By: Greg Lehrmann, Attorney and Cindy Pham, CCIM
The tax code offers incentives to deploy capital in ways that achieve desired social outcomes. Section 1031 exchanges help businesses expand and increase the capacity of investment properties nationwide. Section 1400 of the tax code, commonly known as the “Qualified Opportunity Zone” (OZ) provision, provides favorable tax treatment on deferred gains along with tax exclusion for new gains on assets held at least 10 years. These OZ tax incentives are available to investors who invest in a designated Opportunity Zone through an Opportunity Zone Fund (OZ Fund) targeting economically depressed areas. Here is a brief summary of the tax benefits of an OZ investment:
Following are three possible ways investors can take advantage of OZ investments in conjunction with 1031 exchanges along with two approaches that will not qualify.
1031 exchange requirements and OZ rules are separate tax provisions and investors must adhere to the rules for each of these tax codes separately. However, an OZ can be a fallback position for 1031 exchange investors with a failed exchange. Here is how this approach can work: An investor initiates a 1031 exchange and does not find suitable replacement property within 45 days or changes their mind within 45 days and decides to invest money into an OZ instead of like-kind real property in a 1031 exchange. The investor notifies the qualified intermediary (QI) that they haven’t identified any replacement property and want to receive their 1031 exchange proceeds on day 46. The QI releases exchange proceeds to the investor on day 46. Now the investor has 135 more days (up to 180 days from the sale of relinquished property) to invest proceeds into an OZ Fund. One significant benefit of changing strategies from a 1031 exchange to OZ is that the investor only needs to invest the gain (not all net proceeds like needed for full deferral in a 1031 exchange) into the OZ Fund.
The entity (which must be a regarded entity like partnership or corporation, not a disregarded entity for federal tax purposes) completes a 1031 exchange into a qualifying like-kind replacement property. Next, after the 1031 exchange is complete, the entity elects for OZ Fund status. After this, new OZ Funds coming from deferred capital gain from other sources or from syndicated funds are used to substantially improve the 1031 replacement property. As a result, the gain in the 1031 exchange is deferred past 2026 (until the regarded entity sells in a later taxable sale) and separately the gain deferred in the OZ Fund used for improvements qualifies for favorable OZ tax treatment.
When an investor sells a relinquished property held for investment, they have 3 options involving 1031 exchanges and OZ. (A) Initiate a 1031 exchange and obtain tax deferral under the 1031 exchange rules and requirements; (B) Invest the capital gain into an OZ Fund under the OZ rules and requirements or (C) Take advantage of both tax strategies and split the exchange proceeds, allocating some proceeds to a 1031 exchange in conjunction with using a QI and investing the remaining proceeds into an OZ Fund.
An investor cannot do a 1031 exchange into an OZ Fund as replacement property. The OZ Fund is a fund, and not qualifying like-kind real property required for deferral under Section 1031. Only real property held for investment or used in a business qualifies for 1031 tax deferral.
2. An investor cannot initiate a 1031 exchange, identify property in 45 days and not purchase all the identified property, and then decide to later invest remaining exchange proceeds into an OZ Fund after the 1031 exchange is over. Section 1.1031 (k)-(g)(6) specifies an investor must generally acquire all replacement property they are entitled to (i.e. all property identified within the Identification Period) or wait until day 181 (the expiration of the Exchange Period) to receive 1031 exchange proceeds from the QI. If an investor receives proceeds from the qualified intermediary on day 181, they are outside the 180-day reinvestment time required by OZ rules and not eligible to invest into an OZ Fund. There is a narrow exception for certain investors who have Section 1231 gain (gain from the sale of assets used in a business for more than one year.) Section 1231 gains and losses must be netted at the end of the tax year so the 180-day period for Section 1231 gain being invested in an OZ Fund may begin on the last day of the taxable year in some situations
The law and tax benefits around OZ Funds are complex and evolving. Investors should seek the advice of their legal and tax advisors who can review their unique facts and circumstances and long-term objectives before investing.
Greg Lehrmann and Cindy Pham are Division Managers with Asset Preservation, a leading national qualified intermediary. They can be contacted at 866-394-1031 or email@example.com; firstname.lastname@example.org