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Pro Tax Tip: How to Sell Airbnb(s) Like the Real Estate Elite - Part 4

Updated: Mar 29, 2023




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Section 1031 Exchanges vs. Qualified Opportunity Zone Funds: Which Is Better?


Let’s say that Larry Landlord purchased a residential rental duplex 20 years ago for $100,000 and it’s now worth $1.1 million.


Larry wants out of this property, but he doesn’t want to pay $238,000 in tax on his $1 million capital gain.


One option is to defer the tax due on the gain by doing a Section 1031 exchange for another real property—for example, Larry could sell his duplex and use the proceeds to purchase a rental triplex of equal or greater value.


But there is another option: selling the property and investing the proceeds in a qualified opportunity zone fund. Which is better? Like most things in life, it depends. Specifically, it depends on Larry’s goals.


Goal: Get Out of the Real Estate Business


If Larry is tired of being a landlord and wants to get out of the real estate business, a Section 1031 exchange won’t help. You must exchange one property for one or more like-kind properties of equal or greater value. “Like-kind” real property is very broadly construed to include all business and investment real property in the United States, whether improved or unimproved.[1]


Larry doesn’t have to exchange his rental duplex for another residential property. He could exchange it for an office building, a farm, a ranch, or a strip mall. But with the exchange, he’ll still be a real property owner with all the headaches and responsibilities that entails.


Investing in an opportunity zone is different. You don’t buy and manage a specific property. Instead, you sell your real property (or any other capital asset) and invest all or part of the proceeds in a qualified opportunity fund (QOF). QOFs are corporations, partnerships, or LLCs organized to pool money from investors to invest in opportunity zone property.


There are thousands of QOFs to choose from. The vast majority of QOFs invest in real estate, although they can invest in other businesses in opportunity zones. The QOF (not the investors) manages the real estate.


So if Larry wants to relieve himself of actively managing a real property investment, putting his money in a QOF is the way to go.


Goal: Diversify Your Real Estate Investments


Ordinarily, when you do a Section 1031 exchange, you replace one property with another.


In contrast, you can diversify your holdings when you invest in a QOF. First, you can invest in more than one QOF. Also, many QOFs have multiple real properties in multiple opportunity zones.


Goal: Defer Long-Term Capital Gains


Gain in a like-kind exchange is tax-deferred until you sell or otherwise dispose of the property you receive in the exchange. You can do as many like-kind exchanges as you want. So long as you exchange for replacement property of equal or greater value, you’ll owe no tax.[2] Thus, Larry can defer paying tax on his $1 million capital gain for decades.


In contrast, capital gains invested in a QOF are tax-deferred only until December 31, 2026. At that time, the capital gains tax must be paid.[3] Thus, Larry would pay capital gains tax on his $1 million gain from the sale of his duplex with his 2026 tax return.


Goal: Sell the Property in 10 or More Years


A Section 1031 exchange is tax-deferred, but it is not necessarily tax-free.


The basis of the original property follows the property owner through the exchange and is used when the replacement property is ultimately sold.[4] Upon such a sale, the owner must pay capital gains tax on the difference between the basis in the original property and the sale amount of the replacement property.


For example, let’s say Larry sells his replacement property triplex for $2 million in 10 years. Since the basis in his original duplex was $100,000, he’ll owe capital gains tax on $1.9 million ($2 million - $100,000).


In contrast, when an investor sells his or her investment in a QOF, its basis is increased to its fair market value at the time of the sale, provided that the QOF was held for at least 10 years.[5] Thus, if Larry sells his QOF investment for a $250,000 profit in 2033, he’ll owe no tax. This is a huge tax benefit for those who are willing to hold on to their investment for 10 years.


You may hold your QOF until 2047 and avoid paying capital gains tax on any appreciation that occurs through the end of that year.[6] But it’s anticipated that most QOF investors will sell after 10 years. For this reason, QOFs are best viewed as a medium-term (10-year) investment.


Goal: Give the Property to Your Heirs Tax-Free


Section 1031 exchanges are a superb estate planning tool because the taxes deferred in the exchange can roll on indefinitely until the property owner dies. At that time, the owner’s heirs

will get a step-up basis equal to the property’s fair market value at the time of death. The heirs can then immediately sell the property tax-free. In other words, the capital gains disappear.


For example, if Larry exchanges his $1.1 million duplex for a triplex that is worth $2 million, when he eventually dies, it will get a step-up basis to $2 million. His heirs can sell the property for $2 million tax-free.


With a QOF investment, there is no step-up upon death. If Larry dies before December 31, 2026, his heirs will assume the original tax basis in the QOF and will have to pay tax on Larry’s $1 million capital gain with their 2026 return.


