I see all sorts of articles online regarding the benefits of doing $100,000 Roth conversions over a 10-year period, which makes me think that a lot of people aren’t even evaluating income tax brackets. But that’s the best place to start when evaluating whether a Roth conversion makes sense.

Here are three thresholds you need to consider before deciding to do a Roth conversion:

1. Your income tax rate.

This is us looking left. The reality of a Roth conversion is that it’s just a bet that your current tax rate is lower than your future tax rate. If so, you’d rather pay the taxes today. If you’re in the period between retirement and when you start RMDs (required minimum distributions), this can be a pretty safe bet.

I met with a client the other day who is three years out from RMDs. Once both spouses start receiving RMDs, that will push them from the 24% marginal bracket to 32%. So, in doing the conversion calculation, we want to see how much we can convert while staying in the 24% bracket.

2. Your capital gains tax rate.

We are looking right. People talk about capital gains tax rates as though they are 15% for everyone. That is not the case. Evaluating capital gains rates is most important at low income levels and at high income levels.

When your income is very low, a Roth conversion can cause you to go from paying 0% in capital gains to paying 15% on everything. This is an expensive trigger.

Once taxable income crosses above $518,900 (S) or $583,750 (MFJ) for 2024, you jump from 15% to 20%. Less talked about is the 3.8% net investment income tax, which, as it sounds, is a tax on investment income over $200,000 for individuals and $250,000 for a married couple filing jointly.

3. Your Medicare premiums.

Finally, we are going to check the bike lane to ensure we don’t get smacked by an e-bike. Premiums for Medicare Parts B and D are income-adjusted. However, unlike the above income tests, Medicare premiums are determined by gross, not taxable, income. The Part B premiums can increase by as much as $419 per month, per person, based on income. In my experience, this is the one that upsets people the most.

To be clear, you’re not always trying to stay under every threshold. In many situations, it makes sense to pay more in Medicare premiums to avoid a much larger income tax bill down the road.

Evaluating Roth conversions in your situation requires projecting out your future tax rates; i.e., should you even be crossing the road at all? To get a sense of what your rates may look like, you can build out a free plan here.

Related Content

• Roth Conversions: Convert Everything at Once or as You Go?
• Are You Ready to ‘Rothify’ Your Retirement?
• Is a Roth Conversion for You? Seven Factors to Consider
• Roth IRA Conversions: Benefits and Considerations Beyond Taxes
• How a Backdoor Roth IRA Works (and Its Drawbacks)

Nevertheless, it happens from time to time that politicians say and do things that do fall within my purview. And the recent release of the president’s proposed budget for next year certainly qualifies.

So let’s dig in…

As you may know, the Biden administration recently released its proposed budget for fiscal year 2025. Buried within the $7.3 trillion budget is a provision that would limit capital gains tax deferrals under Section 1031 of the Internal Revenue Code to an aggregated $500,000 per taxpayer annually. While there are currently no statutory limits on capital gains tax deferral, the president’s proposal would mean that real estate investors could defer only a maximum of $500,000 in capital gains taxes ($1 million for couples filing jointly) through 1031 exchanges each year. Any gains above that amount would be fully taxable.

Section 1031 has been in place since the early 1900s and is an important tool for investors seeking to preserve and grow their wealth. The proposed change would be devastating to real estate investors, to the real estate market in general and to the American economy as a whole. And yet, it has taken me a while to address it, for one important reason: I am unconcerned about its prospects of ever becoming law.

Dead on arrival

Let’s be clear: The proposal certainly warrants concern and an aggressive response from the real estate community and investors. And it will certainly get one — just as it did last year when Biden’s proposed budget for 2024 included the exact same proposal. And just like last year, the proposal (and most of the budget with it) will be deemed “dead on arrival” by Congress, including some members of the president’s own party.

To understand why this might be, and why a president would float an idea with virtually no chance of gaining traction, it’s important to understand the process of the federal budget as a whole. The U.S. Constitution grants the U.S. Congress — not the president — the so-called “power of the purse,” or the ability to tax its citizens and spend public money. So Congress can certainly take the president’s budget proposal under consideration. Or they can do what they usually do: hold hearings, debate priorities and ultimately produce a budget whose resemblance to the president’s is entirely coincidental.

It's all politics

The president’s proposed budget is basically symbolic, which begs the question: Why bother producing one at all, much less expend the thousands of hours that go into its production? The answer, in a word: politics.

The president’s budget proposal is a political document, not a practical one. Lacking the force of law, it nevertheless is effective at signaling the administration’s priorities, appeasing various constituencies and, at its most effective, setting the terms of the public debate on certain subjects. Presidents often include items in their budgets that have virtually no chance at becoming law, but that do achieve the goals of energizing their base of voters and possibly forcing their opponents to take unpopular votes, especially in an election year.

This practice is always pilloried as wasteful by the president’s opponents, but it’s clearly a bipartisan tradition. Tracing back through the budget proposal of presidents from the past several decades, it becomes apparent that these “zombie” ideas have a consistent feature:

• President Trump proposed billions for a border wall with Mexico, which served as an effective political rallying cry, if not a serious budget proposal (as it was never going to be accepted, much less funded, by his Democratic opponents).
• President Obama annually proposed a “Buffett Rule” millionaires’ tax, endorsed by Warren Buffett himself, which stood no chance of success, but which enabled him to paint Republicans as “defenders of the rich.”
• President George W. Bush championed the concept of partially privatizing Social Security, an idea that went nowhere in Congress but signaled his conservative bona fides to his supporters.
• President Clinton included a provision to study an internet sales tax in his final budget, a poison pill for the GOP, but a bouquet at the feet of the brick-and-mortar retailers who were important Democratic constituents.
  

