For many years there have been periodic threats that Congress would eliminate the ability to defer gains from property sales by reinvesting in “like-kind property.” These exchanges were allowed for real and personal property held for investment or business use.
The 2017 tax act did eliminate the use of like-kind exchanges for personal property. Real property exchanges, which have always been the bulk of these tax deferral transactions, survived the tax changes.
Carrying out an exchange with real property is not easy. It almost always requires hiring a “qualified intermediary” to facilitate the exchange. Once real property is sold, the taxpayer then has 45 days to identify replacement property and 180 days to actually receive that property.
To avoid current gain, the seller must reinvest the gross sale proceeds. Gain is recognized dollar-for-dollar if the reinvestment is not equal to the sales price. Also, even if the property sold had a liability that was paid off, the reinvestment must be the full sales price.
For example, assume qualifying real property is sold for $800,000. The property had debt of $500,000 that is paid off and $300,000 of cash is available to reinvest. The property’s tax basis is $600,000.
The gain is $200,000 ($800,000 sales price minus $600,000 tax basis). There is only $300,000 of cash, but the reinvestment must be $800,000. For every dollar of reinvestment less than $800,000, gain is recognized up to the total gain of $200,000.
Even with a full reinvestment, the $200,000 gain is only deferred until the replacement property is sold.
While the new tax law preserved tax deferral for real property exchanges, it did something perhaps much more important. A new opportunity to invest in a “qualified opportunity fund” that invests in a designated “opportunity zone” may be more attractive than a like-kind exchange.
An investment in a QOF must be done within 180 days of the gain recognition event. A timely QOF investment allows tax deferral of gains just like an exchange would.
That’s where the comparison ends. The QOF deferral is available for any capital gain, not just one from the sale of real estate. Sales of stock qualify. Sales of personal property, tangible or intangible, qualify.
There is no need to identify replacement property within 45 days. This is a big deal because it is often very difficult to do the appropriate due diligence on replacement property within 45 days.
The seller must reinvest only the gain. So returning to my example from above, the seller would only need to invest the $200,000 gain into a QOF.
QOF investments eliminate 10 percent of the deferred gain in five years and another 5 percent in seven years. Any appreciation on the invested gain will disappear from your tax return if the investment is held for 10 years. One downside – the deferred gain is recognized no later than Dec. 31, 2026.
So you sell real estate and don’t want to pay tax on your gain. A like-kind exchange is an option. But so is a QOF investment, and with a smaller investment, no need to identify alternative investments and the possibility of eliminating gain if the investment grows in value.
You sell a business and some consideration is allocated to goodwill. This is self-created goodwill so it has no tax basis and all proceeds are taxable. But you can invest the goodwill proceeds in a QOF and get the same benefits as the seller of real estate.
You sell Apple stock that you bought when people thought apple was a fruit. This gain, too, can be rolled into a QOF.
A QOF investment is in the form of an interest in a partnership or stock in a corporation. There will likely be a QOF sponsor who will call the shots. A like-kind exchange allows you to pick the property and also to manage it.
If you invest more than the gain, the special tax treatment applies only to the deferred gain portion of the investment, and a QOF will be a long-term (illiquid) investment.
But it’s something to consider. Consider it only if the sponsor has a history of success in prior real estate investments and also has some of their money in the QOF.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.