By John Berlet
As a seasoned multifamily syndicator, I am sometimes asked whether 1031 exchanges continue to be investors’ preferred tax deferral strategy. My answer is it depends.
Since becoming involved in Qualified Opportunity Zone programs (QOZs), I have realized that QOZs provide a potentially more attractive alternative to 1031 exchanges. Both QOZs and 1031s offer you the chance to re-invest gains from selling a property and defer taxation. However, 1031s require both basis and gains to be re-invested, while you only have to re-invest the gain in a QOZ. Short-term or long-term gains from the sale of non-real-estate assets, such as proceeds from selling a business or selling stocks, can also be deferred when investing in a Qualified Opportunity Zone Fund.
For those focused on estate planning, 1031 exchanges could be preferable to QOZs. 1031s, for example, allow you to defer taxable gains for as long as you own the asset. A 1031 can give your heirs a step-up in basis to the asset’s fair market value if the investor dies.
However, if you’re someone who would like to increase your wealth while doing something positive for a community, QOZs might be a better option. One of a QOZs main selling points, after all, is that they are focused on helping develop underserved, struggling areas. QOZs may also be attractive if you are an investor wanting access to capital during your lifetime.
What is a 1031 exchange anyway?
Frequently used by real estate investors, a 1031 exchange allows you to sidestep capital gains taxes.
1031s are popular with people who want to take an underperforming property and exchange it for another property without needing to pay taxes on the proceeds. Named after Section 1031 of the Internal Revenue Service’s tax code, 1031 exchanges are tools that allow real estate investors to swap out one investment property for another and defer capital gains or losses. Typically, you’d owe these capital gains taxes when you sell a property, but 1031s make it so you can swap now and pay later. Another name for 1031s is “like-kind” exchanges.
1031’s have some potential benefits beyond capital gains tax deferral. A 1031 might allow investors greater diversification and the ability to consolidate multiple properties into one. Using a 1031, an investor could improve their bottom line by swapping a property that generates low or no cash for one with positive cash flow.
1031s, while they remain popular with investors, are fraught with potential pitfalls. You must jump through numerous hoops, rules requiring strict adherence, and deadlines. There are three basic steps necessary to effect a 1031 exchange.
- You must identify the properties you want to buy and sell. The piece of property you are selling must be substantially similar, or like-kind, to the one you wish to purchase. While this does not necessarily mean they have to be of identical quality, there are guidelines for like-kind to which you’ll need to adhere.
- You need to select a “qualified intermediary.” 1031 exchanges require you to work with a qualified intermediary, also known as an “exchange facilitator.” Your qualified intermediary choice is critical because they hold your funds in escrow until you complete your exchange. Without a carefully-chosen qualified intermediary, you risk losing money or missing deadlines that could void your 1031 exchange and leave you with a huge tax bill.
- You must notify the IRS. Using IRS form 8824, you will describe your 1031 exchange properties, explain the parties involved in the process, provide a timeline, and list all funds used. The property you sold and the new property acquired is subject to strict IRS requirements.
What is a Qualified Opportunity Zone fund?
Established by the 2017 Tax Cuts and Jobs Act (TCJA), Opportunity Zones aim to add value to low-income communities by spurring investment and job creation while giving attractive tax benefits to investors.
To create Opportunity Zones, each state nominates low-income areas by census tract. These selections are then certified by the Treasury Secretary via delegation of authority to the IRS. Investors file form 8896 through the IRS to create Qualified Opportunity Funds.
These vehicles are structured as corporations or partnerships formed to invest in an OZ census tract. The investment may be either in real estate or in business equity. A Qualified Opportunity Fund must have at least 90% of its assets in that OZ area.
Potential benefits of Qualified Opportunity Zones include:
- You may eliminate capital gains taxes resulting from certain sales or exchanges of your Qualified Opportunity Fund investment after ten years.
- You can defer short or long-term capital gains taxes on the exchange or sale of not only real estate but any property, along with other investments generating capital gains.
- OZs allow socially-conscious investors to do good by bringing value to low-income communities.
Summing it up:
Both 1031 exchanges and QOZs can help investors avoid the sting of capital gains taxes. Depending on your unique goals as an investor, you may find advantages in selecting one over the other. It’s wise, however, to consult your financial advisor or other qualified tax specialists to determine if using these strategies makes sense in your particular situation.