gain from taxable income. The strategies for deferring a gain are varied, and each method has unique requirements for qualification and reporting.
The Installment Sale Method
An installment sale is a disposition of property where at least one payment is received after the tax year of the sale. This method allows a seller to spread the recognition of a gain over the years payments are received, reporting a portion of the gain with each payment. This aligns the tax liability with the cash flow from the sale.
The gross profit percentage determines how much of each principal payment is a taxable gain. To calculate this, divide the gross profit (selling price minus adjusted basis and selling expenses) by the contract price, which is the total amount the seller will receive.
For example, imagine selling a property with a $300,000 gross profit and a $500,000 contract price. The gross profit percentage would be 60% ($300,000 / $500,000). If the buyer makes a principal payment of $50,000 in a given year, the seller would recognize $30,000 of that payment as a taxable gain.
This method cannot be used for sales of inventory or for stocks and securities traded on an established market. Any gain from depreciation recapture must be reported as ordinary income in the year of the sale, regardless of when payments are received.
To use this method, a seller files IRS Form 6252, Installment Sale Income. The form is used to calculate the gross profit percentage and must be attached to the tax return for every year a payment is received from the agreement.
Like-Kind Exchanges for Real Property
A like-kind exchange, governed by Section 1031 of the Internal Revenue Code, allows for the deferral of gain on the sale of real property held for business or investment. In this transaction, the “relinquished property” is swapped for a new “replacement property.” Since the Tax Cuts and Jobs Act of 2017, this treatment is exclusively available for real property and no longer applies to personal property like equipment or vehicles.
The term “like-kind” is interpreted broadly for real estate; an office building can be exchanged for raw land. Both the property sold and the property acquired must be held for productive use in a trade or business or for investment. Property held for personal use, such as a primary residence, does not qualify.
Two strict deadlines must be met for the exchange to be valid. The taxpayer has 45 days from the date of selling the relinquished property to identify potential replacement properties in writing. Following this, the taxpayer has a total of 180 days from the original sale date to complete the acquisition of one or more of the identified replacement properties.
To ensure the taxpayer does not have receipt of the sale proceeds, the transaction must be handled by a Qualified Intermediary (QI). The QI is an independent third party who holds the funds from the sale and uses them to purchase the replacement property. This prevents the taxpayer from accessing the cash, which would disqualify the exchange and make the gain taxable.
The transaction is reported to the IRS on Form 8824, Like-Kind Exchanges. This form is filed with the tax return for the year the relinquished property was sold and is used to detail the exchange and calculate the basis of the new property.
Deferral from Involuntary Conversions
An involuntary conversion occurs when property is disposed of due to circumstances beyond the owner’s control. These events include destruction, such as from a fire or natural disaster; theft; seizure; or condemnation by a government entity. If the owner receives compensation, such as an insurance payout, that is greater than the property’s adjusted basis, a gain is realized.
Tax law allows for the deferral of this gain if the proceeds are used to acquire a qualified replacement property within a specified timeframe, as provided in Section 1033 of the Internal Revenue Code. The deferral is not automatic, as the taxpayer must elect to apply these rules.
The replacement property must be “similar or related in service or use” to the converted property. This standard is stricter than the “like-kind” rule for Section 1031 exchanges. For example, if a warehouse used for business is destroyed, replacing it with an apartment complex might not qualify. However, a more lenient “like-kind” standard applies to the condemnation of business or investment real property.
The taxpayer has two years from the end of the tax year in which the gain was realized to purchase the replacement property. This period is extended to three years for condemned real property held for business or investment. Failure to acquire a qualifying property within this window makes the gain taxable in the year it was realized.
To elect deferral, the taxpayer omits the gain from income on the tax return for the year the proceeds are received. A statement must be attached to the return detailing the conversion and the intent to replace the property. Details of the replacement property are then reported on the tax return for the year of its acquisition.
Reinvesting Gains in Qualified Opportunity Funds
Investing in a Qualified Opportunity Fund (QOF) is a strategy for deferring capital gains. A QOF is an investment vehicle, such as a partnership or corporation, that invests in economically distressed communities known as Qualified Opportunity Zones (QOZs). By reinvesting eligible capital gains into a QOF, taxpayers can postpone the associated tax.
A taxpayer must invest an eligible capital gain into a QOF within 180 days from the date of the sale that generated it. This deferral applies to gains from the sale of most property types, including stocks, bonds, and real estate.
The tax on the reinvested gain is deferred until the QOF investment is sold or December 31, 2026, whichever comes first. The amount of gain to be recognized is the lesser of the deferred gain or the fair market value of the QOF investment minus its basis.
The program offers an additional benefit for long-term investors. If the QOF investment is held for at least ten years, the taxpayer can elect to increase its basis to the fair market value on the date it is sold. This “step-up” in basis can eliminate tax on the appreciation of the QOF investment.
The deferral election is made on the tax return for the year the gain was realized. The taxpayer files Form 8949, Sales and Other Dispositions of Capital Assets, to report the sale and election. Form 8997, Initial and Annual Statement of Qualified Opportunity Fund Investments, must also be filed to report and track the investment.
Rollover of Qualified Small Business Stock Gain
A deferral provision under Section 1045 of the Internal Revenue Code allows a shareholder to roll over the capital gain from selling Qualified Small Business Stock (QSBS). This rule allows for the deferral of tax by encouraging reinvestment in other small businesses.
To qualify, the shareholder must have held the original QSBS for more than six months. The proceeds from the sale must then be used to purchase replacement QSBS within 60 days of the original sale date.
The basis of the replacement QSBS is reduced by the amount of the deferred gain. For instance, if a shareholder has a $100,000 gain and reinvests the proceeds into $250,000 of new QSBS, the basis in the new stock is $150,000 ($250,000 cost minus the $100,000 deferred gain). This adjustment ensures the gain is taxed when the replacement stock is sold.
The rollover is reported on Schedule D, Capital Gains and Losses, for the year of the sale. To make the election, the taxpayer reports the sale and enters the deferred amount as a negative number on the line below it. The description for this entry must state “Section 1045 Rollover” to inform the IRS of the election.