Everything You Need to Know About 1031s and QOZs

Nobody likes paying taxes, and the same is true of real estate investors. For decades, investors have used Section 1031 exchanges, also known as like-kind exchanges, to swap real estate assets without triggering taxable gains.

Now, thanks to a passage of the Tax Cuts and Jobs Act in 2017, Qualified Opportunity Zones (“QOZs”) have become the latest phenomenon in the real estate and tax worlds. Both options have stringent rules determined by the IRS, and some investments may qualify for both tax breaks.

We’ll go into everything you need to know about 1031 exchanges and Qualified Opportunity Zones (1031s and QOZ) and how they impact taxable gains.

 

What is a 1031 Exchange?

Participation in a 1031 Exchange has evolved from an almost century-old incentive known as a like-kind exchange, allowing investors to defer taxes due to gains realized from an investment property sale. A 1031 Exchange is one of the most generous sections of the IRS tax code, which offers a range of potential benefits to grow a real estate investor’s wealth, which includes:

• Tax deferral
• Diversification
• Tax-advantaged cash flow
• Wealth preservation

 

1031 Exchanges Must Adhere to a Strict Timeline

Using a 1031 tax-deferred exchange requires precise planning and there is a defined timeline that must be followed. Here are three rules to help guide investors to a successful 1031 Exchange:

• Rule #1: Replacement property should be of equal or greater value to the one being sold.
• Rule #2: Replacement property must be identified within 45 days.
• Rule #3: Replacement property must be purchased within 180 days of the relinquished property sale.

 

Rule #1: Greater or Equal Value Replacement Property

The three best-known 1031 exchange property identification rules are:

1. Three-Property Rule: Regardless of value, an investor may identify up to three properties and acquire any or all of them.
2. 200% Rule: An investor may identify more than three potential replacement properties as long as their combined value does not exceed 200% of the original property being sold.
3. 95% Rule: An investor may identify an unlimited number of potential replacement properties, regardless of their value, as long as the properties acquired are valued at 95% or more of the property being replaced.

 

Rule #2: 45-Day Time Limit to Find a 1031 Exchange Property

Before 1979 tax-deferred exchanges had to be completed almost simultaneously. As you could imagine, this caused various problems for real estate investors because it can be hard to transfer titles and funds in a short period of time.

However, the current 1031 exchange process still has a time limit. You must either close on or identify and report on the potential replacement property within 45 days of selling the original property. However, if these guidelines are not followed, the sale of an investor’s relinquished property becomes a taxable event, resulting in capital gains taxes on the sale of the original property.

Rule #3: 180 Days For the Transfer to Complete

Once the replacement property is selected or purchased, the investor has 180 days from the original property sold to close on the replacement property. But remember that 180 days is not the same thing as six months. The IRS counts each individual day, including weekends and holidays (even federal holidays), to determine the 180-day time frame. Thus, it is crucial to consider selecting more than one property to buy if one of them falls through.

 

Wrapping Up 1031 Exchanges

Investors can think of a 1031 exchange as having an interest-free loan from the IRS. But instead of paying tax on capital gains, real estate investors can put that extra money to work immediately and enjoy higher current rental income while growing their portfolio faster than would otherwise be possible.

Participation in a 1031 exchange also provides investors with numerous ways to protect capital, supplement additional income from a property, and diversify asset holdings in a portfolio. However, there are many rules that real estate investors must follow to qualify for a 1031 exchange, and if one is bypassed, it can result in substantial tax penalties.

What are Qualified Opportunity Zones (QOZs)?

Real estate investors looking for opportunities to defer realizing a capital gain have historically been limited to a few specific techniques, such as 1031 exchanges, that only apply to certain types of investments. However, thanks to the 2017 Tax Cuts & Jobs Act (TCJA) provision, a new investment opportunity has emerged that offers more flexibility—and even better tax advantages—than nearly any other real estate strategy available today.

Qualified Opportunity Zones (“QOZs”) are an economic development tool that provides tax incentives to real estate investors who roll over their capital gains to invest in the growth and revitalization of underserved communities. The QOZ program allows the governor of each state (or the mayor in the case of the District of Columbia) to designate 25% of the state’s low-income census tracts as QOZs, subject to certification by the U.S. Secretary of the Treasury.

