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How To Use Real Estate Opportunity Zone Investments For Tax Deferral

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Deferred tax isn’t what it used to be!  The years and years of low-interest rates changed many minds about deferred taxes.  Mind you, deferring large once in a lifetime capital gains tax, will still get the blood flowing.

Opportunity Zones Are All The Rage

According Forbes.com. At the moment, Opportunity Zones are all the rage. If you invest in an opportunity zone, you are allowed to defer the capital gain.  On the one hand, there are some distinct advantages of doing it this way. You have to invest the gain, but you are free to do with the proceeds as you wish. Also, by holding on to the gain long enough, you can reduce the amount realized.

However, none of these opportunity zone funds have track records, and they are attracting very substantial amounts of money. Paying your taxes instead of going this route might be the wiser option.

Three Techniques We Like

Pure Deferral

If you sell an upmarket residence, some commercial real estate or a business and you are in for some substantial capital gains, there are some new techniques available to keep you in financial assets or that will make it possible for you to do with the proceeds whatever you want.

If we assume that you have a large cash offer for your property, and that is not interested in the property remaining in your name, and assuming that ordinary income recapture is negligible, your default option, option A is to collect a percentage of the sales price of the property in cash. The amount of money will be decided by:

  • Your adjusted basis
  • Unrecaptured Section 1250 depreciation
  • Applicability of NII
  • State Income Taxes

For the sake of argument, say the cash is 80% of a $5 million deal. That leaves you with $4 million to use however you please.

KEEP IN MIND

Stretching the capital gain over a few years can lead to lower taxes for you. For valid projections, it is advisable to consult a tax professional. Keep state income tax, thresholds, phase-out’s and net investment income tax in mind when you make your projections.

 

real estate tax

Tax Planning for U.S. Real Estate Investors

Deferred Sales Trust (DST)

Much hype surrounds the so-called DTSs.  If you stand back from the secretive sales pitches and the non-disclosure agreements that surround the DSTs it boils down to this — you sell your asset to a special purpose entity that sells it to your buyer. What you get from the entity, is an installment notice based on your risk tolerance.

Put differently; you get an obligation secured by a portfolio that is managed to provide you with a return, let’s assume, of 5%.  Renegotiations are possible within reason; i.e., the term of the note can be extended.

The opposing party gets to manage assets.  Your net returns are turned over to your asset manager, for which you pay 1% or less.  In this scenario, a DST is a terrific deal. The money that you would have spent on capital gains tax is now also working for you.

NDAs shroud the intricacies of the DST[1], but looking at it from the outside DSTs would probably survive IRS scrutiny.

Structured Installment Sales

Structured installment sales are straightforward.  You sign an installment sale agreement with your buyer. The buyer, in turn, pays a financial institution to assume the obligation to perform on the note on his behalf.

Trust companies offer this service, and it is rumored that one major insurance company plans to enter the market soon.

What you gain is smoothed out capital gains recognition. If this saves you much tax, and you are willing to live on relatively low returns, this is the one for you.

If you use a robust institutional intermediary, execution will be compliant and done well, and you end up with minimal risk.

Monetized Installment Sale (MIS)

Whenever you use an installment obligation as collateral, gain recognition is triggered.  The MIS seems to avoid this, and leaves most of the proceeds in your hands to do with as you please, while still deferring the gain.

The IRS Chief Counsel Office advisory letter 20123401F supports this view in a somewhat equivocal manner.  The letter merely states that a transaction like this should not be attacked with “substance over form” or “step transaction.” The letter only says what the view of the IRS towards the transaction is not.  Several public companies disclosed the transaction in their SEC filings, which adds some “credibility” to it.

 

Here Is What You Do:

You sell your property to your dealer for a thirty-year interest only installment note. In turn, the dealer sells the property for cash, which goes into escrow. Subsequently, you borrow money on a nonrecourse basis from a third party lender protected by the escrow agreement.

In theory, the seller’s interest payments are tax-deductible while the interest payments the seller receives are taxable as income, and the two are supposed to wash.

All this will, of course, depend. How did you spend the money? Did you spend it on personal items? If so, it will not be deductible.  However, there are many ways in which interest deductions can be suspended for federal purposes.

Will It Work?

On the one hand, if the transaction is executed congruent to the Chief Counsel Letter, it should work.  On the other hand, problems exist.

  • The arrangement is not undertaken as a formal pledge by the seller-taxpayer of the intermediary’s installment obligation.
  • The intermediary’s obligation to the seller is not formally “secured” by cash or equivalents.

However, the MIS arrangement (described above) is substantially the same as one or both of the gain-recognition-triggering events. Arrangements that have a similar effect should be treated the same.  Only the IRS can clarify this uncertainty.

 

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In the meantime, the IRS is attempting to assess promotor penalties on at least one MIS promotor.  MIS then is not for the faint-hearted.  If you want absolute certainty in life, pay your full tax bill and only then spend your remaining proceeds your way.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.

Contact us for more info about tax strategies for Real Estate Investments. 

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Fulton Abraham Sanchez, CPA

Fulton Abraham Sánchez, CPA is a Certified Public Accountant, specialized in Tax Planning for Real Estate, Hedge/Equity Funds, Fintech, Crypto, Expats, IRS Debt Resolution and Offshore Strategies. You can email him to fa@fascpaconsultants.com and follow us on Facebook : FAS CPA & Consultants.

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