Political positioning

All of these proposals shared the same status as opening moves in a long negotiation process at best and pure political positioning (as opposed to an attempt at serious policymaking) at worst.

Which brings us back to Biden’s proposed $500,000 cap on like-kind exchanges in his 2025 fiscal-year budget. The provision would be an unqualified disaster for the real estate market — if enacted, of course.

A 2015 study by Ernst & Young examined the idea of repealing Section 1031 entirely and determined that the cost to the American economy would be over $13.1 billion. A subsequent study by two professors in 2020 concluded that the cost would be closer to $20 billion and would effectively create a “lock-in effect,” resulting in fewer transactions and, ultimately, industrywide price declines.

Not a realistic policy goal

However, once we understand the symbolic nature of presidential budget proposals, it becomes clear that the suggestion of a 1031 cap serves primarily as an opportunity to signal progressive tax priorities, not as a realistic policy goal. The chances of the 1031 cap becoming law are slim to none, just as they were when it was proposed and ignored by Congress last year. But by proposing it again this year, Biden addresses the goal of telling his progressive base that he is still trying to crack down on “loopholes for the rich,” even while moderate members of his own party will distance themselves from the proposal and tout their defense of middle-class homeowners.

They know what we know

Limiting or repealing 1031 exchanges would blast a hole in real estate values, hurt the economy and ironically reduce tax collections over time by depressing activity. Even the more limited $500,000 cap (as opposed to full repeal) would do immense damage because the vast majority of the 1031 exchange dollar volume comes from a small number of high-value transactions that would be largely gutted. Many investors would simply freeze in place, unwilling to sell appreciated assets, removing a huge chunk of supply from the market. We would also see a steep drop in demand and new investment because the after-tax returns on real estate would fall sharply. Inevitably, property values and rents would decline.

So what should you do now?

• Don't make any panic moves or radical changes to your investment plans at this stage. There is a high probability that this provision will not pass congressional muster, just as it didn't last year.
• Stay informed and get involved. Subscribe to my weekly newsletter and watch this space for news of any movement toward enacting this harmful proposal. Contact your representatives in Congress to voice your concerns.
• Should the proposal show signs of gaining any traction, it might be prudent to consider expediting any planned 1031 exchanges in anticipation of potential future legislative changes. However, it's essential to avoid making rash or poorly thought-out decisions. As of now, there are no indications pointing toward restrictions or limits on 1031 exchanges, let alone their complete elimination.

As always, consult your tax advisers and legal counsel about your specific situation before making major initiatives. Everyone's circumstances are different.

Related Content

• It’s Not Too Late to Defer 2023 Capital Gains Taxes
• Can You 1031 Exchange into a REIT?
• 1031 Exchanges: A Matter of Life and Death?
• 11 Reasons to Consider a 1031 Exchange
• Can I 1031 into a Qualified Opportunity Zone?

True, it’s possible to file for an automatic extension that kicks the can down the road another six months (though that’s seldom advisable unless absolutely necessary since Uncle Sam is as kind about interest and penalties as Tony Soprano). But by most estimates, roughly nine out of 10 of us have finished up the task of making sure our federal and state tax returns are filed and paid for.

Sizable capital gain for 2023?

But if you’re an investor sitting on a sizable capital gain for 2023 and facing the grim reality of paying a hefty capital gains tax, you might want to take a fresh look. Because depending on the source of your capital gain, there might still be time for you to devise a strategy that defers the payment of these taxes through the end of 2026 … and perhaps longer.

For certain partnership gains, the deferral can still be effectuated using one of our favorite strategies: a new investment in a qualified opportunity zone (QOZ).

Let’s review how to defer capital gains tax

Regular readers of this space know the basics well enough by now: The Tax Cuts and Jobs Act of 2017 created an opportunity to reinvest realized capital gains into any of over 8,500 QOZs in the U.S. and its territories. The twofold aim of a QOZ investment:

• Tax-exempt growth on the new investment
• The deferral of capital gains taxes on the original gain through at least December 31, 2026 (or at the time the QOZ investment is sold, whichever comes first)

The deferral of the initial gain is valuable, of course: A new QOZ investment today lets investors keep their money out of the tax man’s pockets and at work for them for another two to three years. The longer the payment of taxes can be deferred without penalty or interest, the better it is for investors.

The most significant benefit of a QOZ investment is the opportunity to not only let that new investment grow but also cash out of it completely free of any further capital gains taxes. Any QOZ investment that’s held for at least 10 years can subsequently be sold free of federal (and, in most cases, state) capital gains taxes, at least through 2047 (the current date of expiration of the QOZ program). It’s important to note that this exemption also extends to depreciation and tax credit recapture.

But what about the timelines?

As astute readers know, receiving these tax benefits generally requires the QOZ investment to take place within 180 days of the sale of the original asset.

But final regulations (released in December of 2019) provided an added benefit for partnerships, whose partners receiving a Schedule K-1 (Form 1065) can choose to initiate the 180-day window on any of three dates:

• 180 days from the date the asset is sold by the partnership
• 180 days from the last day of the partnership’s tax year (December 31 for calendar-year partnerships)
• 180 days from the date that the partnership’s (nonextended) tax return is due (March 15 for calendar-year partnerships)

The ramifications for 2023?

Let’s say a partnership realized a substantial gain in January 2023 and passed it through to its partners via a 2023 K-1. Using the first (best-known) methodology, it’s already more than 180 days past the date the gain was realized and thus too late for the tax benefits of a QOZ investment.

