Real estate investors have used 1031 “like-kind” exchanges to defer capital gains taxes on the proceeds from the sale of real property for nearly 100 years. But passage of the Tax Cuts and Jobs Act of 2017 added a new tax-deferral provision to the tax code for investors who reinvest proceeds from the sale of real property into certain types of new property. Savvy real estate investors need to understand the differences between the two approaches in order to maximize the benefits of these tax deferral provisions.
Qualified Opportunity Funds
Qualified Opportunity Funds were created to direct investments into Qualified Opportunity Zones (QOZ), which are Census tracts identified by states as low-income areas that would benefit from investment. The concept of QOZs and the tax benefits related to them was created by the TCJA.
To qualify for the tax deferral allowed by TCJA, an Opportunity Fund must invest at least 90 percent of its assets in QOZ properties.
Capital gains tax deferrals on investments made through Qualified Opportunity Funds extend through Dec. 31, 2026, or as of the sale of the property, whichever happens first.
1031 “like-kind” exchanges
A 1031 exchange enables a taxpayer who owns real property that is used in a trade or business to defer taxes on any gain when the property is sold, as long as the taxpayer identifies another property to acquire, also to be used in a trade or business, within a specified timeframe.
Capital gains taxes on properties sold in a 1031 exchange are deferred indefinitely until the replacement property is sold.
1031 exchanges and QOZ investments are similar in two significant ways:
- They enable investors to defer recognizing the gain on the sale of an investment or property.
- Both provisions encourage investors to reinvest gains from previous investments, which helps keep money in the real estate market and stimulates growth.
How they differ
It is the differences between 1031 exchanges and QOZ investments that real estate investors must be aware of and plan for:
Type of investment. Investments in Qualified Opportunity Funds can be, but are not necessarily, tied to a specific piece of property. As long as the fund puts at least 90 percent of its assets into one or more QOZs, the investment qualifies for the tax deferral. With a 1031 exchange, however, the buyer reinvests gains from one property into another specific piece of property to qualify for the tax deferral. In addition, a 1031 exchanged property can be located anywhere in the United States and need not be contained in QOZs.
Time horizon. Like many provisions of TCJA, the tax deferral for investments in Qualified Opportunity Funds expires on Dec. 31, 2016. Hence, the tax deferrals for investments made through this provision expire on that date, or earlier if the property is sold. On the other hand, tax deferrals on properties sold in connection with a 1031 exchange remain in force indefinitely. Therefore, a taxpayer who is looking at a time horizon longer than seven years to enable an investment to grow would do best to look at a 1031 exchange rather than a Qualified Opportunity Fund.
Exclusion of certain gains from tax liability. Under a 1031 exchange, the entire gain from the sale of an exchanged property is subject to capital gains taxation when the replacement property is sold. However, Qualified Opportunity Fund investors who hold their investments for at least five years may exclude 10 percent of the original deferred gain from tax liability. An investor who holds a property for at least seven years may exclude 15 percent. However, since the Qualified Opportunity Fund provision of TCJA expires at the end of 2026, an investor must have invested in a QOZ property before the end of 2019 to qualify for the seven-year exclusion.
Stepped-up basis. One of the most significant differences between a 1031 exchange and an investment in a Qualified Opportunity Fund is the stepped-up basis on the latter investment if an investor holds a QOZ property for more than 10 years. This means that when an investor sells an investment in a Qualified Opportunity Fund, the basis (the amount of proceeds reinvested in the QOZ) is increased to the fair market value at the time of the sale. This can result in little to no taxable gain. In a 1031 exchange, the original basis is used to calculate the gain at the time of sale, no matter how long the investment has been held, and the investor pays capital gains taxes on the difference between the basis and the fair market sale price. Therefore, the stepped-up basis for investments into Qualified Opportunity Funds is a significant benefit for investors who can hold an investment for at least 10 years.
There are many subtleties to 1031 exchanges and Qualified Opportunity Fund investments that may make one or the other more advantageous in your situation. Contact us for a consultation.
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