Tax strategies like Section 1031 exchanges and qualified opportunity fund investments can help real estate and construction professionals defer taxes and even exclude some income from tax altogether. Here’s how.
There’s been a lot of discussion recently on significant changes to the tax law under the Tax Cuts and Jobs Act (TCJA) and the Inflation Reduction Act (IRA), many of which have created tax-saving opportunities for real estate and construction professionals who take on projects that qualify for the new tax benefits. With some of those tax provisions set to expire if they aren’t extended by Congress, and others facing possible opposition from the new administration and new Congress, it’s a good time to review some more stable beneficial tax strategies that have been part of the tax code for some time and seem likely to continue.
Incentives that have existed in the tax code for some time to support real estate development and construction include:
Section 1031 and 1033 exchanges.
Qualified opportunity fund investments.
Bramblett transactions.
Seller carryback notes.
Cost segregation studies.
There are nuances that exist in some of these areas. There are a lot of opportunities here for tax deferrals and savings, but some formalities and complexities have to be observed early on in the process to make sure that a transaction intended to qualify for these incentives doesn’t get disqualified on an early technicality.
Section 1031: Deferring tax on sale of real property
Section 1031 exchanges allow taxpayers to defer the tax liability associated with the sale of real property by acquiring replacement real property with the proceeds. It applies to real property held for productive use in a trade or business or real property held for investment. The deferral applies very specifically to the value of the real property involved in the transaction. Any personal property within a building, such as furniture or fixtures that are part of the business, wouldn’t be included in the value of the real property considered as part of the exchange.
Section 1031 exchanges allow taxpayers to defer the tax liability associated with the sale of real property by acquiring replacement real property with the proceeds.
A Section 1031 exchange must meet the following three requirements:
Third-party involvement. The parties must use a “qualified intermediary” to manage the transaction. A qualified intermediary is an organization set up to take control of the funds at the time of the close and maintain those funds in their possession as the seller goes through the process of finding and buying a replacement property. Consultation with tax advisors at this stage is crucial to make sure that everyone understands the timelines and that the intermediary selected does in fact qualify under the rules.
Two deadlines. From the time of the sale, the seller is on the clock to qualify for section 1031 treatment. The seller has:
45 days to identify a new replacement property (or multiple properties).
180 days to fully acquire and complete the exchange.
Reinvestment of 100% of proceeds. To get full deferral under the rule, the seller must invest 100% of the proceeds. In some cases, taxpayers can meet the 100% reinvestment requirement by making qualifying improvements to the acquired property within the 180-day completion period. What sometimes catches taxpayers off guard here is that it’s not just 100% of cash received, but it also includes debt proceeds on the relinquished property.
The IRS requires that taxpayers hold the actual real property for business reasons. A partnership interest in a business that holds the real property is not sufficient to qualify. Also, the ultimate owner of the new property needs to be the same owner that sold the previous property. This isn’t too complicated when it’s a transaction that involves one business or a sole proprietor, but it can get complicated when one partnership sells the previous property, and the new property is acquired by a partnership that includes different investors.
A few caveats apply to 1031 exchanges, including:
Taxpayers will be required to recognize gain dollar-for-dollar on any cash “boot” payments received as part of the transaction. In some cases, this can negate the positive tax benefits of a 1031 exchange.
U.S. property can’t be replaced with foreign property — that’s not considered “like property.” The rules do allow for replacement of foreign property with foreign property.
States may “claw back” 1031 tax benefits. Some states will recognize the initial deferral under 1031 but require that the seller report on any and all replacement property, even if it’s out of state, until such time as the seller engages in a sale transaction that results in recognition of the gain that was initially deferred in the state where the first property was located.
Section 1033 allows deferral on involuntary conversions
A related provision in the tax code allows taxpayers to defer gain on the involuntary conversion of real property due to circumstances such as:
Destruction
Theft
Seizure
Condemnation
The simplest example would be a business whose building was destroyed by fire that generated an insurance payment that would have resulted in gain for tax purposes. If the business reinvests the proceeds by the end of the third tax year from the time of the involuntary conversion, it can qualify for 1033 deferral. There is no need for a qualified intermediary, only the filing of an election with the return in the year that the property is converted. The new property must be of “similar use” to the property it replaced. In many cases, it will be impossible to have exactly the same use when a property is destroyed, so taxpayers are given some leeway here. Funds aren’t traced directly, so the insurance proceeds can be used for other business purposes in the interim and the new building can be purchased with cash that isn’t directly traced to the insurance payment.
Qualified opportunity fund investments: Deferring capital gains tax with targeted reinvestment
The ability to defer taxes on capital gains by investing in a qualified opportunity fund (QOF) came into the tax code with the Tax Cuts and Jobs Act in 2017 (see our previous articles). Many of the initial benefits were time-sensitive and some of the deadlines for those have passed, but a few opportunities remain. What’s perhaps most significant here is that if a taxpayer owns the QOF for greater than 10 years, they qualify for a permanent exclusion from tax on the gain on the QOF assets sold after that holding period.
The ability to defer taxes on capital gains by investing in a qualified opportunity fund (QOF) came into the tax code with the Tax Cuts and Jobs Act in 2017.
Bramblett transactions allow capital gain treatment for land appreciation
Developers have an opportunity to convert land appreciation that would otherwise be treated as ordinary income into lower-taxed capital gains by using what’s known as a “Bramblett transaction.” The benefit is available to land developers who have held a large parcel of land with appreciation before the ultimate development.
The consideration here is that the IRS uses a fairly subjective “facts and circumstances” test to separate out “dealer activities” that would generate ordinary income and “investor activities” that allow for capital gain treatment. Developers who currently hold land for investment should work closely with their tax advisors to discern what activities might qualify them for the tax advantages of this process and what activities might prohibit them from being taxed at the preferable 20% capital gains tax rate.
Seller carryback notes can help with financing but complicate taxes
Given climbing interest rates in recent years, seller carryback notes have become a slightly more common form of financing. They provide short-term financing to a buyer and give the seller the benefit of electing installment treatment on the property. There are a few potential pitfalls with this financing method. From a buyer’s standpoint, it can limit the basis in the acquisition that can be claimed for depreciation deductions. From the seller’s standpoint, gain is recognized proportionate to total proceeds received, including proceeds from extinguishment of seller’s debt, and ordinary income recapture will be recognized in the year of disposition regardless of proceeds received.
Given climbing interest rates in recent years, seller carryback notes have become a slightly more common form of financing.
Cost segregation studies help to recover costs more quickly
Lastly, one of the most consistent strategies to accelerate deductions related to real property is a cost segregation study. These studies break out the components of real property that can be depreciated over much shorter asset lives in order to frontload the depreciation deductions for buildings and property in the earlier years of ownership. There’s a lot to consider with these studies, including how to carefully choose a qualified professional to perform the study and thoroughly document the results.
Tax code changes are inevitable, but careful planning always pays off
Even with some of these strategies, it’s not uncommon to hear discussion from time to time about “should it be modified or eliminated.” But these strategies have remained a part of the tax code for some years now and have proven to be reliable sources of tax deferral and exclusion for owners of commercial real property. It pays to stay current on developments as they occur, and to consult with your tax professionals on the strategies that work best for each business.
