Tired of the Perpetual 1031 Like-Kind Exchange Game? Explore Opportunity Zones Instead.
While the Tax Cuts and Jobs Act (TCJA) made some adjustments to section 1031 of the Tax Code when it eliminated the tax-deferred like-kind exchange treatment of personal property, it left intact the ability to utilize like-kind exchanges for real property. 1031 Exchanges have been a popular planning tool for real estate investors. In fact, I cannot think of a more widely used tool to defer taxes in the real estate sector than 1031 exchanges, but that trend might change now.
The TCJA also introduced another incentive that most real estate investors are aware of by now, Opportunity Zones (OZs). Opportunity Zones are economically distressed and under-served census tracts that provide investors tax incentives for placing capital into these communities. If you’re looking for more in-depth information on Opportunity Zones, you can visit EIG’s Opportunity Zone page for a full rundown and history of the incentive program. What we are going to explore today is the difference between 1031 Exchanges and Opportunity Zones.
Talk to any investor who has utilized 1031 Exchanges and the first thing they will gripe about is the timeline. Investors are pushed to identify a replacement property within 45 days of their sale and all the proceeds from the prior sale must be reinvested within 180 days. The Opportunity Zone program on the other hand allows investors to reinvest their capital gains into a Qualified Opportunity Fund (QOF) within 180 days and put their original principal back into their pockets. In fact, you do not even have to invest the total amount of your capital gain, you can choose how much you wish to allocate to a QOF. Another thing to take note of here is that the OZ program simply states that you must reinvest the capital gains within 180 days, you do not have to identify an asset within that timeframe.
When you are exploring the sources of capital that can be used for either strategy, there are some glaring differences. The Opportunity Zone program allows for a reinvestment of any capital gain, short-term or long-term. For those tax nerds out there, you can even utilize 1231 capital gains to make your investment without having to net out 1231 losses. This structure allows investors far more flexibility and includes capital assets such as stocks, bonds, ETF’s, rental properties, art, or even an antique car. On the other hand, using the 1031 like-exchange limits investors to proceeds from real property held for investment or for real property held for productive used in a trade or business. You can immediately see that the universe of options available to investors to make a reinvestment in the OZ program is much larger.
The holding period for like-kind exchanges is essentially nonexistent. Investors can choose to exit at any time and pay their taxes. While that option is available, what is widely seen is a perpetual utilization of exchanges until an investor has passed away and the asset is passed through to their heirs receiving a step-up in basis in the process. I call this the 1031 until death strategy. To receive the full benefits of the OZ incentive program, investors must hold at least ten years. While that may seem like a long time, that full benefit I am talking about is a complete exclusion of any gain on your investment. That’s right, if you hold your investment for ten years, you don’t have to pay any of the capital gains. A worthy trade off in my opinion.
As I alluded to in the previous section, the deferral period for 1031 like-kind exchanges can be indefinite. This differs from an OZ investment in the sense that investors can defer out to no later than December 31st, 2026. While the deferral period may end at that time, any investor that has held their investment for five years will receive a ten percent step-up in basis. Holding that investment for an additional five years now qualifies investors for the exclusion benefit that was mentioned previously.
1031 Like-Kind Exchanges do offer more flexibility from a geographic perspective. Investments can be made in any of our fifty states, D.C., Guam, and the Virgin Islands. An investment in the Opportunity Zone program however must be made in one of the designated census tracts. Not to worry though, there are over 8700 designated census tracts to choose from. If you’re wondering where the census tracts are you can search the Opportunity Zone map on our website under the Resources tab. You can also find an infographic that layouts the differences we are discussing in this article.
While 1031’s may offer a wider range of locations to choose from, it does not offer what I consider to be the hidden gem of the OZ program, the avoidance of depreciation recapture. The mechanics behind this are quite simple. Any investment that is properly held for the ten-year period will be eligible for the exclusion of gain. This is achieved by increasing the basis by 100% upon the sale of the asset after ten years. This means that through the life cycle of the asset investors will have enjoyed the benefits associated with depreciation but will not have to deal with the ramifications of depreciation recapture on the back end.
We are often asked at Opp Zone Capital which strategy is more advantageous to investors. We believe that depends largely on each investor’s goals. With that said, we find extreme value for investors in a program that provides three impactful tax incentives, the ability to put your original principal back in your pocket, forego depreciation recapture, exit the program after ten years, and have a major impact on the communities that are being rebuilt.
Opp Zone Capital is an Opportunity Zone fund sponsor, third-party fund manager, and advisory services firm based in Clearwater, FL. Investors interested in Opportunity Zones should always consultant their tax and legal counsel before making an investment in a Qualified Opportunity Fund. For more information about the OZC – Southern US RE QOF visit us at oppzone-capital.com/funds/. For more information about third-party fund management or advisory services, click here.