Passive Real Estate Investing and Capital Gains Tax | The Peak Group

While the residential real estate market has carried through the COVID-19 crisis, the same could not be said for the commercial sector. With certain major metropolitan areas looking at a property value drop as steep as 30% in some cases, investors who have chosen to diversify their portfolio using passive real estate investing are anxious. Watching the impact of social distancing and the rise of the work-from-home workforce on commercial assets has certainly been a blow.

If you invested primarily in residential real estate, you’re probably breathing a sigh of relief that the housing market has continued to remain stable during these confusing—and, in some cases, outright stressful—times. Now that restrictions are starting to lift again on the showing and sale of real estate, you might be thinking: now is the ideal time to cut ties to your portfolio. This is especially relevant for investors who find themselves in a “house rich, cash poor” scenario where most of your assets are illiquid—meaning they are mainly out of reach should you need to tap into them.

However, if you’re planning on offloading your portfolio, you’ve likely encountered a serious roadblock in your considerations a la the capital gains tax. If you haven’t thought about this element yet, we’re here to tell you why you should be focusing on how to defer capital gains tax with any moves you plan to make regarding your portfolio.

Side view of african american businessman gesturing near businesswoman in glasses sitting on chairWhy You Should Seek to Defer Capital Gains Tax

As an investor in residential real estate, you’ve built a kind of “equity empire.” Owning and holding land is one of the oldest and most secure forms of achieving wealth. Whether it was the kings of the past or the tycoons of our modern present, all acknowledge that property (and by default, land) were the primary means by which families rose to prosperity. However, kings likely didn’t have to contend with taxes on their own land—which is why we need modern strategies today to defer capital gains tax.

When you look for strategies to defer capital gains tax on the sale of your properties, you’re essentially seeking an option to shelter all you’ve earned from taxes that gouge into the developed equity and value of the properties you’ve purchased. At its worst, you can expect losses upwards of 20% across your appreciated portfolio. If you have five properties, that’s like giving the government a “buy four, get one free” deal on what you’ve worked so hard to build. This is why we support investors at The Peak Group who are looking for options on how to defer capital gains tax: you deserve to keep more of what you’ve earned through passive real estate investing.

Unfortunately, there are several reported ways to defer capital gains tax, but few are genuinely ideal for investors’ needs when you need immediate access to your assets. The best way to show you why is to outline the flaws of a few of the methods available before we get to the meat of what works.

Avoid the Following Strategies

The two approaches we’re about to outline are similar to one another in that they defer capital gains tax—but they don’t help you sever your connection to your portfolio.

The Section 1031 Exchange

This is probably the more widely-explored method, having existed in our tax code in some form since 1921. A 1031 exchange allows investors to defer capital gains tax when the proceeds from a sale are used as part of a “like-kind exchange.” Essentially, investors trade one portfolio for another while a certified intermediary holds onto the proceeds.

This could introduce some much-needed diversity into your portfolio geographically if that’s what you’re truly after; this approach will also defer capital gains tax. However, if you’re trying to parse your properties into easily accessible capital, this won’t do the trick. If you’re looking for increasing diversity and ready access to what you’ve earned, then you’ll love the final method we’ll explore in today’s article! However, before we get to the good news, we have to finish assessing the bad.

Using “Opportunity Zones”

This is a relatively new player in the tax field: it was introduced as part of the Tax Cuts and Jobs Act of 2017, which went into effect during the 2018 fiscal year. The language in this legislation allowed investors who reinvested their capital gains into specially-designated, low-income “opportunity zones” to defer capital gains tax until the year 2026 (or as long as they hold this new property). It also allowed them to reduce or eliminate their tax liability over time, depending on the number of years they continued to hold the reinvestment.

Not only is this method limited by government-selected zones, but it ensures you’ll be retaining and maintaining your investment properties for a long time under this structure. Ultimately, if you’re ready to enjoy what you’ve built, this is not the strategy for you.

Cropped image of african american man using tabletChoose What Works for You—Not Against You

Keep in mind; the above were just two strategies among many more that simply don’t offer investors the approach they need to defer capital gains tax and preserve what they enjoy about passive real estate investing. Thankfully, there’s a superior method for investors who want access to the following benefits:

  • You want to maintain a hold on the reliable income you’ve come to appreciate from buying and holding residential real estate.
  • You appreciate the stability of residential real estate when it comes to your portfolio and any of your riskier investments.
  • You want to defer the capital gains tax you might experience on a hard sale, but you still want to tap into the cash value of the properties you own.

If any of these apply to you, you’ll want to turn your focus to REIT investing.

REIT investing allows investors to tap into all of the above benefits—and then some—when they convert their portfolio of properties into operating units in the UPREIT structure. At The Peak Group, we recommend an UPREIT structure for investing over a DownREIT structure simply because it is far easier for investors to navigate. The last thing you need when trying to leave your portfolio behind is more complications.

Thankfully, you also don’t have to try and walk this path alone. The Peak Group was formed by investors for investors: we’ve been where you are, and it’s why we sought better solutions to defer capital gains tax. If you’re interested in learning more about how to put this type of REIT investing structure to work for you, get in touch with us! We’re always happy to help guide other investors toward true financial freedom.