However, partners remain eligible to participate in the QOZ program by redeploying their capital gains in a new QOZ investment by June 28, 2024 (using the second methodology), or by September 11, 2024, using the third methodology. The later deadline is particularly important when considering that partnerships frequently issue late K-1s as late as the summer in some cases, which often makes either of the first two deadlines inoperable.

Just a few caveats

While a QOZ investment offers significant advantages, especially given its extraordinary tax benefits, some qualifiers must be considered.

Most important, QOZ investments generally occur within the context of a qualified opportunity fund, a pooled investment that can include a single property or project or multiple properties. In either instance, QOFs should be considered illiquid investments, especially since the tax benefits of ownership require a 10-year commitment; certain QOFs may expect an even longer commitment.

Of course, QOFs are not generically wonderful investments, any more than one stock is as good as the next or bonds are interchangeable; returns can and do vary from one QOF to another, based on any number of factors, and there are no guarantees for any of them.

Some QOFs focus on a specific sector, including oil and gas, health care or consumer retail; all QOFs have a geographic component as well, and investors may seek to concentrate in a specific state or city or to diversify according to their needs.

Selecting a qualified opportunity fund is decidedly not “amateur hour,” and it’s wise to consult with experts whose experience can guide you in the right direction (and, just as important, away from the wrong direction).

Deadlines

Finally, as with any tax benefits, it’s critical to observe the relevant deadlines, to submit all paperwork correctly and to perform all due diligence related to the investment itself. The financial team you choose to work with should be well-versed in the ins and outs of QOF investments and should be able to keep you on task in meeting these deadlines; while K-1 partners have more time to use this strategy, the existing deadlines remain firm and inflexible.

Your advisers should be able to show you a wide variety of possible investments to choose from and explain the pros and cons of each one.

Given the thousands of available QOFs in existence, there’s likely to be a good fit for you and still time to mitigate your 2023 capital gains taxes, but you must act promptly.

Related Content

• Opportunity Zone Investing Still Hot Despite Looming Sunset
• Four Reasons to Tap Opportunity Zones Before They Expire
• How to Invest in Qualified Opportunity Zones: Step-By-Step
• Qualified Opportunity Zones vs. 1031 Exchanges
• Qualified Opportunity Zones With an Energy Boost

Essentially, an installment sale, as defined by the IRS, involves selling an asset with at least one payment received after the tax year of sale. This approach offers a strategic advantage by allowing sellers to spread their capital gains tax liabilities over a predetermined period, typically two years. The appeal lies in its ability to mitigate tax exposure, enabling sellers to manage their tax burden more efficiently.

For instance, imagine an individual decides to sell real estate valued at $5 million with a capital gain of $3 million. By structuring the sale as a two-year installment plan, the seller can realize several benefits.

First, it allows for a more favorable tax treatment, as the capital gains are recognized proportionally over the installment period. This can potentially keep the seller within lower tax brackets, optimizing tax efficiency.

Second, it provides a buffer against sudden spikes in taxable income, reducing exposure to additional taxes such as the net investment income tax.

However, the successful implementation of this strategy necessitates a nuanced understanding of tax regulations and financial implications. Collaboration with legal experts, tax advisers and financial planners is essential to ensure compliance and tailor the strategy to suit individual financial objectives.

In the realm of asset sales, the two-year installment sale strategy emerges as a potent tool for optimizing tax outcomes and enhancing overall financial efficiency. Its strategic application can significantly contribute to wealth preservation and tax management, positioning sellers for long-term financial success.

Related Content

• Worst States for Investors With Long-Term Capital Gains
• States With Low and No Capital Gains Tax
• Capital Gains Tax on Real Estate and Home Sales
• Biden Calls for Doubling Capital Gains Tax
• How Retirees Can Minimize the Net Investment Income Tax

Most states also impose taxes on long-term capital gains (typically, gains held for more than one year), some at a higher rate than others. So, you may want to familiarize yourself with these worst states for investors before purchasing that investment property or those high-growth stocks.

Worst capital gains tax states for investors  

To determine the worst states for investors, we considered each state’s top long-term capital gains tax rate. We did not compare state tax rates for investors with lower incomes. For that reason, the states on this list might not apply to those with nominal investment earnings. All investors should carefully consider possible tax implications when buying and selling assets.

California

High long-term capital gains tax rate: 13.3%

It’s probably no surprise to see California make this list. The Golden State is well-known for imposing high tax burdens on its wealthiest residents (and investors). 

California is the most expensive state for wealthy investors, with a capital gains tax rate of 13.3% on income exceeding $1 million. And high-earning employees should take note. A newly expanded payroll tax means California’s highest earners to pay an additional 1.1%.

New York

High long-term capital gains tax rate: 10.90%

New York comes in on this list as the second worst state for investors. The high New York 10.90% tax rate applies to capital gains and earned income. 

While this tax rate only applies if your income reaches $25 million, even lower earnings are often taxed at high rates. For example, in the Empire State, income that exceeds just $21,400 ($43,000 for joint filers) is subject to a tax rate of at least 6.21%.

Minnesota

High long-term capital gains tax rate: 10.85%

For the most part, Minnesota taxes long-term capital gains the same as it does short-term gains and ordinary income. 

However, high-earning investors in Minnesota are subject to an additional 1% tax on net investment income that exceeds $1 million. That makes the top tax bracket for capital gains in the North Star State 10.85%.

New Jersey

High long-term capital gains tax rate: 10.75%

New Jersey ranks just below Minnesota, with a high tax rate of 10.75%. The 10.75% rate applies to all taxable income of $1 million or more for single filers. The rate drops to 8.95% if your earnings don’t exceed half a million. 

However, investors with as little as $75,000 in gains will still pay more than 6% to the Garden State.

