Real Estate Trends

Opportunity Zones vs. 1031 Exchanges—Can They Co-exist?

August 13, 2019 - Posted by Maura A. Snabes, Esq., CES®, CLTP - Sr. Underwriting & Compliance Counsel

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Many real estate investors are familiar with the parameters and tax advantages of a Section 1031 tax-deferred exchange to defer the payment of capital gains taxes when exchanging certain qualifying property for other qualifying property. However, there is a newer investment concept that may prove to be just as advantageous to some investors—Opportunity Zones.

The concept of Opportunity Zones (OZs) stemmed from a truly philanthropic idea designed to benefit distressed communities while being lucrative to investors. It also provides enticing tax breaks and returns for their investment. From a real estate professional’s perspective, OZs offer benefits not only for investors but for realtors, attorneys, communities, and many other associated real estate professions as well. Jason Gordon wrote an informative overview of some of the pros and cons of The Investment in Opportunity Act, which was the legislation that created OZs. However, qualified OZs, and whether they pose a real threat to the 1031 qualified intermediary business, remains at the forefront of the minds of many qualified intermediaries.

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To understand whether they genuinely pose a threat or if they can co-exist, one must define what exactly is a Qualified Opportunity Zone. Formed under the tax reform package, the Tax Cuts and Jobs Act of 2017, OZs offer capital gains tax deferral and relief for new investments in specific economically distressed areas nationwide. An investor may earn a profit from the sale of an asset and invest that profit within 180 days in an opportunity fund. (The investor must invest at least 90% of their assets in OZs. This is defined as a real estate investment in an opportunity zone or a partnership or stock ownership interest in a business that conducts all or most of its operations in a designated zone.) As such, the investor can obtain substantial tax incentives, including the following: having the tax liability on that gain deferred or reduced, reducing tax liability by 10% if invested for 5 years, reducing tax liability by 15% if invested for 7 years, and no capital gains liability on any appreciation of the opportunity fund when shares are sold if they are held for 10 years.

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But, as with everything, there are requirements, restrictions, and parameters that must be met with an OZ and with a 1031 exchange in order to take advantage of their benefits. Below is a comparison of some of the benefits and requirements and restrictions of both.

Benefit Comparison:

Opportunity Zone:

  • Not limited to real property.
  • Proceeds are invested in real and personal property.
  • 10% step-up in basis after a 5-year holding period.
  • Additional 5% step-up in basis after a 7-year holding period.
  • Appeals to passive investors.
  • No benefit unless held for a minimum of 5 years.
  • No requirement for a qualified intermediary.
  • Access to proceeds until day 180.
  • As long as the investment is held for ten years, any increase grows tax-free and has a stepped-up basis when the asset is sold.
  • If sold before ten years, can invest proceeds.
  • In another opportunity zone, the period of the original investment tacks on to the new investment.
  • Value of properties in OZs increasing.

1031 Exchange:

  • Limited to real property.
  • Proceeds are invested in real property only.
  • No step-up in basis.
  • Can do exchanges as needed/wanted/less than five years.
  • Can identify and acquire replacement property before the sale of existing property.
  • Holding period of a property is not tacked to the next property.
  • No change in the value of properties involved in 1031 exchange.

 

 

 

Requirement Comparison:

 

Opportunity Zone:

  • Only need to reinvest the actual gain.
  • The property must be located in an opportunity zone.
  • 180 days to identify replacement property.
  • Funds must be contributed by 180th day, but project need not be underway.
  • The fund must demonstrate how it improves the community.
  • Must invest more in the improvement of property than it paid for the property.
  • Limitation: Investors can defer capital gains taxes until 2026 from prior investments if those gains are reinvested into an Opportunity Zone fund project.
  • By 2026, however, the original capital gains tax is due and payable, even though the Opportunity Zone reinvestment is still being held and/or operated.

1031 Exchange:

  • Need to reinvest principal and gain.
  • Property located anywhere in the US.
  • 45 days to identify replacement property.
  • Termination at 180 days.
  • Invest in any qualifying property.
  • Can acquire property and not improve.
  • Indefinite tax deferral.

 

 

 

 

 

 

 

Given these differences, it seems likely that these two tax-saving mechanisms can co-exist and that the introduction of Opportunity Zones will not cause the demise of the 1031 tax-deferred exchange or even cause much of an impact on the traditional 1031 industry. Speak with an attorney or CPA to determine if either of these tax-saving programs will work for you.

TOPICS: 1031 Exchanges, Opportunity Zones

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