^{April 18, 2024 | Reading Time: 8 Minutes}

Opportunity zones, Delaware statutory trusts and real estate income funds can help investors maximize gains and mitigate taxes.

Historically, tax-smart investing has proven to be a robust strategy for real estate investors. Essentially, it focuses on utilizing diverse investment strategies and vehicles to potentially enhance returns while simultaneously reducing tax liabilities.

When it comes to real estate investing, three of the most powerful tax-smart options include:

• Qualified opportunity zones (QOZs)
• Delaware statutory trusts (DSTs)
• Real estate funds

All three of these distinct real estate investment avenues can provide investors the unique opportunity to navigate tax implications while potentially maximizing financial gains.

Why is tax-smart investing crucial in today’s investing landscape? Smart investors recognize that by minimizing taxable events, they can unlock substantial financial benefits, ranging from boosting returns to facilitating intergenerational wealth transfer.

How qualified opportunity zone funds work
One of the most overlooked tax-savvy investing vehicles is the qualified opportunity zone fund. QOZ funds were born out of the Tax Cuts and Jobs Act of 2017 and were designed to encourage long-term investments into low-income communities across the United States. QOZ funds invest in real property or operating businesses within an opportunity zone, typically a geographic region that has been designated as underserved or blighted. In some ways, QOZ funds can be considered a social investment designed to entice private capital to underserved communities.

Here are a couple of examples of how QOZ funds work:

Example No. 1: Investors who receive capital gain income from the sale of any appreciated asset can reinvest this income within 180 days of the sale of the investment asset into a QOZ fund until the end of 2026 to successfully defer their capital gains taxes. That means investors don’t owe the IRS a penny on that income until April 2027.

Example No. 2: Investors can potentially receive an even bigger benefit with QOZs by holding their investment for at least 10 years and a day. After this hold period, they don’t have to pay even a single penny in taxes on the profits they made over that 10-year span — no matter how large these profits are. As always, there are never any guarantees that a QOZ fund or any investment vehicle will appreciate in value.

What to beware of with QOZ funds
As great as QOZ funds sound, investors need to evaluate a project’s true investment potential before considering the tax benefits, especially since investors are typically required to keep their money locked up for at least 10 years in order to enjoy the full tax benefit. Like any real estate investment, there is no guarantee for cash flow, distributions or appreciation, and such an investment can result in the full loss of invested principal.

On the other hand, plenty of QOZ development projects are available, and because many of these locations were determined to be economically challenged areas based on the 2010 Census, it is very possible that some could be in economically improving neighborhoods.

How Delaware statutory trusts work
Delaware statutory trusts (DSTs) qualify as “like-kind” real estate for 1031 exchanges. This designation enables investors to defer capital gains taxes when selling an investment property. To capitalize on this benefit, investors redirect proceeds from property sales towards acquiring a DST interest, gaining access to professionally managed, high-quality institutional real estate assets.

Moreover, DSTs may own properties leased by single tenants operating under long-term net leases, including notable corporations such as FedEx, Amazon, or Walgreens.

Second, DSTs allow investors to potentially diversify their real estate portfolios without triggering immediate tax liabilities. With the capacity to encompass a portfolio of properties, DSTs enable investors to spread their investments across various assets, locations, and industries, thereby mitigating risks associated with investing in a single property or market.

Third, DSTs offer significant estate planning benefits by facilitating the transfer of ownership interests to heirs. Passing real estate assets to heirs comes with a key tax advantage—a step-up in basis. This adjustment resets the property’s current market value, providing a substantial benefit to heirs inheriting properties that have experienced even modest appreciation.

Risks associated with DSTs:
DSTs carry inherent risks synonymous with all real estate investments, including persistent vacancy, tenant bankruptcies, troublesome tenants, economic downturns, physical damages, and unforeseen repairs. This real estate investment offers no guarantees.

Furthermore, unlike stocks and other liquid investments that can be swiftly bought and sold, real estate investments such as DSTs usually lack the liquidity to be sold within a day, week, or even a month.

How real estate funds work
In broad terms, a “fund” represents a collective pool of capital amassed on behalf of a group of investors for asset acquisition. A real estate income fund, a distinct subset of funds, focuses exclusively on investing in potentially income-generating real estate. These funds hold particular appeal for accredited investors seeking access to institutional-quality real estate that might otherwise be beyond their reach. Oversight of a real estate income fund’s operations lies with its sponsor, who manages activities ranging from real estate assessment and analysis to underwriting and property management.

Moreover, real estate income funds offer investors the opportunity for depreciation. This non-cash expense serves to decrease the taxable income generated within the fund. Such a feature may yield significant advantages for investors residing in high-tax jurisdictions like California and New York.

In addition, investors can potentially receive interest deductions in real estate income funds by deducting interest expenses associated with a variety of components within the fund.

These can include:

• Mortgage interest. Interest paid on loans or mortgages used to purchase, improve or refinance real estate properties within the fund.
• Operating expenses. Interest on loans used for operational expenses related to real estate, such as repairs, maintenance or renovations.
• Development loans. Interest incurred on loans for property development, construction or significant renovations within the fund.

In navigating the intricate landscape of real estate investing, embracing the nuances of tax-smart strategies is not just a choice, but a pivotal advantage. QOZs, DSTs and real estate funds are the trifecta of tax-savvy investment options.

Regardless of the real estate investment avenue chosen, it’s crucial for investors to consult with their CPA or tax attorney before committing to any of these options. Additionally, thoroughly reviewing each offering’s private placement memorandum (PPM) is essential for gaining a comprehensive understanding of the business plan and associated risk factors.