How can I avoid capital gains tax without a 1031 exchange?

How can I avoid capital gains tax without a 1031 exchange?

Understanding capital gains taxes from a property sale and the legal strategies you can pursue to manage tax liabilities from selling an asset can help you preserve the wealth you’ve built in your property. Although you may have heard of using a 1031 exchange to defer capital gains tax from real estate sales, do you have other options for avoiding capital gains tax without a 1031 exchange?

In this story, 453 Trust Powered by Pennington Law highlights alternatives to 1031 exchanges for managing the tax implications of a property sale, including deferred sales trusts.

What Is a 1031 Exchange?

A 1031 exchange allows a property owner to defer paying capital gains taxes after selling a piece of real estate that has appreciated during ownership. When real estate gains in value during ownership, the owner must pay capital gains tax (usually 15% or 20%) on the amount of appreciation — the difference between the property’s value when the owner acquired it and the value when the owner sold it. With a 1031 exchange, a property owner can defer paying capital gains taxes when they reinvest the sale proceeds through an intermediary facilitator in other qualifying real estate within a specific timeframe after the sale.

What Are the Benefits of a 1031 Exchange?

A 1031 exchange can offer a property owner various benefits to assist with financial and legal planning when selling their property. The top 1031 exchange benefits include the following:

• Deferring capital gains taxes – A 1031 exchange allows a property owner to defer capital gains tax when they sell a piece of real estate by reinvesting the sale proceeds into a new property.
• Enabling reinvestment into a property with greater growth potential – 1031 exchanges allow property owners to reinvest their gains from one real estate investment that has reached its full growth potential into another property with future growth potential.
• Passing assets to heirs – Using a 1031 exchange to reinvest money in real estate, a person’s beneficiaries may avoid capital gains taxes once they inherit the person’s real estate holdings, since they inherit the property on a “stepped up” basis at the current market value.

What Are the Limitations of a 1031 Exchange?

Although a 1031 exchange can offer numerous financial benefits, it may also have various drawbacks and limitations that make it unsuitable, depending on a property owner’s financial needs and goals.

Some of the major limitations of a 1031 exchange include the following:

• Limitations on reinvestment – 1031 exchanges only allow property sellers to reinvest their sale proceeds into other real estate. For example, a seller may not reinvest the money into a business or stocks.
• Deadlines for reinvestment – A 1031 exchange requires a seller to find and reinvest the sale proceeds into a qualifying property within a specific timeframe after the property sale. Otherwise, the seller loses the right to defer capital gains tax from the sale.
• “Like-kind” requirement – 1031 exchanges require property sellers to reinvest their sale proceeds into a “like-kind” property — another parcel of real estate of equal or greater value than the sold property.
• Need for facilitator – A 1031 exchange requires a property owner to close on the sale with the participation of a facilitator to qualify for capital gains tax deferral, who “facilitates” the reinvestment of the sale proceeds into a new property. Not utilizing the services of a facilitator may mean the seller has constructive receipt of the sale proceeds and thus becomes liable for the capital gains tax.

What Are the Differences Between a 1031 Exchange and a Deferred Sales Trust?

Structuring a property sale through a deferred sales trust can provide an alternative to a 1031 exchange for managing capital gains taxes from the sale. Deferred sales trusts can offer tax benefits by leveraging the tax treatment afforded to an installment sale under Internal Revenue Code §453.

With a deferred sales trust, a property owner must establish a trust managed by a bona fide third-party trustee. The owner transfers their property to the trust in exchange for an installment payment contract, which governs how the trust must pay the principal and income from the property sale proceeds to the owner.

The trust then sells the property to a bona fide purchaser and takes legal and equitable title to the sale proceeds. The trust can either distribute principal from the sale proceeds as required by the installment payment contract or invest the proceeds and pay the owner’s income generated from the investments. The owner pays capital gains tax on the sale proceeds only when the trust distributes the principal to the owner.

Some of the differences between a deferred sales trust versus a 1031 exchange include the following:

• Eligible assets – A deferred sales trust may allow a person to manage capital gains taxes from the sale of many kinds of appreciating assets, such as businesses, investments. Conversely, a person may use a 1031 exchange to defer capital gains tax only for real estate sales.
• Reinvestment opportunity – Deferred sales trusts have substantial flexibility for reinvesting proceeds from an asset sale. However, a 1031 exchange requires a property seller to reinvest the sale proceeds into a “like-kind” property — another piece of real estate of equal or greater value.
• Control over wealth – A 1031 exchange allows a property owner to retain control over their wealth, as they can determine how to reinvest the sale proceeds. Conversely, a deferred sales trust requires a property owner to place their wealth under the control of a bona fide third-party trustee, who will manage the owner’s property and the sale proceeds as directed by the trust document.
• Timing of disposition of sale proceeds – 1031 exchanges require property owners to reinvest their proceeds within a specific timeframe after the property sale to take advantage of the benefit of deferring capital gains tax. Conversely, deferred sales trusts allow for the deferral of capital gains tax as long as the principal from the sale proceeds remains in the trust.

How to go about finding an alternative to a 1031

When you need an alternative to a 1031 exchange for managing capital gains taxes from a property sale, follow these steps.

Review Your Financial Circumstances, Needs, and Goals

Examine your financial situation to identify the appropriate legal solution for your needs and goals, such as a 1031 exchange or a deferred sales trust.

Properly Establish a DST to Reap Its Full Benefits and Avoid Errors

When you choose a deferred sales trust as an alternative to a 1031 exchange, make sure your trust meets the necessary criteria so you do not lose the critical tax benefits of a DST, including the ability to defer capital gains taxes. Take steps to avoid errors that may result in an unexpected substantial capital gains tax bill or penalties, fees, and interest on unpaid capital gains taxes.

Structure Your Deferred Sales Trust to Meet Your Needs and Goals

When you wish to manage the capital gains tax hit from a property sale, you can structure a DST to pay the sale proceeds over time, allowing you to spread the capital gains tax liability over multiple years. Alternatively, suppose you intend to sell your property to create a retirement or family wealth fund. In that case, you may consider structuring your DST to reinvest the sale proceeds so you and your family can benefit from the income generated from such investments.

This story was produced by 453 Trust Powered by Pennington Law and reviewed and distributed by Stacker.