For real estate investors, the 1031 exchange has long been a preferred, efficient strategy to defer taxes on capital gains associated with their real estate investments. However, the development of Qualified Opportunity Funds (QOFs) under the Qualified Opportunity Zone (QOZ) program brings another compelling tax strategy to the table.
With the QOZ final regulations released in December 2019, investors have more information to work with and decide which investment strategy makes the most sense for their unique situation. This article takes a closer look at some of the key characteristics of both the 1031 exchange and the opportunity zone program in order to give investors greater insight into each.
What’s in this article?
- What are Qualified Opportunity Zones?
- What is a 1031 Exchange?
- QOZ vs 1031 Exchange: A side-by-side comparison
- What are some of the advantages of a QOZ investment?
- What are some disadvantages of a QOZ?
- What are some advantages of a 1031 exchange?
- What are some disadvantages of a 1031 exchange?
- How do I decide the best path for me?
- How can Squar Milner help?
What are Qualified Opportunity Zones?
The Tax Cuts and Jobs Act of 2017 (TCJA) established opportunity zones and qualified opportunity funds (the investment vehicle) with the principal objective of stimulating new economic investments in qualifying communities throughout the United States.
Virtually anyone with substantial capital gains can receive federal, and potentially state, tax benefits by investing those capital gains in a QOF and subsequently using the fund to invest in real estate projects or operating businesses located within any of the thousands of qualified opportunity zones throughout the country.
The opportunity zone program, governed by Internal Revenue Code (IRC) section 1400Z-2, enables investors to harvest capital gains and defer payment of capital gains taxes until 2026 by investing those gains as equity into a QOF within 180 days from the date the gain would have been recognized for federal income tax purposes.
Qualified Opportunity Zones create three key tax incentives for investors:
- If the investor contributes recognized capital gains into a QOF within 180 days of the asset sale, they can defer capital gains taxes on that gain until December 31, 2026.
- If an investor holds their QOF investment for at least 5 years prior to December 31, 2026, they can reduce the deferred capital gains tax liability by 10% through a step-up in basis. (To maximize this opportunity investors must invest prior to December 31, 2021.)
- If the investor holds the QOF investment for 10 years, they can pay zero dollars in capital gains taxes on any appreciation from their original QOF investment.
What is a 1031 Exchange?
A 1031 exchange (also known as a “like-kind” exchange) allows investors to defer paying capital gains tax on the sale of property by selling a piece of property and reinvesting the proceeds into a new, like-kind property. This strategy allows investors to preserve the gross equity earned from a real estate investment, which thereby increases their buying power.
In a 1031 exchange, the investor may exchange real property used for business or held as an investment. An exchange of personal or intangible property no longer qualifies for a 1031 exchange, pursuant to changes under the TCJA. The Internal Revenue Service (IRS) defines like-kind property as properties of the same nature or character, even if they differ in grade or quality.
Common examples of qualifying property include single-family rentals, apartment buildings, townhome or condo rentals, mobile home parks, vacant land, industrial structures, office buildings, retail, hospitality, senior housing, cell towers, billboards, windmills, solar farms, boat docks, and fractional ownership (Tenants-in-Common or DSTs).
Like the QOZ, a 1031 exchange also has some time limits that investors must follow. First, the Exchanger must identify the potential replacement property within the first 45 days of the 180-day exchange period. Next, the Exchanger must acquire the replacement property or properties within the earlier of (a) 180 days, or (b) the date the Exchange must file the tax return for the year of the transfer of the relinquished property. There are no exceptions to these deadlines (except as a result of a “force majeure” event like a natural disaster), and the 180 days includes weekends and holidays.
One of the most significant benefits of a 1031 exchange is the potential to defer tax indefinitely.
What are some of the advantages of a QOZ investment?
One of the most notable characteristics of the QOZ program is the inherent flexibility. Unlike a 1031 exchange, investing in a QOZ provides flexibility in terms of investment timing, development/rehab opportunities, and type of investment. No longer are investors handcuffed by the like-kind requirement of a 1031 exchange or the strict 180-day rule. Instead, the program offers the ability to defer tax on gains on any investment one may have regardless of whether it is real estate, securities, a business, or other (i.e. any investment that generates a capital gain). You may then use those proceeds to purchase real property or any type of active trade or business located in an opportunity zone. Overall, the goal of the QOZ program is to increase the potential return on investment by utilizing a tax-deferred structure at the time of investment and be able to realize the exclusion benefits after holding the investment over a 10 year period.
2. Normal depreciation
The QOF can claim normal depreciation deductions over the life of the investment. This would also include potential bonus depreciation if a cost segregation study were done on the real property. However, you should take note that there might be some limitations to the deductions at the investor level depending on their basis.
3. Refinance and redistribute proceeds
A main advantage of a QOZ investment is the ability to refinance and distribute the proceeds, and any equity in the real property, to investors after two (2) years in the investment. This is important when you consider the deferral period and the December 31, 2026 gain recognition deadline. The idea for most QOZ investments is that they will have enough equity to refinance and distribute proceeds and help to cover the tax liability for investors.
