Opportunity Zone Funds, a feature of the 2017 Tax Cuts and Jobs Act (“TCJA”), allow investors significant tax breaks on capital gains by incentivizing investments in qualified low-income communities known as “opportunity zones.” When selling real estate, it’s important to weigh the benefits of investing in a qualified opportunity zone with those of a 1031 exchange to determine which investment vehicle may be better suited for your particular situation. Before you dive head first into either option, read on as we highlight key components and tax advantages.
Deferring the Gain Through a Qualified Opportunity Zone
Capital gains realized on the sale of real estate can be deferred through the investment of an amount equal to the capital gain into an opportunity zone fund. The proposed regulations issued on October 19, 2018 clarify that only amounts treated as a capital gain for Federal income tax purposes are eligible gains that can be deferred. The sale of real estate held for investment or used in a trade or business typically generates Section 1231 and Section 1245 gains. Section 1231 gains treated as long-term capital gains can be deferred. However ordinary Section 1245 gains and Section 1231 gains converted to ordinary gains as a result of a Section 1231 loss recapture cannot be deferred. Once the eligible gains are invested into the opportunity zone fund, 15 percent of those gains will be permanently excluded if the opportunity zone fund investment is held for at least 7 years, and the 85 percent balance of the gain will be recognized as taxable income on December 31, 2026. If the opportunity zone fund investment is held for at least 10 years, any gain realized on the sale of the opportunity zone fund will be permanently excluded from taxable income.
If the opportunity zone fund itself purchases real estate that is pre-existing and not new construction, the tax basis of the property must be divided between the land and building. The proposed regulations clarify that within a 30-month period the fund must double its investment in the building in an amount equal to the adjusted basis of the building (excluding the basis allocated to the land) at the beginning of the 30-month period. The land is not required to be substantially improved. In other words, if the fund purchases a pre-existing building for $1 million, of which $200,000 is allocated to the land and $800,000 is allocated to the building, within 30 months it has to invest an additional $800,000 in the building through activities such as renovations in order for the property to be considered a qualified asset for opportunity zone fund purposes. If the real estate is new construction, there should be no additional reinvestment requirement.
There is no requirement for the opportunity zone fund to invest the proceeds into real property as there is in a Section 1031 exchange. Other types of assets, such as an operating trade or business, also qualify. However, any pre-existing tangible property purchased by the opportunity zone fund is subject to the 30-month requirement for the fund to double its investment in the asset.
Deferring the Gain Through a Section 1031 Exchange
Through the use of a Section 1031 exchange, assuming all requirements are met and no boot is received, the full amount of gain on a real estate transaction will be deferred. There is no requirement for the taxpayer to double the investment of the initial cost of the investment property through renovations, remodeling, etc. The tax basis of the replacement property is reduced by the amount of the deferred gain, so the ultimate sale of the replacement property will result in recognition of the deferred gain. However, if an individual taxpayer holds the replacement property until death, the tax basis of the property will be stepped up to fair market value as of the date of death, and the gain will be permanently excluded. Further, the taxpayer can keep exchanging one piece of real estate for another, continually deferring the realized gain.
Finding What Works for You
There are definite advantages to a Section 1031 exchange when real estate is involved. An opportunity zone fund investment only provides for a temporary deferral of realized capital gains through December 31, 2026. Ordinary gains on the sale of real estate are ineligible gains and cannot be deferred through investment into an opportunity zone fund. In contrast, a properly structured Section 1031 transaction can result in an open-ended deferral and potentially permanent elimination of realized gains. However, if the original realized gains are from property ineligible for Section 1031 treatment, such as marketable securities, an investment into an opportunity zone fund will provide for a deferral of the gain.
The rollover of the gain into an opportunity zone must occur before December 31, 2026. With the recent stock market boom resulting in a stockpile of unrealized capital wealth—over $6 trillion as of December 31, 2017— many investors could maximize their benefits by investing in an opportunity zone fund.
The provisions regarding qualified opportunity zone investments are complex, and Friedman has established an Opportunity Zone Fund Team to handle these issues. For more information on how you can benefit from the incentivized qualified opportunity zone development, contact your experienced Friedman professional.