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Tax Mitigation Strategies – What’s right for your investment portfolio?

By James Holleman, Grubb Properties, and Stephen Covington, Mercer Consulting

No investor likes to pay unnecessary taxes, so tax mitigating investment strategies have found a place in most High Net Worth (HNW) investment planning discussions. In the private equity real estate world, five primary strategies have emerged as attractive options for investors with substantial capital gains. 

The vehicle that’s right for an investor depends on several factors including liquidity, exit, duration, exposure/diversification, structure, investor rights, future tax burden, and most importantly, investment strategy. Broadly, each tax mitigation strategy offers its own unique benefits and drawbacks. We’ll provide a broad overview here, but urge investors to speak to their financial planners and tax accountants to select the most appropriate strategy for their situation.

        1. Qualified Opportunity Zones 

Now in its fourth year, the Qualified Opportunity Zone (QOZ) program is the newest of the five strategies. Introduced as part of the 2017 Tax Cuts and Jobs Act, Opportunity Zones are economic development tools that enable individuals to invest in underinvested areas across the United States, receiving attractive tax incentives for doing so. QOZ tax benefits can be accessed by people making investments into Qualified Opportunity Funds. 

Two main benefits are at play with the QOZ tax incentive in 2022: 

            1) The deferral of eligible capital gains until 2026, payable in calendar year 2027 
            2) A complete exclusion of appreciation on the QOF investment if held for at least 10 years.

Qualified Opportunity Fund development, Link Apartments℠ 4th Street in Winston-Salem, NC

Certain qualifications must be met when considering an investment in a QOF. First, the investment in a QOF must be funded from a capital gain, and the realization causing the gain must have occurred within 180 days of the QOF investment. The capital gain can be sourced from any asset type and is not limited to real estate. Gains can be combined to make a single investment in a QOF, or a gain can be split to make several investments into various QOFs. There is no need for qualified intermediaries, as the QOF investment is self-reported.

Investment opportunities within the QOZ space are diverse, as QOFs are not limited to investing solely in real estate, but rather any qualifying business that is located within a QOZ. Drawbacks to the QOZ program are centered around the illiquid nature of the investment, and that the chance to place new capital into the OZ program will end in 2026, if not extended through the recently proposed Opportunity Zone Reform Act.

        2. §1031 Exchange

A tried-and-true way to defer capital gain tax obligations derived from real estate transactions, the §1031 Exchange program has been a powerful wealth-building tool for real estate investors for over 100 years. The exchange enables investors to defer capital gains tax and depreciation recapture by reinvesting proceeds from the sale of a property into a similar property or properties. 

Certain rules must be considered when addressing a §1031 Exchange: 

  • The property being exchanged must be like-kind, as defined in Sec §1031 as any held for investment, trade, or business purposes of the same or higher value outside of the primary residence. 
  • Proceeds from the sale must be held with a Qualified Intermediary (QI) as part of a compliant exchange, and the funds held with the QI are then used to purchase the like-kind property/properties. The investor cannot receive the proceeds. 
  • There are no limits to how many times you can do §1031 Exchanges.

Unlike the QOZ program, which allows access to tax-free appreciated capital after year 10, the §1031 Exchange never allows access to the tax-free appreciation, unless the §1031 property is passed to a new investor through an estate, in which the heir would then establish it at a new cost basis (stepped-up-basis) at the fair market value of the asset. If the investor wants access to the capital in their lifetime, they eventually do have to pay capital gains taxes. 

        3. Delaware Statutory Trust 

A Delaware Statutory Trust (DST) is an investment vehicle designed to own real estate, which qualifies as a replacement property in a §1031 Exchange. Like private equity funds, DSTs are actively managed investment vehicles that are diversified offerings and can span across multiple real estate asset classes. The same general rules that apply to a §1031 Exchange apply to a DST.

The same tax incentives achieved when conducting a §1031 Exchange are achieved with a DST placement. Additional benefits of investing into a DST would include: 

  • The ability to invest in a diversified fund of commercial real estate assets 
  • The ability to receive passive income with no active management 
  • Efficient estate planning, as shares can be split among heirs 
  • Generally low investment minimums and are commonly open to accredited investors 

The same drawbacks that apply the §1031 Exchange tax incentive apply when investing into a DST. If the investor sells the DST in their lifetime, they will owe capital gains taxes on the transaction unless they continue to defer tax via additional §1031 Exchange transactions.

        4. Custom Structures

For most §1031 Exchangers, DSTs can be an effective way to access passive and fractional real estate ownership at lower investment minimums. For those exchangers considering their options for larger exchanges, custom acquisition structures can be a compelling alternative. While providing the same passive and fractional ownership benefits, custom structures can establish greater ownership control, financial flexibility, and lower expense ratios. Custom structures also provide access to a broader range of asset classes and real estate business plans, where tax law limits the DST structure.

Custom structures create direct relationships between an exchanger and an institutional operator.  Where DST investments focus on a more traditional “buy and hold” strategy, custom structures can provide the control necessary for families to manage their wealth, future liquidity and estate planning needs with greater intention.

        5. §721 UPREIT 

§721 IRC UPREIT transactions allow the full tax deferral within a §1031 like-kind exchange, with the additional benefit of converting later to shares in a Real Estate Investment Trust (REIT). 
Typically, the exchanger will purchase interest into the fund (oftentimes structured as a DST) followed by a subsequent two-year hold period once the fund is closed. Once the UPREIT conversion takes place, the exchanger is left with operating units (“stock”) in the REIT.  

The same general rules apply to §721 UPREITs that apply to a standard §1031 Exchange, and the tax incentives achieved through a §721 UPREIT are the same as a standard §1031 Exchange. Additional benefits of the §721 UPREIT program include: 

  • The ability to exchange property for a diversified fund of real estate assets 
  • The ability to receive passive income with no active management
  • Efficient estate planning, as shares can be split among heirs

Drawbacks to the §721 UPREIT are like those of a standard §1031 Exchange, in the fact that investors are essentially delaying capital gain tax obligations if their holding is liquidated within their lifetime. Control over liquidation is also questionable with §721 UPREITs, as the manager of the REIT can sell contributed property and trigger a liquidation, which would require the investor to pay the deferred tax.

Summary

It’s important to understand all options when considering tax-incentivized investments. There is no right or wrong solution for a capital gain tax burden, but rather a set of options to choose from to help mitigate the tax implications. The best option will depend on several factors such as estate plans, active vs. passive management, control, and if investors want access to the capital in their lifetime. 

At Grubb Properties and Mercer Consulting, we highly encourage investors to consider all options, and to educate themselves and consult with their tax and financial advisors to choose the path that best fits their investment plans.

To learn more about our Link Apartments Opportunity Zone REIT, click here.


The information, statements and opinions contained in this article are provided for informational purposes only and should not be construed, or relied upon, as tax or investment advice to any recipient. The information contained in this article is derived from tax laws and regulations in effect as of the date of this article, which are subject to change. Recipients considering investments in real estate or investment funds should consult their own tax, investment and legal advisers. This article does not constitute an offer to purchase or sell real estate or securities from Grubb Properties or any of its affiliates. 

This article contains and is based on internally and externally sourced information and data that Grubb Properties believes are reliable, but that have not been audited or otherwise verified by independent third parties. No representation or warranty is made as to the accuracy or completeness of the information contained in this article.

James Holleman
James Holleman

Vice President of Capital Formation