Owners selling small businesses are often confronted with significant tax obligations related to the sale of business assets, including real estate. For those considering selling a business, financial professionals can serve an essential role in helping extract value by introducing tax-advantaged investment strategies.
If business succession planning is not a service you currently provide to clients, now might be a good time to reconsider. The latest statistics show there are approximately 34 million small businesses in the U.S., and baby boomers own 41 percent of these businesses. With the boomer generation aging and retiring at an accelerated pace, there could be nearly 12 million boomer-owned small-to-midsized businesses on the table in 2025.1
Leveraging QOZs and IRC Exchanges
The U.S. Internal Revenue Code (IRC) includes provisions that can help business owners reduce tax obligations and maximize profits when selling a business.
The Qualified Opportunity Zone (QOZ) investment program was signed into law as part of the Tax Cuts and Jobs Act of 2017, allowing investors to participate in the development of economically distressed communities throughout the U.S. while enjoying certain tax benefits. The QOZ program allows for a business owner who sells a business at a significantly appreciated value to defer paying capital gains tax on those profits until December 31, 2026. If the QOZ investment is held for at least ten years, the original business owner may be able to permanently exclude any capital gain from the sale of the qualifying investment.
QOZs in 2025 and Beyond
Current legislation has the QOZ program set to expire on December 31, 2026, requiring QOZ investors to realize any capital gains from the sale of a business.
The Trump Administration, however, has big plans for QOZ legislation in 2025. With the House of Representatives passing a 2025 budget resolution, the stage is set for Congress to extend or modify the program. The consensus among QOZ experts is that a basic extension to 2028 or beyond is the most politically viable option. Zone re-designation and expansion is also gaining traction with governors able to nominate new Opportunity Zones based on updated economic data, replacing certain tracts that may no longer qualify.1
Potential Capital Gains Tax Deferral with a QOZ
To clearly illustrate the tax-advantages of a QOZ investment, let’s look at the hypothetical example below.
A business owner sells a small business in 2025, which has been owned for more than 30 years. The business started with no basis but is now estimated to have a $1 million value. By reinvesting the proceeds into a QOZ fund, the owner can defer paying capital gains tax on the $1 million until December 31, 2026. Further, if the owner continues to hold their investment in the QOZ fund for ten years, or earlier if the fund liquidates before ten years, they are expected to have no tax obligation on the gain realized in the fund.
After-Tax Hypothetical Scenario2,3,4,5
Simplified QOZ Timeline
**QOF investment ends per terms outlined in the specific fund. If the Investor holds an interest in a qualified opportunity fund for at least 10 years then, in connection with the sale of such interest, the Investor’s basis in such interest will be equal to the fair market value of such interest on the date it is sold if a specified tax election is made, thereby eliminating any federal income tax with respect to any appreciation in the value of the interest.
IRC Exchange Solutions are tax-efficient investment strategies that may preserve wealth while offering the potential for long-term returns.
-
A 1031 exchange, named after IRC Section 1031, stipulates that no gain or loss shall be recognized if real property held for use in a trade or business or for investment is exchanged solely for property of like kind. So, a business owner may be able to defer capital gains tax on the sale of a building or other real property by reinvesting the proceeds in similar property as part of a qualifying like-kind exchange.
-
A Delaware statutory trust, or DST, is an investment structure in which multiple investors own fractional interests in a single property or portfolio of properties. Investors can gain access to institutional-quality property that may otherwise be out of reach. Using DSTs, investors can allocate assets to one or more DSTs, potentially providing a more diversified real estate portfolio across geographic areas and property types. DST interests are the structure of choice for a 1031 like-kind exchange and qualify as real property for exchange purposes.
-
A 721 exchange allows investors to contribute ownership in real property to an operating partnership (OP) of a real estate investment trust (REIT) that is structured as an umbrella partnership real estate investment trust, or UPREIT, in exchange for units in the OP. A 721 exchange also may be structured through the exchange of DST interests for OP units if an OP wants to purchase, or has an option to purchase, the property owned by such DST. A 721 exchange may provide investors with a redemption option, providing them access to liquidity. Unlike a 1031 exchange, which allows for subsequent 1031 exchanges, once a 721 exchange takes place the investor may no longer execute another exchange transaction.
To learn how business owners can utilize a combination 1031/721 exchange via a DST to grow long-term wealth, read our previous blog Unlocking the Potential of the 721 Exchange.
Understanding and leveraging tax-advantaged strategies is crucial for small business owners. By incorporating these tools into financial plans, owners may be able to not only defer or reduce tax liabilities but also reinvest more capital for long-term wealth. Staying informed and seeking professional guidance can make a substantial difference in maximizing investment goals.
Sources:
2 Illustration assumes investor is subject to top marginal U.S. federal income tax rate of 20% on long-term capital gains for individuals, net investment income tax of 3.8% and state tax of 6.2% for a total tax liability of 30%. This illustration assumes that no brokerage or investment advisory fees are accounted for with respect to Non-Qualified Opportunity Fund example and assumes that no fees are due to the asset manager and its affiliates and no sales commissions, deal fees or placement agent fees are accounted for with respect to Qualified Opportunity Fund example. This communication is not intended as tax advice, and investors should consult with their own tax advisors regarding an investment in a Qualified Opportunity Fund.
3 Illustration assumes that Qualified Opportunity Zone investor is a resident of a state that conforms with QOZ Program.
4 Example assumes investor does not pass away during 10-year period. If investor were to pass away, heirs receive a step-up in basis in Non-Qualified Opportunity Fund example and a carryover basis for Qualified Opportunity Fund example.
5 Assumes that investor has no capital losses to reduce such capital gain and refers to inclusion of the original, invested capital gains in such investor’s taxable income on December 31, 2026.
