Deferred tax liability is a key concept for real estate investors. Unfortunately, it’s not an easy one to understand or manage effectively.
This article will dig into how deferred tax liability works, and we’ll provide some strategies you can use to keep your IRS bill as small as possible.
What Is Deferred Tax Liability?
The term deferred tax liability refers to a gap between what your accounting books say an item is worth and what the tax laws say the item is worth. The discrepancy may be temporary, but it doesn’t go away. In time, you may be required to fix it with a tax bill.
The following issues could result in a deferred tax liability for you or your business:
Depreciation
Many companies use depreciation to lower the earnings used to calculate their taxes. For example, you might use this method to cover the wear and tear of your property.
For example, your accountant might use depreciation to reduce the building’s value on your books from $55,000 to $50,000. However, tax rules allow for a $10,000 deduction, creating a temporary difference between your books and the tax liability of $5,000.
Capital Gains
Capital gains are taxes you owe when you make a profit on the sale of a capital asset. After the sale of a property, you may record a financial gain that represents only the purchase price. However, the IRS may allow you to deduct expenses associated with the property’s repairs or improvements. This gap between what you’ve recorded and what you can deduct could mean a tax liability.
Amortization
You may spread the cost of an asset (like your loan origination fees) over what accountants call the property’s “useful life.” That step can reduce the asset’s value on your books. However, tax laws might allow you to deduct all of the costs in the year they’re incurred.
For example, you may pay a $5,000 origination fee when you purchase the property. Your accountant amortizes this cost over five years, expensing at $2,000 per year. But the tax laws allow you to deduct the entire $5,000 in the year it was paid. You have a temporary difference of $3,000. When you sell, you may have to pay taxes on the full unamortized value.
Strategies for Managing Deferred Tax Liability
Managing your deferred tax liability is crucial, and you have several options available to do so. Here’s what you need to know about each one.
1031 Exchanges
In a 1031 exchange, you swap one property for another of a similar value. You must choose the replacement property within 45 days, and the sale must be finished within 180 days. These timelines are strict.
This method allows you to keep your equity in total rather than paying capital gains on the sale and (potentially) losing a third of your money in a big tax bill. If you’re worried about issues like depreciation or capital gains, this could be a smart move.
Opportunity Zones (QOZ)
An opportunity zone is typically inside a distressed community that desperately needs outside investors. If you purchase a property in a zone like this, you could defer eligible gains (including capital gains).
Unlike a 1031 exchange, you’re not required to trade to participate. However, you have 180 days from the sale of the asset to invest the capital gain dollars into a qualified opportunity fund, which then invests in the QOZ property.
The rules are tricky, but this method could help you avoid tax liabilities associated with capital gains, depreciation, or amortization.
Installment Sales
An installment sale is a property sale that takes place over time. You’ll take at least one payment after the tax year of the sale and then more in the years that follow. The income is included each year in your taxes. With this method, you pay taxes over time instead of all at once.
This method can’t help as much as the others we’ve mentioned, but it can help you reduce the tax burdens you’ll pay when you purchase a large property.
Making Informed Decisions
Crafting a strategy that’s right for your risk tolerance, tax bracket, and goals is critical, and it’s very difficult to do this without help. With the right assistance, this process can be greatly simplified.
At My 1031 Pros, we specialize in 1031 exchanges. If you’re looking for a way to manage deferred tax liability in real estate, this approach could be just right for your situation.
When you work with us, we’ll explain how these transactions work, and we can handle all of the details if you choose to move forward with one. Contact us to set up a conversation today.
References
Publication 946 (2023), How to Depreciate Property. (February 2024). Internal Revenue Service.
Topic No. 409, Capital Gains and Losses. (January 2024). Internal Revenue Service.
About Form 4562, Depreciation and Amortization. (December 2023). Internal Revenue Service.
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
Opportunity Zones Frequently Asked Questions. (February 2024). Internal Revenue Service.
Topic No. 705, Installment Sales. (February 2024). Internal Revenue Service.
Like-Kind Exchanges - Real Estate Tax Tips. Internal Revenue Service.
2023 Instructions for Form 8824. (2023). Department of the Treasury, Internal Revenue Service.
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