Previous blog articles discussing Opportunity Zone investments have focused on comparisons to a 1031 exchange. Our general summary was that tax deferral through a 1031 exchange versus an Opportunity Zone investment would be preferable to most investors who are selling appreciated rental properties. There is also a greater incentive for investors who utilize the 1031 exchange who reside in states such as California that do not recognize Opportunity Zone benefits for deferral of state income taxes.
In this blog article, we will share insights that we have learned from our analysis of how Opportunity Zones can work in concert with a 1031 exchange and perhaps even offer a solution for investors who are running out of time to complete their exchanges.
What is an Opportunity Zone Investment (QOZ)?
The Opportunity Zone investment option was introduced as part of the Tax Cuts and Jobs Act of 2017 and was widely supported by politicians on both sided of the aisle. It permits investors to defer taxes owed on the sale of most appreciated assets e.g., real estate, stocks, art collections, etc. though investing sales proceeds in designated Opportunity Zone areas throughout the US in to improve housing, infrastructure, and fuel creation of small businesses.
The investor has 180 days from the date of sale of the appreciated assets (including properties) to invest funds into a Qualified Opportunity Fund. The fund will then invest in a property located in a Qualified Opportunity Zone area.
Investors are allowed to defer payment of capital gains taxes until December 31, 2026, with the tax payable in 2027. For Opportunity Zone investments made prior to December 31, 2021, investors would receive a 10% discount on previously owed taxes. As of January 1, 2022, discounts on prior owed taxes are no longer available although a deferral of taxes is still allowed. In addition to receiving a deferral of owed taxes investors are also permitted to receive a full exemption of capital gains taxes on the sale of projects completed in the select Opportunity Zone provided the investment is held for 10 years.
While the investor may invest both the return of their initial investment as well as the capital gain, only the capital gain portion will be eligible for future tax exemptions from gains resulting from the eventual sale of Opportunity Zone property.
Most states allow their residents to enjoy Opportunity Zone tax benefits against state income taxes. California, North Carolina, and Mississippi do not recognize QOZ benefits, and Arkansas, Hawaii, Massachusetts, and Pennsylvania only allow limited QOZ state tax benefits.
Even with these limitations, investors from across the US have found QOZ investments to be appealing and have invested over $75 billion during just the first three years of the program.
What are Partial and Failed 1031 Exchanges?
Readers may recall that in order to complete a full 1031 exchange tax deferral, three conditions must be satisfied with regard to replacement properties:
- Investors must acquire replacement properties valued equal to or greater than the property that they sold
- All net proceeds after repayment of loans and other expenses must be reinvested in the replacement properties
- Any debt in the property that was sold must be replaced by either equal or greater debt in the replacement properties or// by adding cash from outside the exchange to reduce this debt requirement dollar-per-dollar
Furthermore, from a timing standpoint:
- All replacement properties must be identified within 45 days of the close date of the sold property
- Identified properties must be acquired within 180 days of the close date of the sold property
A partial or failed 1031 exchange may occur when the investor is not able to achieve all these requirements either by making a conscious decision to take funds out of the exchange, reducing debt in the acquired property (thereby incurring a partial tax liability) or by simply not being able to meet all the exchange requirements e.g., inability to find and identify suitable replacement properties, obtain financing, or to successfully close on the identified replacement properties.
While the tax liability incurred in a partial exchange may be tolerable, the consequences of a failed exchange resulting a full tax liability may not be an acceptable outcome.
How Can an Opportunity Zone Investment Save a 1031 Exchange?
Recent discussions with 1031 investors, Qualified Exchange Intermediaries, and real estate attorneys have provided useful insights as to how Opportunity Zones investments can be utilized to defer taxes that may be owed either in a partial or failing 1031 exchange.
There are two broad areas where it may make sense for investors to shift away from a 1031 reinvestment strategy to a Opportunity Zone investment may be helpful in negative lessening tax consequences:
Inability to Find Suitable Replacement Properties within the 45-day ID Period
In our experience, most real estate investors who evaluate options to either defer taxes via a 1031 exchange or an Opportunity Zone, will elect to move forward with a 1031 exchange due primarily to their ability to continue to defer and potentially avoid taxes altogether.
However, many investors who are not able to find suitable replacement properties face the risk of incurring a tax obligation when their 45-day ID period comes to end.
Even though the Opportunity Zone may have not been their first choice, many who are running out of time may elect to take their funds out of the exchange and, instead, invest those funds in a suitable Opportunity Zone investment. Yes, capital gains taxes will need to be paid in 2026 (at a slight discount) – but, in combination with the potential capital gain exemption on the property developed in the Opportunity Zone, the overall investment may prove to be an attractive alternative to paying a hefty near-term tax on the sale of their rental property.
Inability to Close on Identified Replacement Properties within the 180-day Period
The selection of properties during the 45-day ID period is only one step in the 1031 exchange process. Identified properties must also be fully acquired within 180-days of the close of the sale. As all seasoned real estate investors know, there are an infinite number of reasons why acquisitions fail to close. Unanticipated events are common in real estate including discovered property defects, issues obtaining financing, personal reasons, etc.
When it appears that closing an acquisition within 180 days cannot be achieved, an Opportunity Zone alternative may make sense.
It is very important for investors who are initiating a 1031 exchange to review permitted options to make changes during the exchange with their selected Qualified Intermediary. Rules governing changes during the exchange are not uniform throughout the exchange industry and not all Qualified Intermediaries will allow investors to make desired changes, even if not prohibited in the tax code.
We encourage all 1031 exchangers to confirm the limit to which their Qualified Intermediary will permit possible changes in their exchange process including exiting the exchange and instead reinvesting funds in Opportunity Zones.
For more information on Opportunity Zone investments or 1031 exchanges, please reach out to our investment team at firstname.lastname@example.org. We're happy to answer your questions and help you explore your options.