Washington DC

High long-term capital gains tax rate: 10.75%

The District of Columbia ties with New Jersey as the fourth worst state for investors when it comes to long-term capital gains tax rates. The high 10.75% tax rate in Washington DC applies to taxable income that exceeds $1 million. 

However, lower-earning investors can also experience high tax burdens. For example, the tax rate doesn’t fall below 9% unless you have less than $250,000 in gains, and even then, income that exceeds $60,000 is taxed at more than 8%.

Oregon

High long-term capital gains tax rate: 9.9%

Long-term capital gains tax rates fall below 10% in Oregon. However, the investment income brackets are far less generous than in many states on this list. 

Single filers with taxable income of $125,000 or more ($250,000 or more for joint filers) are subject to the 9.9% tax rate. And taxable income in the Beaver State that exceeds $3,750 ($8,100 for joint filers) is taxed at a minimum of 6.75%.

Massachusetts

High long-term capital gains tax rate: 9.0%

While the Massachusetts income tax rate is 5% for most people, millionaires can pay significantly more. That’s because a Massachusetts millionaire tax enacted last year requires investors and — other earners with taxable income — to pay a 4% surtax on earnings over $1 million. 

In Massachusetts, investors with short-term gains (i.e., investments held for less than one year) can face even higher tax burdens, with rates that climb to 12.5%.

Vermont

High long-term capital gains tax rate: 8.75%

Long-term capital gains are taxed as regular income in Vermont. The rates range from 3.35% (on up to $42,150 for single filers and $70,450 for joint filers) to 8.75% (on more than $213,150 for joint filers and $259,500 for joint filers). 

However, Vermont offers a long-term capital gains tax exclusion of up to $5,000.

Hawaii

High long-term capital gains tax rate: 7.25%

While the long-term capital gains tax is higher in Hawaii than in most states, the Aloha state places lower tax burdens on investors than workers. 

All capital gains in Hawaii are taxed at a flat 7.25%, but the tax rate on earned income can reach as high as 11%. Even single filers with earned income of just $25,000 pay a higher tax rate than investors with the same earnings.

Maine

High long-term capital gains tax rate: 7.15%

Maine taxes long-term gains the same as earned income, which means investors with gains that exceed $58,050 ($116,100 for joint filers) are subject to the high 7.15% income tax rate. 

The Pine Tree State doesn’t favor taxpayers with lower investment income. The lowest tax rate in Maine is still a high 5.8% and applies to income up to $24,500 (up to $49,050 for joint filers).

Honorable mention: Washington

High long-term capital gains tax rate: 7.0%

Washington didn’t quite make the list of the top 10 worst states for investors. However, the Evergreen State deserves an honorable mention since it taxes certain long-term capital gains but not earned income. 

The good news is that the controversial Washington capital gains tax only applies to certain long-term gains that exceed $250,000, and there is no capital gains tax on real estate.

Related Content

• States With Low and No Capital Gains Tax
• Capital Gains Tax on Real Estate and Home Sales
• Biden Calls for Doubling Capital Gains Tax
• Capital Gains Tax Rates for 2024
  
  
  

Directly exchanging into a REIT does not qualify for tax deferral under IRS rules, for reasons we’ll explore below. However, two compelling alternative vehicles exist that check many of the same boxes that REITs do, allowing investors to still delay tax obligations while accessing exposure to institutional-quality real estate assets.

We’ll explore both of these REIT-like options: the UPREIT (umbrella partnership real estate investment trust), also commonly known as the 721 exchange, and the Delaware statutory trust (DST), both of which enable participation in diversified portfolios of professionally managed properties while continuing tax deferral.

Let’s examine these instrumental strategies for unlocking real estate investments without triggering immediate capital gains tax burdens.

Exchanging into a REIT disqualifies tax deferral

First, why does the simple act of swapping directly into a REIT not qualify for a 1031 exchange? On the surface, it would seem to follow logically that a REIT would qualify as the “like-kind” asset needed to complete a 1031 exchange since REITs focus on owning and operating commercial real estate assets.

The IRS politely disagrees, however, holding that REIT shares are personal property, not real property. There is indeed real property that serves as the underlying investment, but the REIT investor has no direct claim, control or specific legal rights over any of the assets held by the REIT structure itself. Instead, REIT shareholders have a paper asset, affording no tangible rights to use, access or dispose of the properties in question.

Additionally, while REITs have predominant exposure to real estate assets, many also generate substantial ancillary revenue streams from activities like lending, advisory services, development and securitization, well beyond straight property acquisition, management and disposition. These secondary revenue streams further serve to undercut the argument that a REIT would be a like-kind investment in a 1031 exchange when relinquishing a piece of real estate investment property fully owned by the investor.

UPREITs to the rescue: The magic of a 721 exchange

Enter the 721 exchange, or the UPREIT. This increasingly popular financial structure allows REIT vehicles to bake in tax-deferred exchange capacity through a paired operating partnership tied to the REIT itself.

Here’s how it works in brief:

• A public REIT establishes or takes a controlling ownership stake in a separate operating partnership
• Investors directly contribute investment property into the operating partnership, in exchange for fractional ownership units in the UPREIT
• Operating partnership units received can be exchanged, without triggering tax liability, to eventually redeem fractional ownership equity directly in the founding umbrella REIT

In other words, directly contributing investment real estate into the underlying operating partnership tied to a REIT addresses the IRS’ definition of like-kind property. The operating partnership units serve as connective tissue, allowing 1031 investors to redirect tax liability through the continuity of direct ownership interest in like-kind property assets.

The UPREIT approach has proven popular in recent years. Over $100 billion in commercial real estate assets now use such partnerships to enable tax-deferred injections from 1031 exchangers seeking to roll over their gains.

