Step One | Discerning triumph over inadequacy

As a general principle the reallocation process may be an excellent opportunity to analyze your overall stock and bond portfolio with a trusted advisor. It may be that individual stocks and/or mutual funds have not lived up to their expected income or growth potential and could be divested. The process of eliminating losers from the portfolio may provide greater realized losses at disposition that may be helpful in providing for a tax-free reallocation and minimize the use of the QOZ to defer capital gains-both are discussed below.

In an inflationary environment, the private investor should take a hard look at his or her bond portfolio. The reason that the traditional 60 percent stock and 40 percent bonds model for hedging risk may be ineffective is that inflation is the bond’s worst enemy. For a bond to provide a yield that will match inflation given the fixed income and certain return of capital at the end of the hold, the bond must sell at a significant discount. This means that bond prices experience significant downward pressure over time given meaningful inflation. Accordingly, bonds may be the losers to sell and reallocate into real estate-based alternative investments. Given that bonds typically compose up to 40 percent of the traditional portfolio, there should be sufficient proceeds from bond sales alone to fully fund an alternative real estate investment portfolio and the losses would serve well to offset any gains realized from better performing equities.

Furthermore, the income provided from cash flowing real estate should be significantly higher than the fixed interest from corporate bonds of institutional credit quality. In reallocating from bonds, the private investor is essentially trading unsecured corporate debt for secured leasehold interests and often of the same corporations. The leasehold is not only secured by the real estate but also higher on the capital stack and more senior for repayment in case of a corporate bankruptcy. The income from the alternative real estate portfolio should be better sheltered from income tax than bond interest. State and federal bonds with acceptable interest rates should be retained within the traditional portfolio given their credit quality with the full faith and credit of the jurisdiction and their tax exemption.

Step Two | Net Gains and Losses

A key factor in deciding which stocks to sell for reallocation is the tax gain or loss that the sale will realize. The first step is to net capital losses against capital gains. To accomplish this, we must analyze the stock portfolio to determine the level of capital losses at the time of the reallocation. Capital losses may be netted against capital gains. If there are more losses than gains, then the net capital losses may only be deducted against ordinary income up to $3,000 per year. If you are still left with net losses after divesting the percentage of your portfolio that you want to reallocate then you will have a tax-free reallocation. Any losses greater than the $3,000 deducted against ordinary income may be carried forward indefinitely. This may allow for another deduction up to $3,000 in each of the following years or for an additional tax-free reallocation in future years. If, on the other hand you are left with capital gain after the netting process then you will need to reinvest the remining capital gain proceeds into a QOZ within 180 days to enjoy a tax-free reallocation.

Step Three | Income vs. Growth

The reallocation process is also a good time to evaluate if the private investor should retain more income-oriented stocks or more growth-oriented stocks. Given the potential income provided by the new alternative real estate investment portfolio, it may be that there is less of a need for stocks with higher dividend rates and less growth potential. However, extreme care should be taken to assess the private investor’s future liquidity needs as well as current income requirements. The future growth potential of certain stocks is a major reason why the majority of the traditional portfolio should be retained and continue to be invested in the securities market.

Step Four | Shelter Gains Using Qualified Opportunity Zones

The enactment of the Qualified Opportunity Zone (QOZ) provision in the 2017 Tax Cuts and Jobs Act provides an unprecedented opportunity to defer capital gains on the sale of stocks and bonds for portfolio reallocation. This allows 100 percent of the proceeds from the sale of the securities to be reinvested into new alternative real estate properties. It should be noted that only the capital gain portion of sale proceeds need to be invested into the QOZ while the portion of the sale that represents the investor’s original basis (return of capital) may be reinvested into other cash flowing alternatives such as DST properties, private REITs, and real estate funds.

Reallocating Gains | The capital gain portion is reinvested into the selected QOZ offering to defer the capital gain on the sale of stocks, bonds, or other capital assets. The tax on this gain is paid with new dollars from a tax-free distribution with refinancing once the QOZ property is developed and stabilized. The current tax provision allows for a deferral until December 31, 2026. This is a tremendous advantage that was previously unavailable to investors looking to reinvest the gains from the sale of stocks and bonds and may be considered another compelling reason for portfolio reallocation.

Reallocating Basis | The proceeds from the sale of stocks and bonds that represent a return of capital will have a full tax basis in the new alternative real estate investment. This fact provides a little-known opportunity to make your “lazy” stock and bond tax basis go to work for you by transforming it into depreciable real estate tax basis to shelter cash flow and increase your after-tax income. This new tax basis may be depreciated over the hold period to shelter the passive income (cash flow) from both federal and state income taxes. The depreciation deduction is calculated on a straight-line basis over 27.5 years for multifamily and 29 years for commercial properties. In most cases, this new tax basis will generate annual tax deductions that should fully shelter the cash flow income from the investments. In addition, some DSTs and funds may provide bonus depreciation from cost segregation reports that may provide for excess losses that may be used to shelter other passive income or be carried forward. In either case the alternative real estate portfolio should not only be sheltered from capital gain on the front end but income during the hold period should also be fully sheltered.

Step Five | Building a Tax-Sheltered Diversified Portfolio

Sheltering Cash Flow | The full gain from the sale of the stock is tax sheltered and all proceeds from the sale are available to be reinvested. In addition, the cash flow income from both QOZs, DSTs, private REITs, and real estate funds is tax sheltered with depreciation and bonus depreciation. This provides for a fully tax sheltered alternative real estate portfolio. Lastly, the sale of the QOZ, if held for 10 years, qualifies for a full tax exclusion (full stepped-up basis to the sales price) eliminating any taxable gains. Through the stepped-up basis provision, not only is any capital gain eliminated but there is no recapturing of the depreciation taken during the hold period. This is a tremendous tax planning advantage. The capital gain from the sale of DST properties can be deferred under IRC section 1031 exchange. Only the gains from the sale of private REITs, UPREITs, and real estate funds will have exposure to capital gains tax. If structured strategically, the reallocation to alternative real estate investment is a clever way to build a tax sheltered private real estate portfolio and maximize after tax yield from the sale of stock and bond holdings.