But if Larry’s heirs hold on to the QOF for 10 years, it will receive a step-up to its fair market value when they sell it. They won’t need to pay capital gains tax on the appreciation of the QOF.


Goal: Gain Liquidity by Freeing Up Original Principal


You have to invest only your capital gains from the sale of real property or other capital assets in a QOF.[7] You may keep your original basis in the property tax-free. For example, Larry’s basis in his $1.1 million property is $100,000. He may pocket the $100,000 tax-free and invest the $1 million in a QOF.


In contrast, in a Section 1031 exchange, investors are required to leave in their original principal and their gains, and even roll forward their debt.


Goal: Maximize the Long-Term Value of the Real Estate


With a Section 1031 exchange, you may exchange for virtually any real estate of equal or greater value anywhere in the United States. You get to choose property with good investment potential. Once the exchange is completed, you own the property and can take steps to help increase its long-term value.


With a QOF, you are limited to giving your money to a fund that you don’t own or manage. The QOF chooses the investment. Moreover, QOFs are limited to investing in opportunity zones.

These are 8,764 census tracts total, in all 50 states. Most have at least a 20 percent poverty rate. But up to 5 percent of qualified opportunity zones did not need to be low-income, and much of the investment by QOFs has been in these less distressed opportunity zones.


QOFs are unregistered private placement investments outside of the Securities and Exchange Commission (SEC) oversight. They typically invest in either new construction in opportunity zones or significant rehabilitation projects. There is no guarantee they will choose investments wisely or manage them well. If the investment turns sour, there may be little or no appreciation after 10 years.


Goal: Achieve Simplicity


Section 1031 exchanges can be complicated. There are a lot of rules to follow. For example, you must identify a replacement property within 45 days after the property to be exchanged is sold.


The like-kind exchange must be completed within 180 days.[8]


Many Section 1031 exchanges are complex three-party exchanges in which a “qualified intermediary” sells the exchanged property and acquires the replacement property on the taxpayer’s behalf. In a complex three-party exchange, the qualified intermediaries often charge hefty fees, and there are expenses as well.


Investing in a QOF is relatively simple. Once you sell property for a capital gain, you have 180 days to invest in one or more QOFs of your choosing.[9]


Takeaways


A Section 1031 exchange is preferable to a QOF investment if your goal is to hold on to the replacement property for the rest of your life and then give it to your heirs. Your heirs will get a step-up basis to current market value and be able to immediately sell it tax-free.


In contrast, capital gains tax must be paid in 2026 on the money invested in QOFs in 2023.


If you don’t plan to hold on to your investment for life, investing in a QOF may be preferable to a Section 1031 exchange because there will be no tax due on any appreciation in a QOF after a 10-year holding period.


In contrast, if you sell Section 1031 replacement property, you must pay capital gains tax on the difference between the basis in the original property and the sale amount of the replacement property.


If you’re looking to avoid the headaches and responsibilities that come with ownership of commercial or rental property, a QOF investment is preferable because the QOF—instead of you—manages the investment.


If you want to gain liquidity by freeing up your original principal in the property, you should invest in a QOF. With a QOF, you can invest some or all of your gain. But when you do a Section 1031 exchange, you must exchange both your principal and your gain for a replacement property.


If you are leery of investing in opportunity zones, which are low-income or low-income-adjacent areas, you should do a Section 1031 exchange. With an exchange, you can invest in almost any real property of equal or greater value anywhere in the United States.


You have choices. Pay tax, pay no tax, or pay tax at your own pace.


There Are Thousands of Tax Planning Strategies You May Be Missing Out On.

Learn how Prosperity Tax Advisors can help you save money in taxes.



This article was reviewed by:



The material discussed on this page is meant for general illustration and/or informational purposes only and is not to be construed as investment, tax, or legal advice. You must exercise your own independent professional judgment, recognizing that advice should not be based on unreasonable factual or legal assumptions or unreasonably rely upon representations of the client or others. Further, any advice you provide in connection with tax return preparation must comply in full with the requirements of IRS Circular 230.


1 Reg. Section 1.1031(a)-1(b).

2 IRC Section 1031(a)(1).

3 IRC Section 1400Z-2(b)(1).

4 IRC Section 1031(d).

5 IRC Section 1400Z-2(c).

6 Reg. Section 1.1400Z2(c)-1(c).

7 IRC Section 1400Z-2(e)(1).

8 IRC Section 1031(a)(3).

9 IRC Section 1400Z-2(a)(1)(a).


Sourced with the help of The Bradford Tax Institute.



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