The groundbreaking 2017 Tax Cuts and Jobs Act legislation sent shock waves through the real estate industry when it introduced qualified opportunity zones. These federal zones help real estate investors and developers alike save taxes and expand their operations – but not without some challenges. Here are some tips to shed some light on this new tax law so you can navigate your 2020 investments with ease.
Is QOZ Investment the New 1031 Exchange?
Scott O’Sullivan, Margolin, Winer & Evens Partner and authority on real estate taxation, noted that Section 1031 exchanges – also called like-kind exchanges – have exploded in popularity since they were first introduced in 1954.
“1031 exchanges have been around for many, many years. It is the premier tax deferral mechanism for real estate owners and developers.”
While the law was not originally intended for real estate, the industry adopted it as its own. As the years progressed, policymakers tweaked the law and made it even more appealing to real estate owners. Today, real estate professionals can defer capital gains resulting from almost any real property sale if they purchase similar property within 180 days and make the appropriate elections.
The QOZ program is an entirely new animal. Individuals can defer capital gain recognition when they invest those gains into qualified opportunity funds (QOFs) that support new businesses and real estate, including real estate developments, in economically depressed zones across the country.
Although it is its own unique legislation, the program provides some of the same benefits as like-kind exchanges. Both laws allow taxpayers to temporarily defer capital gain recognition when they make new investments. However, Section 1031 investors can put off gain recognition for as long as they hold their replacement property, while QOZ investors must recognize their gains no later than December 31, 2026, even if they hold onto their investments beyond that date.
The QOZ program only defers taxes for a finite period, but there are three ways it outperforms 1031 exchanges.
First, some taxpayers will be able to permanently exclude 10% of their original gain if they meet these requirements: They make their investment before December 31, 2021 and hold that investment for at least five years. They will then receive a step-up in basis that effectively eliminates 10% of their original gain. They must recognize the remaining gain on December 31, 2026 or the year they dispose of their investment, whichever occurs first.
Second, taxpayers who hold their investment for at least 10 years can exclude the gain on their investment in the QOF by receiving a step-up in basis to fair market value when they sell their investment. Although this does not eliminate the original gain (which must be recognized on or before December 31, 2026), it permanently eliminates gain resulting from appreciation within the fund. Section 1031 investors can only permanently eliminate gain if they hold their investment until death.
Third, taxpayers are not limited to gains from, and investments in, real estate as they are required to under Section 1031. To receive the gain deferral, they must simply invest their capital gains into an opportunity zone (or rather, into a QOF). They can invest any capital gains, even those that occur from sales of stock or business interests, into a QOF and qualify for the gain deferral and potential gain elimination.
Using Opportunity Zone Investment to Raise Capital
Kris Eimicke, tax partner at law firm Pierce Atwood, points out how the indirect benefits of the QOZ program have the potential to help real estate developers more than the tax deferral aspects ever could.
“The 1031 exchange is a way to defer your own capital gains. The opportunity zone program can do that as well, but for many developers, the key benefit of the opportunity zone program is attracting investment to your project.”
To attract investors, many developers create a QOF to attract capital for their particular project or projects. The QOF then holds investment capital and invests it in a particular to project to be spent on the construction project in the economically depressed zone. Developers can develop new projects within a qualified zone, create a QOF, and use that fund to raise capital they need to fund their project.
C.J. Follini, Principal at the privately held real estate investment firm Ranger Asset Management, recognizes the industry’s interest in raising capital using QOFs and believes the benefits are evident, with the caveat that the tactic is completely untested. “They haven’t been audited, they haven’t been adjudicated, and they haven’t been challenged,” he said. “You are going into a total unknown.” Section 1031 has been around for more than half a century, so real estate professionals have it down to a science. The same cannot be said about raising capital in accordance with the QOZ program.
And unfortunately, investors don’t have much time to get comfortable with the QOZ program. Investments made after December 31, 2021 will no longer qualify for the 10% deferral, and the program will shutter its doors altogether on December 31, 2026, unless Congress extends it. While QOZ investments may prove to be a boon to some, they will never fully supplant 1031 exchanges, which offer tried-and-true tax planning strategies.