Blue-chip REITs like Prologis, Digital Realty Trust, Vornado Realty Trust and W.P. Carey not only pioneered 721 exchanges to enable steady growth through tax-efficient asset pooling but continue to use them as such today. The structure has an established history of providing capital, liquidity and scale while often rewarding contributing partners.

Exploring the powerfully flexible Delaware statutory trust

While UPREITs provide scalability and professional management access, more tailored high-touch exposure also exists for those seeking greater involvement, control or niche sector participation absent the constraints of mammoth institutional vehicles.

Enter the Delaware statutory trust, a specialized trust that legally structures fractional beneficial ownership of commercial real estate assets among a pool of as many as 500 stakeholders. Unlike REITs, DSTs directly hold legal title to physical property assets like apartment communities, affordable housing sites, medical offices, self-storage facilities, retail power centers, industrial warehouses or specialty commercial developments among virtually all classes, with the goal of reliable occupancy and stable cash flows.

The direct ownership of multiple tangible assets then enables fractionalized sale of divvied-up beneficial interest to cohort investors, making a DST an attractive option for a 1031 exchange and even for the eventual division of an asset among multiple inheritors.

This effective framework is a boon for 1031 exchangers, allowing them the flexibility to redeploy capital gains into fractionalized shares in tangible fully owned properties. In addition, by directly deeding commercial real estate assets into a tailored DST and fractionalizing them into distinct equity shares (available for purchase by 1031 exchangers), specialized trust sponsors enable 1031 exchangers exposure to a higher-quality property portfolio that is generally not attainable by everyday investors.

Portfolios potentially spanning dozens of properties across both geography and sector mitigate the risks of concentration. Fractional shares translate into lower investment minimums, while direct ownership builds in the tax deferral that is central to the value of a 1031 exchange.

DST investors benefit from property management access, passive investment simplicity and diversification. DST structures also generally target stability and preservation of capital over higher-risk value-add or opportunistic plays — although sponsors continue to expand the risk/reward profiles as DSTs gain in popularity.

Ease of execution constitutes another desirable advantage over traditional physical 1031 exchanges. Investors need only wire proceeds and select a fractionally owned asset portfolio that fits their needs, as opposed to identifying potential swap properties, conducting physical inspections and due diligence, structuring financing and negotiating with the realization of deferred tax liabilities post-exchange.

The DST sponsor assumes responsibility for everything from acquisition and improvement to financing, compliance, accounting, reporting, customer relations, disposition and all administration. Investors can sit back, collecting distributions generated from assets now partially owned yet otherwise outside their ability to source or manage individually.

DSTs are also frequently used in tandem with UPREITs, particularly in cases where the DST is offered with a two-year 721/UPREIT feature. With this common setup, an investor will exchange into a DST, subsequently using a 721 exchange within a couple of years to move from the DST into a REIT. An experienced adviser will be able to handle all aspects of this transaction.

In sum, the DST combines flexible customization with institutional sophistication in a tax-efficient vehicle for savvy real estate investors looking for an alternative to simply rolling over into another piece of personally owned and operated real estate.

Think ‘best of both worlds’

While the traditional public REIT fails to enable a seamless 1031 exchange, both 721 exchanges/UPREITs and DSTs can bridge qualified investors into the stability, cash flow, appreciation and wealth preservation benefits of pooled large-scale institutional real estate investing.

For investors navigating the deployment of lump-sum capital gains from selling appreciated property, redirecting those gains into durable cash-flowing portfolios with the tax benefits of a 1031 exchange allows beneficial interest in assets that would otherwise demand deep expertise, even deeper pockets and disproportionate individual effort. Both vehicles blend the principal benefits of direct ownership with institutional access.

The ability to defer tax burdens into the future while still participating in stable value creation makes both the UPREIT and DST compelling solutions for shrewd investors contemplating redeployment of legacy investment proceeds.

Related Content

• Opportunity Zone Investing Still Hot Despite Looming Sunset
• Four Reasons to Tap Opportunity Zones Before They Expire
• 1031 Exchanges: A Matter of Life and Death?
• 11 Reasons to Consider a 1031 Exchange
• Delaware Statutory Trust: A Viable Alternative to Debt Replacement

When it comes to real estate investing, three of the most powerful tax-smart options include:

• Qualified opportunity zones (QOZs)
• Delaware statutory trusts (DSTs)
• Real estate funds

All three of these distinct real estate investment avenues can provide investors the unique opportunity to navigate tax implications while potentially maximizing financial gains.

Why is tax-smart investing so important for today’s investing landscape? Smart investors understand that by minimizing potential taxable events, they can capture significant financial advantages that range from enhancing returns to facilitating intergenerational wealth transfer.

How qualified opportunity zone funds work

One of the most overlooked tax-savvy investing vehicles is the qualified opportunity zone fund. QOZ funds were born out of the Tax Cuts and Jobs Act of 2017 and were designed to encourage long-term investments into low-income communities across the United States. QOZ funds invest in real property or operating businesses within an opportunity zone, typically a geographic region that has been designated as underserved or blighted. In some ways, QOZ funds can be considered a social investment designed to entice private capital to underserved communities.

Here are a couple of examples of how QOZ funds work:

• Example No. 1: Investors who receive capital gain income from the sale of any appreciated asset can reinvest this income within 180 days of the sale of the investment asset into a QOZ fund until the end of 2026 to successfully defer their capital gains taxes. That means investors don’t owe the IRS a penny on that income until April 2027.
• Example No. 2: Investors can potentially receive an even bigger benefit with QOZs by holding their investment for at least 10 years and a day. After this hold period, they don’t have to pay even a single penny in taxes on the profits they made over that 10-year span — no matter how large these profits are. As always, there are never any guarantees that a QOZ fund or any investment vehicle will appreciate in value.
  

