Delaying Taxation of Capital Gains
Posted on 01.09.19
Comparing Qualified Opportunity Zone Funds vs. 1031 Exchanges
For years, IRS Code Section 1031 like-kind exchanges (1031s) have been the primary tool used by real estate investors to defer the recognition of taxable gain when they sell real estate. However, in late 2017, the Tax Cuts and Jobs Act (TCJA) introduced a new way to defer gains – an investment in a Qualified Opportunity Zone fund (QOF). Opportunity Zones are certain federally-designated census tracts in low-income communities, of which there are more than 8,700 located throughout all the states, DC, and Puerto Rico. QOFs have the added advantage of potentially eliminating the taxation of some capital gains.
Naturally, many of our clients are interested in QOFs, but 1031s still make sense for many real estate investors. The purpose of this article will be to briefly compare QOFs vs. 1031s – their comparative advantages and risks.
Keep in mind, this is a summary. Many important details are omitted, and we are still awaiting additional guidance from Treasury, which is expected in early 2019. Also, some states, including Virginia, are not currently in conformance with the TCJA. Accordingly, this discussion is geared toward federal taxation only. Be sure to consult your tax advisor for their opinion before making any final decisions.
First, capital gain deferrals. For a 1031 exchange, taxation of a capital gain is deferred indefinitely as long as the acquired property is held or swapped for other property in another 1031 exchange. If the swapped property is held until death, then the resulting step-up-in-basis may result in the exchange(s) avoiding taxation altogether.
For a QOF investment, the deferral of the original investment’s capital gain is deferred until the earlier of the date of disposition of the property or December 31, 2026. Also, the capital gain is reduced by 10 percent after five years of investment and an additional 5 percent after seven years. Due to the December 31, 2026, deadline, the investment must be made by the end of 2019) to receive the full 15 percent benefit. If the investment is held for more than ten years, any appreciation of the investment when sold is not subject to capital gains tax. Said another way, only 85 percent of the investor’s original investment is taxed if held seven years, and if held for ten years, the appreciation of the original investment up to that point is federally tax-free.
Presumably, under present law, the capital gain may still be subject to the federal net investment income tax of 3.8 percent and state income taxes. Further, the initial capital gain deferral is not eligible for a step-up in basis if a QOF investor dies.
The Initial Investment
For a 1031 exchange, you must exchange real estate for real estate. A QOF investment gives you more flexibility. While you must invest in a qualified fund (a domestic partnership or corporation), the QOF can not only invest in real estate but, among other things, it can invest in an operating business with personal property. However, unlike a 1031, the QOF must be located within an Opportunity Zone. Note also that the investment in a QOF must be made in cash.
Another difference is that a 1031 exchange’s proceeds must be fully reinvested in replacement property. For a QOF investment, only an amount equal to the capital gain has to be invested. You can invest more, but only the capital gain portion will receive the deferral/nontaxable benefit. Moreover, unlike a 1031, the invested capital gain can be from any source, not just real estate. This includes long-term/short-term capital gains, mutual fund and REIT capital gain distributions, and capital gains allocated to investors as reported on K-1s by a pass-through investment (S-corporations, partnerships, trusts, and estates).
Still another difference for 1031s, the investor must never have access to the funds from the sale(s). The funds must be handled by a qualified intermediary.
Finally, real estate acquired in a 1031 exchange does not have to be further improved by the investor – raw land or a fully operating apartment complex is okay. That is not always the case for QOFs – if they are not purchasing property new to the OZ, substantial improvement is required. Testing of the required investment with the opportunity zone must be done annually to ensure compliance.
Capital gains realized from the sale of property to a related party are not qualified for a QOF investment. That is not the case for a 1031 exchange. For 1031s, you can purchase property from a related party, but you must hold the real estate for at least two years.
Timing of Investments
For both 1031s and QOFs, you must reinvest within 180 days of the transaction. While a 1031 exchange requires the closing of the real estate transaction within the 180-day window, a QOF is permitted additional time (up to 31 months) to invest the funds in qualifying property.