 

Where are Opportunity Zones Located?

In total, there are over 8,700 QOZs spread across all 50 states, D.C., and several U.S. territories. From urban to suburban, QOZs run the gamut across the US, and to see which areas are eligible, there is an interactive map on the U.S. Department of Treasury’s CDFI Fund Website.

 

What is a Qualified Opportunity Fund (QOF)?

Investments in QOZs must be made via a Qualified Opportunity Fund (“QOF”) to qualify for tax benefits. The US tax code defines a Qualified Opportunity Fund as an investment fund established as a corporation or partnership, designed to invest in one or more Qualified Opportunity Zone properties. QOFs can make investments in a wide variety of real estate and new or existing businesses, including commercial real estate, housing, infrastructure, and start-up businesses. QOFs can be organized as multi-investor funds or as single-invest funds, which have been established by an individual or business. To qualify as a QOF, an investor must hold at least 90% of their assets in a QOZ property, which includes:

• QOZ business property, which is a tangible asset used by a trade or business within QOZ.
• QOZ stock or partnership interests, which are equity interests organized in a partnership or corporation with a majority of their assets in QOZ property.

What is a Qualified Opportunity Zone Business (QOZB)?

A Qualified Opportunity Zone Business (“QOZB”) can be either a corporation or partnership in which at least 70% of the tangible property owned or leased is located in a QOZ. To qualify as a QOZ, the following requirements must be met:

• The business purchased the property after December 31, 2017.
• The original use of the QOZB substantially improves the property.
• At least 50% of the gross income earned by the business was derived from within the Opportunity Zone.

 

Tax Incentives for Qualified Opportunity Zone Funds

Investors who roll over their capital gains into a Qualified Opportunity Fund are provided with three tax benefits — deferral, reduction, and exclusion.

• Deferral of Capital Gain– Investors can temporarily defer capital gains taxes from the sale of another investment into an Opportunity Fund until December 31, 2026.
• Reduction of taxes owed on deferred gains– Capital gains tax on the initial investment is reduced by 10% after five years and by another 5% after seven years through step-up in basis.
• Exclusion of capital gains – If held for at least ten years, and gains are recognized by December 31, 2047, investors will pay no capital gains tax on any appreciation of their Opportunity Fund Investment.

 

To better understand how QOZs work, let’s take a look at a hypothetical example…

 

 

 

 

 

Source: Varnum LLP

 

Investment Risk

Like all investments, QOZ carries risk and in some cases more than other real estate investments, which is due to the fact that opportunity zones are economically distressed areas. Since a majority of opportunity funds have only been in business for a few years, investors have limited historical data to analyze the long-term success of the program. For investors, this makes it harder to assess the risk associated with investing in QOZ.

Conclusion

Ultimately, Opportunity Zones are a game-changer that will provide significant tax benefits for real estate investors while looking to revitalize America’s depressed communities through social impact investments. For real estate investors looking to defer or even eliminate capital gains tax, few solutions provide such immense benefits. Furthermore, investors can also avoid future capital gain tax by holding their investments for more than 10 years. While QOZ can be risky and occasionally involve high fees, the tax benefits can be worthwhile as long as you research each fund thoroughly. We’ve compiled a comprehensive list of similarities and differences between 1031s and QOZs in a recent article. 

 

To learn more about how to invest in 1031s and QOZs, CONTACT US TODAY or visit our Learning Center.

 

 

 

IRC Section 1031 is complex tax language, therefore you should consult your tax or professional for details regarding your situation.  There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal.

It is not intended and should not be construed or relied upon as legal or tax advice. No tax benefits are guaranteed as a result of investing in a Qualified Opportunity Fund. Potential investors should consult their tax advisers with respect to the U.S. federal income tax consequences of an investment in a Qualified Opportunity Fund.

This is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation of any products or services. Opinions are subject to change with market conditions. The views and strategies may not be suitable for all investors and are not intended to be relied on for legal or tax advice.

Securities offered through National Securities Corporation Member FINRA/SIPC