Tax Planning Structures
By Richard Hillson
Qualified Opportunity Zones (“OZs”) have been at or close to the top of the most interesting and topical conversation list for a while now. Many predicted that amidst all the proposed tax legislation changes last year, that OZs would have their benefits extended. This did not happen, but there is now legislation in the pipeline which may revisit this. Either way, OZs remain a very compelling tax advantaged investment structure.
This seems like a perfect opportunity to examine 3 tax planning tools which are being used more and more regularly in portfolio construction.
Firstly, let’s start with a recap of OZs.
OZs were introduced in the Tax Cuts and Jobs Act of 2017, offering tax relief to encourage investment in areas requiring stimulus. In 2018 there were some 8,700 census tracts deemed as OZs.
If a capital gain was invested into an OZ investment and certain parameters were met, several tax incentives were offered:
- 15% reduction if invested by end of 2019, through a stepped-up basis
- 10% reduction if invested by end of 2021
- Deferral of payment of tax on gains to end of 2026
- If the investment is held for 10 years or more, the growth from within the OZ investment is tax free
For clients, these incentives may be very compelling. It is not just the tax-free growth but the growth on the gross amount until end of 2026 - rather than the amount net of what would have been paid to the IRS.
Earlier this year, the Opportunity Zones Transparency and Improvement Act was proposed and co-sponsored by Cory Booker, amongst others. Some of the provisions are as follows:
- Extending the tax deferral for 2 years to 2028
- Expanding reporting requirements
- Permitting fund of funds structures
- Potential for recategorization of some areas - removal and addition of QOZ status
For advisors, the extension of the tax deferral date is huge, allowing another 2 years of gross amount growth within the fund, the growth is then also tax free, a compound benefit.
Additionally, an expanded reporting requirement is always welcome on the client side. It helps us all with our due diligence and deterring bad actors in a crowded space.
1031 Exchange Delaware Statutory Trusts
The origins of the1031 Exchange date back to 1921 when the first like-kind tax deferral structure was written into law. The 1031 Exchange has survived in various iterations where today it permits a taxable capital gain to be deferred in an exchange for a like-kind asset. The most common type of transaction we see nowadays is a sale of land and a purchase of land within a permitted window of time, any taxable gain being rolled into the new property.
A Delaware Statutory Trust or DST is essentially a home for the entire or partial proceeds of a 1031 exchange. The structure is typically a fractional interest in a pooled real estate investment which can be single of multi property.
The most common examples where a DST can be extremely useful for clients are:
- A client no longer wishes to be a hands-on landlord and therefore a passive investment, collecting a yield is appealing
- There is a difference between the sale proceeds and purchase proceeds. For example, the client sells a property for $1 million and buys a new one for $800k. $800k flows through the property-to-property 1031 Exchange and the remaining $200k would be taxable. This could be invested into a DST, deferring the capital gains tax.
- A client needs a back-up in case their own real estate transaction fails to close within the permitted exchange window. The client is permitted to list 3 properties when declaring their options for the 1031 Exchange.
There are numerous benefits to the client in using a DST. The most important for the majority of investors is earning yield or capital appreciation within the DST on the gross amount, rather than a smaller amount, net of taxes. The growth, however, is not tax free within a DST.
IRC Section 721, the Umbrella Partnership Real Estate Investment Trust (UPREIT) allows an exchange of real estate for operating units in a REIT while deferring tax. The operating units can later be converted into REIT common shares. In most cases, the taxable event occurs upon the ultimate sale of the stock.
The UPREIT transaction in its simplest form can be seen as a 1031 Exchange but without the sale to a third party and deferral into a new property – more simply rolling one’s property into the REIT. In some cases, an owner of DST interests will 721 into common shares of the REIT at a later date.
This is not an exhaustive list, but let’s look at 3 reasons and advisor might recommend this to a client:
- Liquidity - with this transaction, a client turns an illiquid single asset into units in a potentially more liquid structure. This can help stagger a tax burden over several years rather than one sale
- Diversification – a single property is now an interest in a diversified multi property fund
- Estate planning – fractional units are easier to split between multiple heirs than a single property
A “need to have, not a nice to have”
Having some options for these structures for clients is not a “nice to have” but a “need to have”!
- There are multiple reasons advisors should have some options available to clients in the above 3 structures:
- If competitors have these solutions and you do not, you are at a serious disadvantage
- Clients are much more knowledgeable nowadays and will demand this kind of product
- Structures such as OZs and DSTs may help in attracting larger and more sophisticated clients
- This has the potential to bring more assets under your management
- This is a true example of a solution matching a real need
Advisors and clients need to be savvy about these kinds of structures. I talk a lot about the importance of education, in fact, I bang the table about this to the point of exhaustion. The industry is doing a much. better job of educating advisors and BD reps about asset classes rather than simply product specific sales talk. If you, the advisor needs to learn more about anything mentioned above then thankfully, resources are available to you. A sponsor should always be available to help you understand the structure, as is Hillson Consulting to help you understand and navigate what can be a complex space.
Hillson Consulting is a boutique investment consultancy founded by financial services entrepreneur Richard Hillson. The company helps independent advisors enhance and improve their offerings and drive revenue through alternative investments. HC also works with product sponsors to help them with education and access within the independent RIA channel.