What to beware of with QOZ funds

As great as QOZ funds sound, investors need to evaluate a project’s true investment potential before considering the tax benefits, especially since investors are typically required to keep their money locked up for at least 10 years in order to enjoy the full tax benefit. Like any real estate investment, there is no guarantee for cash flow, distributions or appreciation, and such an investment can result in the full loss of invested principal.

On the other hand, plenty of QOZ development projects are available, and because many of these locations were determined to be economically challenged areas based on the 2010 Census, it is very possible that some could be in economically improving neighborhoods.

How Delaware statutory trusts work

Delaware statutory trusts (DSTs) stand out as a tax-savvy choice for many investors. First, DSTs qualify as "like-kind" real estate for the purposes of a 1031 exchange. This alignment grants investors the opportunity to defer capital gains taxes upon selling an investment property. To realize the benefits, investors direct the proceeds from the sale of their property toward purchasing a DST to receive a beneficial interest in professionally managed, high-quality institutional real estate assets. For instance, think of a 300-unit multifamily building located in attractive, secondary markets such as Nashville, Raleigh-Durham, Charlotte or Denver.

Furthermore, DSTs may own properties leased by single tenants operating under long-term net leases, such as prominent companies like FedEx, Amazon or Walgreens.

Second, DSTs enable investors to potentially diversify their real estate holdings without triggering immediate tax liabilities. Because DSTs can include an entire portfolio of properties, investors can spread their investment across various assets, locations and industries to help reduce the risk associated with investing in a single property or market.

Third, DSTs can offer investors significant estate planning advantages by allowing investors to transfer ownership interests to heirs. One of the key tax advantages of passing real estate property to heirs is that those recipients benefit from a step-up in basis. This step-up in basis is much like hitting the reset button on a property's current market value. Furthermore, this step-up in value can represent a significant benefit for anyone who inherits a property that has seen even modest appreciation.

Risks associated with DSTs

DSTs contain the same risks that all real estate investing entails, such as ongoing vacancy, tenant bankruptcies, problematic tenants, economic downturns, physical damage and unexpected repairs. Bottom line: There are no guarantees in real estate.

Also, unlike stock shares and other liquid investments, which can be bought and sold relatively easily, real estate investments like DSTs typically cannot be sold in a day, week or even a month.

How real estate funds work

In general terms, any “fund” is simply a pool of capital that has been assembled on behalf of a group of investors to purchase assets. A real estate income fund is a specific subset of funds that is focused exclusively on investing in potentially income-generating real estate. They are particularly appealing to accredited investors who want to own institutional-quality real estate that may normally be out of reach. A real estate income fund’s sponsor oversees all the fund’s activities, including performing real estate review and analysis, underwriting and property management.

Real estate income funds also provide investors the potential for depreciation. This non-cash expense lowers the taxable income earned in the fund. This may hold significant benefits for investors in high-tax states such as California and New York.

In addition, investors can potentially receive interest deductions in real estate income funds by deducting interest expenses associated with a variety of components within the fund. These can include:

• Mortgage interest. Interest paid on loans or mortgages used to purchase, improve or refinance real estate properties within the fund.
• Operating expenses. Interest on loans used for operational expenses related to real estate, such as repairs, maintenance or renovations.
• Development loans. Interest incurred on loans for property development, construction or significant renovations within the fund.

In navigating the intricate landscape of real estate investing, embracing the nuances of tax-smart strategies is not just a choice, but a pivotal advantage. QOZs, DSTs and real estate funds are the trifecta of tax-savvy investment options. 

Regardless of what vehicle real estate investors decide to pursue, it is important to always consult with their CPA or tax attorney prior to investing in any of these options, as well as to read each offering’s private placement memorandum (PPM) for a full discussion of the business plan and risk factors.

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With certain key provisions in the Tax Cuts and Job Act set to begin expiring after 2026, investors face a closing three-year window to maximize the financial advantages baked into the QOZ cake. Yet several compelling factors still make opportunity zones highly favorable for near-term capital deployment — from proposed congressional extensions to specialty sector funds targeting major industries with footprints in qualifying regions.

Let’s examine what continues to make this arena an attractive avenue for tax-free wealth development, even as deadlines loom.

Core tax incentives driving opportunity zone investments

As many readers are aware, the QOZ program centers on three primary tax incentives for investors rolling existing capital gains from stocks, bonds, business sales, real estate, cryptocurrencies, etc., into qualified opportunity funds within 180 days from the realization of the gain. These funds then deploy those gains into qualifying real estate development or operating businesses located within Census tracts certified as low-income opportunity zones. The primary tax incentives driving investment since 2017 have been:

• Deferral of taxes due on the capital gains invested until December 31, 2026
• Permanent elimination of any taxes owed on appreciation of the opportunity zone investment if held for at least 10 years

A three-year tax deferral on capital gains taxes is certainly valuable but pales in comparison to the possibility of an investment that could potentially be entirely free of any capital gains taxes, provided it’s held for at least 10 years.

With over $10 billion already deployed into job-creating community revitalization projects nationwide, the QOZ incentive has seen tremendous traction since its bipartisan origins. However, with the deferral extension ending after 2026, investors looking to maximize value face a ticking clock that is set to sunset the program at the end of December of that year.

