Tax planning options are varied and complex — almost as if they were designed with some sort of mischievous intent. The Internal Revenue Code is a labyrinth of hard-to-decipher regulations intended to minimize tax sheltering and avoidance. Books could be written about the complexities — if it weren’t that those books would be out of date by the following tax year.
We at Cherrytree would like to help in a somewhat limited, precise fashion. This post will look at and compare a tax deferral strategy most commonly known as a 1031 Exchange with the real estate development tax credit known as the Investment Tax Credit.
In a 1031 Exchange, a seller of property is able to defer the capital gains on the sale by purchasing a like-kind property within a defined time period utilizing a qualified intermediary. It’s a time-honored tactic used by thousands of real estate developers and investors.
An Investment Tax Credit is earned by investment in ways that serve the public good; say, the creation of renewable energy or the rehabilitation of historic buildings. Although tax credits have been around since the 1970s, they have mostly been used by financial institutions and large corporations. However, their use by individuals has blossomed over the past decade.
We won’t dig into too many technical details in this post, but we’d like to compare the pros and cons of these strategies so you will be able to identify which approach — or approaches — might be right for you.
It is important to keep in mind that a tax credit is a dollar-for-dollar direct offset against taxes owed. In a like-kind exchange, the taxes are not offset but rather are deferred. Although sometimes parties could engage in multiple like-kind exchanges with the objective of deferring tax liability beyond death to achieve a stepped-up basis, in most cases taxes are deferred until a later time but ultimately those taxes will be due and payable. Given those conditions, a tax credit would seem to be a preferable tool, but note that a like-kind exchange will defer the entire taxable amount whereas a tax credit will generally provide a tax savings.
The conclusion here is that a tax credit may be a viable tax planning strategy when a 1031 like-kind exchange is not an option, or when a party is unable to effect a 1031 like-kind exchange.
Comparing the strategies with an example might help. Here’s a theoretical scenario for a 1031 Like-Kind Exchange:
Sam is selling his building to Paula for $2 million. Sam has owned the building for 10 years and has an adjusted basis in the property of $800,000. This means Sam is faced with a long-term capital gain of $1.2 million. Assuming a long-term capital gain tax rate of 25%, the resulting tax bill would be $300,000. If Sam identifies a like-kind property within 45 days, keeps his gains on the sale of the building in escrow with a qualified intermediary and closes on the like-kind property within 180 days, that $300,000 tax bill may be deferred.
Now let’s look at the same scenario with a Tax Credit strategy:
The sale is completed, resulting in a $300,000 tax bill for Sam. As Sam is a real estate professional, he is exempt from the passive loss rules and his taxable gains are considered to be derived from passive sources. Therefore, he can utilize the investment tax credit as a direct dollar-for-dollar offset against his Federal taxes (assuming he satisfies the at-risk rules). Now, if Sam invested in a project that completed a qualified rehabilitation of a historic building and generated a tax credit of $300,000 he could use that tax credit to offset his tax bill. To obtain the $300,000 tax credit, assuming current market trends, fees, costs, and expenses, Sam would invest $255,000 and would receive a cash return of approximately $30,000 for a net investment of $225,000, or a total return of $75,000. That works out to a 25% ROI on money that would otherwise be paid to the Federal Government.
Let’s compare the two strategies:
With the 1031 exchange the tax is deferred but the gains of $1.2 million are rolled over into a new property and are not available to Sam. Also, there will be a cost to Sam to effect the 1031 exchange and subsequent exchanges to keep up the deferral, which will be costs out of his own pocket.
Conversely, the tax credit costs are generally built into a tax credit transaction. Obtaining the tax credit has resulted in Sam paying a net $225,000 of the $300,000 tax bill generated from the $1.2mm gain, realizing a reduction in his net tax rate from 25% to 18.75%.
This post does not suggest that one strategy is always optimal or preferable. But if a 1031 exchange is not available, achievable, or in circumstances where payment of a reduced tax bill is preferable to deferring the ultimate payment of the taxes; then a tax credit investment may be an attractive and viable consideration.
And allow us to go one step further with our scenario:
Sam is a real estate professional. While “trading buildings” may play a part in his continuing business strategy, identifying new opportunities and developing them into something worthwhile is something he loves to do. To have the vision to identify potential tax credit-eligible initiatives, and to execute them in such a way so they are likely to become even better dollar-for-dollar investments, then Sam will have created the type of setting which would make any of us want to hop out of bed to go to work in the morning.
Warren founded Cherrytree in 2011 and has spent the past eleven years building a highly specialized tax credit consultation, brokerage, and syndication firm. He has relied on three decades of experience and a law background to focus on the structural and development finance aspects of tax incentivized real estate-based transactions — particularly in the environmental remediation (Brownfields), renewable energy, and historic rehabilitation areas.