4. Liquidate investment
QOZ investors have the opportunity to liquidate the investment and claim the tax benefits after the 10 year holding period expires. This is an important distinction from the 1031 exchange. With a QOZ investment, you can get your hands on some of the cash, use it for other purposes, and still claim the tax benefits during your lifetime.
5. Diversify your portfolio
You can structure your opportunity fund as a pooled fund. By pooling funds from multiple investors, investors can acquire a diversified portfolio of real estate (and possibly other) assets, rather than a single building. This is a key differentiator from a 1031 exchange, as diversification inherently reduces the risk of an investment portfolio.
What are some disadvantages of a QOZ?
- The main disadvantage of a QOZ, compared to a 1031 exchange, is that you must recognize the deferred gain on December 31, 2026. It is possible to recognize earlier if an inclusion event occurs.
- Currently, California does not conform to the QOZ program and, therefore, the deferral and tax exclusion only apply for federal tax purposes (for California residents).
- NNN lease properties generally do not qualify for a QOZ investment.
- Investments can only be within designated opportunity zones. However, there are over 8,700 opportunity zones throughout the country including in places like Portland, Los Angeles, Philadelphia, and more. The IRS provides a list of QOZs, as well as a visual map and other resources.
- The QOZ does involve more complex structuring and ongoing compliance costs.
What are some advantages of a 1031 exchange?
1. Indefinite tax deferral
While a 1031 exchange does not offer the capital gain forgiveness of a QOZ investment, 1031 exchangers can defer the capital gain (and the tax) indefinitely. Investors can conduct a series of rollovers (i.e. swapping Property A for Property B, then Property B for Property C, and so on) while deferring any capital gains tax liability for years or even decades until they eventually dispose of an asset either through a traditional sale or through inheritance and estate planning.
2. Exchange structure
The original objective of a 1031 exchange was to swap properties, therefore they are generally useful for selling a single asset in exchange for another single asset.
3. Geographic flexibility
Unlike QOZs, a 1031 exchange is not limited to reinvestment in federally-recognized economically distressed areas. Rather, you can complete a 1031 exchange with any real property located within the United States.
What are some disadvantages of a 1031 exchange?
1. Investors who conduct a series of 1031 exchanges to defer the capital gains taxes will face other issues along the way, such as depreciation recapture. Furthermore, investors may have difficulty finding a suitable replacement asset to help them avoid additional taxes. To the extent that an investor receives cash or other property that is not of like-kind (known as a “boot”), the investor will realize a taxable gain. A boot can also arise from the differential amount in the equity or debt of the asset being disposed of and the one being acquired.
2. Under the 1031 exchange, investors will eventually be taxed on their capital gains in full upon their final disposition – assuming that the disposition happens while the investor is living. This means that if the last asset acquired in a series of 1031 exchange rollovers appreciates significantly, when that asset is divested the investor (or their estate) could incur a sizable tax bill.
3. Admittedly, there is limited asset flexibility as real estate is the only asset that qualifies for 1031 exchanges. That means an investor can defer capital gains tax payments by conducting a 1031 exchange for the sale of a property, but not for the sale of any other kind of appreciated asset such as stocks and bonds.
How do I decide the best path for me?
To truly get into comparisons, we have to consider that the potential QOZ investor has real estate capital gains. What makes the QOZ program unique and so appealing is the fact that you can invest capital gains for different sources (i.e. real estate, stocks, etc.) into your QOF, rather than just real estate. Therefore for the sake of comparison, let us say that the potential investor is looking for the best option for managing their real estate capital gains.
If you are a real estate investor with capital gains and deciding between a QOZ investment and 1031 exchange, there are benefits and drawbacks to each. It really depends on your objective and appetite for risk. You also have to decide whether or not you are okay being geographically limited or if you are trying to get out of a particular investment and want to get into a different real estate investment without having to substantially improve it (as required in the QOZ program).
When it comes to a QOZ investment, you have to weigh the requirements of program versus the potential upside. For example, the geographical limitations can prove to be more challenging, as can the requirement that you substantially improve the property within a designated amount of time. However, you also have the chance to achieve complete capital gain tax exclusion, at least on the investments, and you can reap the tax benefits during your lifetime. You don’t have to pass it on and achieve a step-up in basis after death, as with a 1031 exchange.
If you are more conservative, a 1031 exchange may be the optimal path for you. In addition, the 1031 exchange opens up the chance to dispose of a property and its associated drawbacks (i.e. owning an apartment building and dealing with your landlord duties), and acquire a new property and business. With the 1031 exchange, there is no requirement to substantially improve the new property in a designated area with an improvement market.
How can Squar Milner help?
The determination of whether to do a 1031 exchange or a qualified opportunity zone investment is complex and depends on the type of investment, the investment goals and risk profile of the investors. When it comes to deciding whether a 1031 exchange or Qualified Opportunity Zone investment is best for your situation, Squar Milner has a team of professionals to help you devise the most practical and tax-efficient strategy.
Our Real Estate industry practice is one of the most robust facets of our firm, and we have deep expertise in working with developers, investors, and more. Whichever investment strategy is right for you, we have the personnel and experience to help you through the process and maximize your tax savings.
For more information on the pros and cons of the QOZ program vs. the 1031 exchange, please check out our recent webinar.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.