Unless …

Proposed legislation could potentially extend QOZs

On the political front, bipartisan efforts through the Opportunity Zones Improvement, Transparency, and Extension Act in Congress seek to strengthen and lengthen QOZ incentives by:

• Making permanent the tax-free appreciation provision for longer-term investments held over 10 years
• Extending capital gains deferral through 2028 — a two-year extension to drive continued near-term investments
• Empowering states to nominate new opportunity zones, based on updated 2020 Census information
• Allowing for qualified opportunity “funds of funds” by enabling a QOF to invest in other QOFs, a practice not permissible under current law

While an uncertain fate awaits in a bitterly divided Congress, it’s also true that Congress was no less divided in 2017 when the original legislation passed, so hope springs eternal. At any rate, the latest bill language signals a willingness by lawmakers to lengthen the most powerful tax provisions, even as parts of the statute are slated to expire after 2026.

The rise of specialized opportunity zone fund strategies

Irrespective of whether legislation can successfully extend the program’s existence, another recent development in the field should provide further incentive to initiate a QOF investment. In the past few years, more niche fund strategies have emerged, targeting specialized industries with major footprints overlapping counties containing certified QOZs. One in particular provides the rare chance to marry a timely investment opportunity to some of the most powerful tax incentives we’ve seen in a generation or more. We’re speaking, of course, about oil and gas QOFs.

In prolific oil states like Texas, specialized QOFs tailor capital raising and asset allocation specifically to the energy sector. The very best funds feature veteran management teams and focus on financing infrastructure or providing expansion/acquisition growth capital to services contractors that are opening new operations in qualifying counties.

The timing couldn’t be better. Despite (or perhaps because of) the proliferation of interest in electric vehicles, a perceived reduction for the need of fossil fuels has led to a sharp reduction in exploratory activity. And as predictably as the rising of the morning sun, demand is now outstripping supply in the oil and gas sector. Perhaps we’ll all be driving battery-operated, windmill-powered cars in the future, but that future is decades away, and here in 2024, the need for fossil fuels is actually increasing, not falling!

Enter these energy-focused QOFs, which allow accredited individuals and institutions to strategically deploy capital gains into tangible drilling, midstream or production assets, while contractually anchoring those assets and activity back into still-recovering communities vulnerable to recurrent industry volatility cycles. As recovering oil regions expand production rapidly among ongoing global supply deficits, new investments in these niche funds could well enjoy embedded exponential growth potential. And all with the sweetener of QOZ benefits like tax-deferred ... or tax-free ... compounding growth!

Compelling reasons to act through late 2026 … and beyond?

Oil-and-gas-targeted qualified opportunity zone funds exemplify sector-specific channels remaining open for those looking to align financial objectives of maximal growth and minimal taxes with outsized social returns on investment. Of course, gains are never guaranteed in the oil and gas sector or in any other investment, and the need to work with an experienced financial team to identify the proper QOF opportunities just can’t be overstated.

While uncertainty hangs over the exact duration of QOZ advantages, compelling reasons persist for qualified investors to put eligible capital gains to work via this program both in 2024 and over the next few years. The confluence of still generous existing tax benefits through 2026, future upside from potential incentive extensions, intergenerational tax exemption on appreciation and sector-specific fund strategies keep opportunity zones offering outsized exposure to burgeoning markets.

Investors just learning about QOFs might think they’ve missed the boat. In fact, while the ideal time to invest in QOFs may have been in 2017, the next best time is right now.

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Tax-loss harvesting is generally considered an end-of-year planning strategy. However, there are opportunities throughout the year to thoughtfully manage your gains and losses in order to plan for your year-end tax bill. Work with your financial adviser to continually review your portfolios and consult your accountant to understand if tax-loss harvesting is appropriate for your situation and you can fully benefit from it.

If you would like to consider tax-loss harvesting, here are a few things to keep in mind.

Tax-loss harvesting basics

When you sell a security at a price higher than you paid for it, you realize a capital gain. Generally, realized gains will be subject to capital gains taxes. Tax-loss harvesting is a strategy to sell securities that have a loss (that is, their current price is less than you paid for them) and use those losses to offset gains on other investments. If done properly, tax-loss harvesting can effectively reduce or eliminate the capital gains tax incurred on realized gains in the same tax year.

In addition, if you have more realized capital losses than realized capital gains in a tax year, you can use up to $3,000 of unused losses to offset ordinary income. You can then carry forward any remaining unused losses to use against future capital gains.

The wash sale rule

Many investors may look to take advantage of unrealized losses in securities they would still like to own. However, if you would like to take advantage of a tax-loss harvesting strategy, you must be careful to not trigger a wash sale, which could disallow your loss in the year it is realized.

A wash sale occurs when you sell an investment at a loss and then purchase the same investment or one that’s “substantially identical” within 30 days before or 30 days after the sale date, excluding the sale date. For example, if you are selling a stock at a loss and then purchase the same stock, a call option of the same stock or a security that is similar enough to the stock you sold, you can trigger a wash sale.

If a wash sale occurs, taxpayers will be prohibited from claiming a loss on the sale in the year it’s realized. Instead, the loss is deferred until you sell the replacement security. You should consult with a qualified tax professional to help determine whether a replacement security may be “substantially identical” to the one you sold.

How to avoid triggering a wash sale

If you’re planning to take advantage of a tax-loss harvesting strategy, it’s very important to be mindful of the 61-day window for triggering a wash sale as you make your investment decisions. For example, if you sell a stock at a loss on January 1, you would have needed to purchase that stock or any substantially identical security before December 2 (of the prior year) or after January 31 to avoid a wash sale.

Purchasing the same or substantially identical security in a different account, for example an IRA, is still a wash sale. If you have multiple accounts, including professionally managed accounts, it’s especially important to keep the wash sale rule in mind. If you sell a security at a loss in one account and your money manager purchases that security in a separate account within the 61-day period, it would trigger a wash sale.

