Opportunity Zones VS 1031 Exchanges
The new program offers another route to postpone or eliminate taxable gains.
By Mark Lee Levine, CCIM, LLM, Ph.D. and Libbi Levine Segev, LLM, MSRECM | March.April.19
While the tax benefits of Section 1031 exchanges in commercial real estate are well-known to most real estate professionals, the new qualified opportunity zone program now offers another approach to deferring or eliminating taxable gain.
The Tax Cuts and Jobs Act of 2017, code sections 1400Z-1 and 1400Z-2, created qualified opportunity zones to encourage investment in specific economically distressed areas across the U.S. This new type of investment allows taxpayers to defer or possibly exclude capital gains from taxation.
The opportunity zone refers to investment in a qualified opportunity fund, or QOF. Opportunity zone investing occurs within a fund that is qualified under the code and regulations.
Qualified opportunity zone investments in commercial property can be similar to 1031 exchanges, to defer taxes, but the differences in tax implications can be significant when there is a disposition of the property. The dispositions might utilize an opportunity zone investment, an exchange, or a sale. Although favorable tax benefits may be generated from dispositions that are followed by investments in opportunity zone areas, this approach is only one option. Taxpayers and advisers also should examine tax-deferred exchanges, sales, and other approaches, rather than assuming that an opportunity zone is the best alternative, even if there are potential tax savings.
While this discussion focuses on real estate, related principles and issues may be applicable to investments in qualified opportunity zones in personal property as well. However, the federal tax law no longer allows 1031 tax deferral for personal property; the exchange must involve real estate.
Laws dealing with opportunity zones are being developed. The lack of well-established case law, regulations, and other guidance for investments in qualified opportunity zones creates risks – risks that should be considered carefully before investing in opportunity zones.
Alternatives When Disposing of Real Estate
The 1031 exchange program provides for non-recognition of gain or loss for exchanges of qualified, like-kind real estate. The 1031 deferral does not apply if the property exchanged is inventory property held for sale by the taxpayer.
Imagine that John owns Property X, and he is undertaking an exchange with Jane for Property Y. This is not a qualified 1031 tax-deferred exchange for John if he holds Property X primarily for sale (dealer) or if he holds Property Y primarily for sale.
An opportunity zone deferral also would not be applicable if the property in question is held primarily for sale.
If the exchange was qualified under 1031, the 1031 law allows for certain delays, such as a case where John will transfer Property X (relinquished property) immediately, but will receive the replacement property (Y), sometime in the future, within specific time limits. Opportunity zone rules also allow for a delay to invest funds in the qualified opportunity zone.
Both 1031 exchanges and opportunity zones also have restrictions when some of the parties to the transaction are related.
Deferral or Exclusion of Taxable Income
Another consideration when disposing of property, even by a sale, is the reinvestment of those funds in qualified properties in an opportunity zone. Investing in a QOF is required to gain the tax benefits under the program.
Benefits of investing in a QOF include:
- The seller, if qualified, can defer gain from the sale. For example, a taxpayer selling stock at a gain of $1,000 can defer the tax on such gain by a proper qualified opportunity zone reinvestment.
- If the taxpayer properly invests the gain in a qualified opportunity zone via a QOF, the taxpayer could be allowed an exclusion of up to 15 percent of the deferred gain.
- If the taxpayer holds the investment in the QOF for at least 10 years, all the capital gain generated since the reinvestment can be excluded, assuming all the program requirements are met.
Section 1031 exchanges differ from QOFs in many ways:
- A 1031 investment does not require reinvestment in a specific area of the U.S., as long as it is in the U.S. Alternatively, by definition, the QOF must be in a qualified zone.
- The structure of a 1031 exchange requires a good deal of formality, dealing only with like-kind property. The type of property in a QOF has a broader range that can involve real estate or personal property. However, both 1031 exchanges and QOFs have additional requirements. For example, QOF property must be acquired after Dec. 31, 2017.
- Section 1031 requires an investment in trade or business property, while the QOF has more flexibility.
- In a QOF, only the gain (not the full sales price) needs to be reinvested in a QOF to come within the deferral rule.
- As a rule, under 1031 exchanges, the entity transferring the relinquished property also must be the one obtaining the replacement property. For example, John could not transfer Property X under the 1031 exchange program and then have his corporation acquire the replacement property. A QOF provides more flexibility for the investor who sold, for example, a partnership interest then invested in a QOZ entity.
- Delayed exchanges are permissible in some cases, which allow for the involvement of other parties and possibly an intermediary. As such, they provide 1031 transactions with flexibility. Section 1031 exchanges normally allow for a maximum of 180 days to complete the transaction, generally from the disposition date of the relinquished property, such as Property X, to a reinvestment in the replacement Property Y. The 180-day timing also can apply to the QOF in some cases. However, in the QOF, the seller can take possession and control of the cash from the sale; such cash control is not allowed in a 1031 exchange.
The QOF may have more flexibility for investors, assuming the investor is willing to move to a QOF and away from, in many cases, personal control of the assets. This lack of control also can create some liquidity issues for the investor in the qualified opportunity zone.
Costs in undertaking these transactions include those associated with being involved in a qualified opportunity zone, such as the fees charged by the QOZ and the costs for the use of an intermediary in 1031.
Most dispositions are structured as sales. The sale may be formulated as a cash sale or by an installment sale, allowing the seller to spread income over time as payments are received. But an outright sale has its advantages and drawbacks when compared to dispositions centered around the exchange or QOF.
Each approach to limiting taxes in disposing of property has its benefits under federal income tax laws. While limiting or avoiding taxes is attractive, as well as full exclusion of the gain, selling for cash improves flexibility in investing. Cash normally is available on a traditional cash sale, but not necessarily on a 1031 exchange or the QOF investment.
Other important issues to consider when choosing the form of disposition include determining management issues for the property; refinancing options; dealing with others in the investment; timing of dispositions and acquisitions; control over decisions; and the requirement to stay invested in the qualified opportunity zone to gain tax benefits. The geographic areas to invest in and the type of property to select are additional factors with 1031 and the QOF.
While QOFs add another alternative for taxpayers and planners when considering the best approach to dispose of property, the decision is complex. The taxpayer must carefully weigh all factors, not only the tax benefits, to find the right option for a particular situation.
Mark Lee Levine, CCIM, LLM, Ph.D. and Libbi Levine Segev, LLM, MSRECM
Mark Lee Levine, CCIM, LLM, Ph.D., is a professor, and Libbi Levine Segev, LLM, MSRECM, is an assistant teaching professor, at the University of Denver. Contact Levine at email@example.com and Segev at firstname.lastname@example.org.