Ways to defer income and lower your current tax bill

Save now, pay later (and maybe pay less!)

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Phillip R. McCollum, Jr., CPA, JD

Are you looking at a high tax bracket and large gain this year because you sold your business and your building? Maybe you’re considering selling the apartment building you’ve owned for many years because the market is really strong, but you’re also still interested in investing in real estate after the sale.

These are examples of major events where the tax liability can be significant, and the deferral of income recognition can be a solid strategy. Planning for these scenarios can save you tax dollars in the current year and move the tax liability to the future where you may be in a lower tax bracket when you decide to recognize the gain. Let’s break down a couple of techniques that can defer income recognition, the payment of tax and potentially allow you to pay less in the future.

Qualified opportunity zones (QOZ)

A QOZ is a brand-new tax deferral strategy that came about under tax reform. This new provision allows for the deferral and partial exclusion of gains from the sale or exchange of any asset that is reinvested in a Qualified Opportunity Fund (Q Fund). In some ways, QOZs are better than a like-kind exchange (more on that later) for deferring tax because with QOZs, you only have to invest the gain portion from the sale or exchange of any asset rather than the total amount of proceeds – as is required for a like-kind exchange.

Additionally, there are permanent tax savings available when the investment in a Q Fund is held, at a minimum, for the following time periods:

  • Five years: 10% step-up in tax basis resulting in no tax on the 10% amount
  • Seven years (the initial five years plus two more): an additional 5% step-up in tax basis resulting in no tax on the 5% amount
  • To take advantage of this potential permanent tax savings (the total 15% step-up in basis), the investment must be done by December 31, 2019.

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Any taxable gain invested in a Q Fund is not recognized until December 31, 2026 or until the interest in the fund is sold or exchanged, whichever occurs first. Additionally, if the investment remains in the Q Fund for at least ten years, any further gains generated through an investment in a Q Fund may be permanently excluded from taxation

Investor beware

Although the tax benefits associated with investing in Q Funds can be significant, be careful to not let the tax tail wag the dog. Because Q Funds are so new, the structure and operations associated with them are still being developed by the Fund managers. So, it’s important to be prudent about entering into a Q Fund investment because the investment still needs to make sense in the long-term, not just for the short-term impact of saving tax. For example, we had a client recently considering investing a gain in a Q Fund; however, we found that the nature of the underlying investment in the Fund was still not set in stone. This scenario shows why you want to exercise due diligence in analyzing the Q Fund and what its underlying investment is, so you don’t end up with an investment that does not work for you long-term.

Like-kind exchanges

Though QOZs are an attractive new option, like-kind exchanges for real estate remain one of the most popular tax deferral methods. If you own real estate that is held for use in a trade or business or for investment, you can sell it for a gain and the payment of tax on the gain can be deferred as long as you take the proceeds from that sale and invest them in like-kind property,

For example: you sell a property for $1 million and your basis in the property is $100,000. As a result, you have a $900,000 gain. If you take the $1 million and put it into like-kind real estate (the replacement property), you defer the tax on the gain on the sale by finding a replacement property. This strategy is purely a deferral of income tax until a later time.

Like-kind properties. Properties are of a like-kind if they are of the same nature or character even if they differ in grade or quality. For example, you can exchange a residential rental property for farm land. An example of what wouldn’t qualify for like-kind exchange treatment is selling your personal residence and putting those proceeds into farm land.

Qualifying transactions. There are additional requirements that must be followed to qualify a transaction for like-kind exchange treatment:

  1. Specific time periods for identification and purchase of the replacement property, and
  2. The use of a qualifying intermediary to hold the proceeds

Don’t try to set these ideas up on your own. If you have any questions about the new qualified opportunity zones or like-kind exchanges, be sure to contact your Henry+Horne tax advisor for help.

Phillip R. McCollum, Jr., CPA, JD, Partner, specializes in tax planning, consulting and compliance work for privately held businesses and their owners. He can be reached at (480) 839-4900 or PhilMc@hhcpa.com.