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Strategic Tax Mitigation: Unveiling Opportunities in Real Estate through 1031 Exchanges and QOZ Investments

By Joseph Carey, CFA®
Alternative Investment Strategist

Navigating a diverse and intricate array of individual financial situations often transforms the mitigation of tax burdens into more of an art than a science. Beyond the conventional practice of tax-loss harvesting in public portfolios, alternative tax-aware solutions exist for distinctive circumstances, proving advantageous when appropriately applied. In the realm of private Real Estate, two notable avenues are the 1031 Exchanges and Qualified Opportunity Zones (“QOZ”).

For individuals actively managing real estate properties, such as rental properties, an exploration of 1031 Exchanges becomes compelling as it allows the deferral of capital gains taxes when exchanging one investment property for another of like kind. This opportunity permits capital to remain invested in the asset class without triggering a taxable event, while enabling the replacement of the existing asset with one that may offer superior quality or preferred real estate exposure. Variations of 1031 Exchanges, including active participation, a hybrid approach, or a complete relinquishment of control event, exist. Our preference lies in the latter, a focus that could significantly alter the risk profile of an investor’s real estate exposure, offering the prospect of perpetually tax-advantaged growth until liquidation. These strategies also prove compelling for estate planning, as they may facilitate a step-up in basis for the beneficiary at the time of death.

While 1031 Exchanges present an appealing tax-deferred option, they are limited to investors with embedded capital gains in directly owned investment property. For those individuals who have recently sold a business, a second home, or an impressive art collection, an alternative tax-advantaged solution may lie in an investment in a QOZ Fund. QOZs present a unique opportunity to channel realized capital gains into real estate within economically underserved communities, offering multiple tax incentives, including the deferral of original capital gain taxes until December 31, 2026, and a step-up in basis for investments held for 10+ years. Consulting with a Financial Advisor is advisable in these cases, as they can provide guidance on thoughtfully allocating capital gains into these funds, potentially spreading tax liabilities and creating an allocation to institutional private real estate on a tax-advantaged basis.

Depending on various factors, these investments may or may not align with everyone’s specific interests when discussed comprehensively with their advisor. Nonetheless, by expanding the financial toolkit, individuals can be introduced to unique opportunities that may lead to tax-advantaged growth or more resilient portfolios. As we approach 2024, consider this as an opportune moment to engage in discussions about tax strategies with your advisor.

The information contained herein is for informational purposes only and should not be considered investment advice or a recommendation to buy, hold, or sell any types of securities. Financial markets are volatile and all types of investment vehicles, including “low-risk” strategies, involve investment risk, including the potential loss of principal. Past performance does not guarantee future results. For details on the professional designations displayed herein, including descriptions, minimum requirements, and ongoing education requirements, please visit Signature Investment Advisors, LLC (“SIA”) is an SEC-registered investment adviser; however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. Securities offered through Signature Estate Securities, Inc. member FINRA/SIPC. Investment advisory services offered through SIA, 2121 Avenue of the Stars, Suite 1600, Los Angeles, CA 90067, 310-712-2323.