If a capital gain is incurred by a pass-through entity, the pass-though may elect to defer the gain via a QOF investment and the capital gain will not be reported on a K-1. But if the pass-through decides not to elect and report the capital gain on the entity’s K-1s, the K-1 recipients have 180 days after the entity’s year-end to make a QOF investment. This 180-day window provides a great opportunity for investors to prepare for a QOF investment, but since K-1s are frequently not issued until after 180 days, management of pass-throughs may need to communicate with its investors as soon as practicable. This could be especially problematic for pass-throughs with outside investments.
While real estate is rarely, if ever, considered to be a liquid investment, a 1031 investor can likely liquidate or cash out more quickly than a QOF investor This is especially true if the property is owned directly by the investor or an entity they control.
Investors can set up their own QOFs, as long as the QOF is “organized for the purpose of investing in qualified Opportunity Zone property.” The QOF must be a partnership or a corporation. Disregarded entities, such as single-member LLCs, are not eligible. We anticipate that most investors will not organize their own QOFs, but instead will participate in QOFs set up by sponsors. Because the goal of these QOFs will be to maximize tax benefits and because the underlying assets will likely be illiquid, QOF investors may find it very difficult to exit their investments.
Theoretically, 1031 investors can invest anywhere, although U.S. real estate can only be exchanged for US real estate and similarly, foreign real estate for foreign real estate.
By contrast, investments in QOFs are restricted to opportunity zones, which by definition, are economically-challenged areas. Because prudent investors will seek the best returns, some zones, particularly in rural or extremely low-income areas, will receive little or no investment. Conversely, some zones, which are already located in hot or rapidly gentrifying areas, are likely to receive the bulk of investment. Taking into consideration that hot areas are eventually overbuilt regardless of tax incentives, the potential for over-investment increases appreciably. Successful real estate ventures brought more competition and given the required length-of-ownership handcuffs, cashing out may not be as lucrative as hoped. And what happens after ten years? Do you see “For Sale” signs throughout the zones?
A few more observations:
- In most cases, acquired 1031 property is going to throw off cash. Given the need to invest in the zones, many QOFs are likely not going to be paying distributions for a number of years, especially if the QOF is a start-up operating business.
- Because an operating business must have 70 percent of its tangible property within a zone, and at least 50 percent of its gross income must come from the “active conduct” of business within the zone, the growth potential for an operating business within a zone may be limited. At some point, management may have to look at creating a spin-off business outside the zone.
- We believe that deferring taxes into a future year is almost always advantageous. With that in mind, an investor must be mindful that when they exit either investment, a 1031 or QOF, their gains will be taxable at the rates in effect in the year of the exit. There is a risk that tax rates will be higher in the future, specifically on capital gain income, so care should be exercised when determining the benefit of either investment.
- With the December 31, 2026, clock ticking to pay the tax on the original investment, investors need to plan their cash flow carefully. Without proper planning, an investor could get hit with a big tax bill for 2026 without the commensurate amount of cash to pay the bill.
- Finally, since an investment in a QOF must be made by the end of 2019 in order to realize the full 15 percent capital gain haircut, there is the possibility (and maybe the probability) that there will be too much cash chasing too many deals. What happens to the cash that can be parked into a QOF that ultimately can’t be invested and is returned to the investor? Lacking further IRS guidance, it may be that the investor’s capital gain becomes immediately taxable.
For many, investments using 1031 exchanges or QOFs make a lot of sense. 1031s are fantastic vehicles when exchanging real estate for real estate without restriction on location, while QOFs are particularly strong vehicles for start-up operations that need capital. However, with any investment or venture, do not make taxes your overriding focus. Rather, does the investment make sense for you on a stand-alone basis and with diversification in mind? If it does, then determine whether a 1031 or a QOF investment works best. As will all investments, please consult your tax professional to determine the impact income taxes may have on your returns before investing.
More tax planning resources for businesses and individuals
- 2019 Tax Planning Guide
- Top Seven State and Local Tax Issues to Consider for 2019
- What you need to know about Neighborhood Assistance Program (NAP) Credit Benefits
- The Latest IRS Guidance on Qualified Opportunity Zones