There are a couple approaches that can keep you exposed to the market without triggering a wash sale:

• You can “double up” on the security more than 30 days before you intend to sell it (and keep the newly purchased portion)
• You can wait at least 30 days after you sell a security before you repurchase it
• You could purchase a substitute security for a company in the same sector that may trade similarly, but is not deemed to be substantially identical by the IRS. For example, if you sell one beverage company stock at a loss and buy a different beverage company stock to replace it, this would not be a wash sale as long as the companies are not otherwise linked
• You could sell a stock and then purchase a mutual fund or ETF that covers that stock’s sector, and it would not be a wash sale, even if the stock is owned by the fund

Ultimately, you should consult with your tax advisers to determine whether you are at risk for triggering a wash sale and undoing any tax-loss harvesting plans you have in place.

The views, opinions, estimates and strategies expressed herein constitutes the author's judgment based on current market conditions and are subject to change without notice, and may differ from those expressed by other areas of J.P. Morgan. This information in no way constitutes J.P. Morgan Research and should not be treated as such. You should carefully consider your needs and objectives before making any decisions. For additional guidance on how this information should be applied to your situation, you should consult your advisor.

JPMorgan Chase & Co., its affiliates, and employees do not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transaction.

J.P. Morgan Wealth Management is a business of JPMorgan Chase & Co., which offers investment products and services through J.P. Morgan Securities LLC (JPMS), a registered broker-dealer and investment adviser, member FINRA and SIPC.

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Folks may be wondering how to avoid capital gains taxes altogether. The short answer is that you likely can't. Indeed, the vast majority of retail investors are unable to sidestep the tax man completely. 

However, with a few subtle but important changes to your investing strategy, you may be able to reap significant tax deductions. Put another way, you could walk away with bigger profits than anticipated as the money stays in your pocket instead of going into Uncle Sam's coffers.

How much will I pay in capital gains taxes?

If you're wondering what investments qualify for capital gains taxes, the answer is quite simple. 

According to current Internal Revenue Service (IRS) policies, "(a)lmost everything you own and use for personal or investment purposes is a capital asset." That includes stocks, bonds and exchange-traded funds (ETFs), but also other non-traditional investment assets including physical real estate properties or even cryptocurrencies like bitcoin. 

But while a broad array of investments qualify for capital gains taxes on their returns, the rate at which you are taxed depends on two main categories: The amount of time you have owned the underlying investment and your taxable income bracket.

If you hold the asset for less than one year before you sell, it is a short-term investment for capital gains tax purposes. This means your profits are taxed as ordinary income just like a paycheck. The 2023 short-term capital gains rates for those income tax brackets are as follows according to the IRS.

• 37% for individual single taxpayers with incomes greater than $578,125 ($693,750 for couples filing jointly)
• 35% for incomes over $231,251 ($462,501 for couples filing jointly)
• 32% for incomes over $182,101 ($364,201 for couples filing jointly)
• 24% for incomes over $95,376 ($190,751 for couples filing jointly)
• 22% for incomes over $44,726 ($89,451 for couples filing jointly)
• 12% for incomes over $11,001 ($22,001 for couples filing jointly)

Long-term capital gains rates, however, can be significantly lower – all the way down to zero. According to the IRS:

• A capital gains rate of 0% applies to those single filers with taxable income of up to $44,625, or $89,250 for investors who are married and filing jointly
• A capital gains rate of 15% applies if your taxable income is more than $44,625 but less than $492,301 for single filers, or more than $89,250 but less than or equal to $553,850 for married couples that file jointly

Anyone above that 15% tax threshold is taxed at a 20% long-term capital gains tax rate – a higher measure, but still less than all but the lowest of all the ordinary income tax brackets. You can find the 2024 capital gains tax rates here.

Dividend tax rates mirror these long-term capital tax rates, so long as they are "qualified dividends." This can sometimes be hard to pin down, but if you're invested in a mainstream asset such as blue chip stock Apple (AAPL) and you have been for a few months, you have qualified dividends. But other less straightforward profit-sharing deals such as dividends on employee stock options or payments from a foreign investment may be "unqualified" and considered "ordinary dividends." 

Always read the fine print on dividends to get the details on tax treatment because in this case it has less to do with your behavior as an investor and more to do with the underlying status of the investment itself.

Unqualified dividends are taxed as ordinary income, just like short-term capital gains, which can be a much higher rate.

How to reduce or avoid capital gains taxes

There may be a small group of investors who don't have much cash and fit into that lowest tax bracket of 0%. But chances are that if you make less than $40,000 a year, you don't have much spare cash to invest in the stock market.

This means the vast majority of us likely fall into the 15% bucket for capital gains taxes – so long as we hold assets for a year plus one day or longer. That lower long-term capital gains tax rate is a way to incentivize investors to buy and hold.

It's also important to acknowledge that gains are not calculated on a position-by-position basis. Your capital losses can offset your capital gains. Put another way, if you achieve a $1,000 investment profit on one asset, you can offset potential taxes by locking in a $1,000 loss on a different investment to net out your capital gains to zero.

These capital losses can also be carried forward to the next tax year, too, if you have a particularly bad run and wind up locking in more losses than you do gains. 

This requires a bit of extra paperwork, including the Capital Loss Carryover Worksheet provided by the IRS, but could be a useful way to ensure next year's profits aren't undercut by taxes.

To be clear, you should never trade investments solely because of capital gains tax risks. Even a 37% haircut on a massive gain is better than a loss locked in just to thwart the IRS. But considering the differences in the tax brackets and the potential for significant capital gains tax savings, all investors should inform themselves about how their behavior can change their investment tax burdens and take that into account along with everything else.

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