For high income earners, one of the most significant benefits of a commercial real estate investment is the favorable tax treatment they receive. In this article, we are going to discuss two of the most beneficial tax programs, the 1031 Exchange and the Opportunity Zone. We will describe what they are, how investors benefit from them, and identify the key differences between the two. By the end, investors will have the information needed to determine which program is the most suitable fit for their own needs.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of this effort, we are always working with our investors to educate them about the tax benefits of a commercial real estate investment – including those offered by 1031 Exchanges and Opportunity Zones. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
Scenario Setup
To understand the benefits of 1031 Exchanges and Opportunity Zones, it helps to set up a scenario in which they might be used (NOTE: This example is simplified for illustrative purposes).
Imagine that an investor purchases a small retail center for $1MM. For years, they collect a small return from the cash flow, but after a decade the property has appreciated significantly and they sell it for $2MM. The difference between the cost basis and the sales price, $1MM, is classified as a “gain” for tax purposes and is subject to capital gains taxes, which can be as high as 25%, depending on the taxpayer’s tax bracket and filing status. So, for example, a 25% tax on a $1,000,000 profit is $250,000 – which is a lot by any measure.
Fortunately both a 1031 Exchange and an Opportunity Zone provide investors with the ability to defer these capital gains taxes – or, in the case of an Opportunity Zone, eliminate it all together. Let’s review each program.
1031 Exchange
A 1031 Exchange is a program, sanctioned by Internal Revenue Code (IRC) section 1031, that allows investors to defer capital gains taxes indefinitely as long as they take their sales proceeds and reinvest them into another property that is “like kind” to the one that was sold. In addition, the IRS lays out several other rules that investors must follow. Among the most prominent are:
- Investors must identify their like kind replacement property within 45 days of the sale of the “relinquished property.”
- Investors must close on the purchase of the replacement property within 180 days of the sale of the Relinquished Property
- Investors must reinvest all of the equity from the sale of the Relinquished Property – any cash proceeds received may be taxable
If all of the rules are followed correctly, the transaction will qualify for full tax deferral and investors will not immediately be on the hook for the capital gains tax bill. Further, there is no limit to the number of times that a 1031 Exchange can be completed so, in theory, an investor could repeat this process over and over indefinitely, allowing their capital to grow tax free over a long period of time. This is a major tax incentive for commercial real estate investors that can prove to be incredibly lucrative.
As great as a 1031 Exchange is, there is another program that could offer even more tax advantages, the Opportunity Zone.
What is An Opportunity Zone?
The Tax Cut and Jobs Act of 2017, a landmark piece of legislation, established dozens of “Opportunity Zones” (identified by census tract) across the United States – areas that are sorely in need of capital investment. To encourage investors to allocate capital to these areas, the government created a powerful tax incentive.
All of the rules can be complex, but the key point is this. If an investor sells a property for a gain and reinvests that gain into a “qualified opportunity zone” or “QOZ” for short, they can defer capital gains taxes or eliminate them entirely depending on how long the property is held.
- If the investment is held for a minimum of 5 years, the investor’s cost basis is reduced by 10%.
- If the investment is held for a minimum of 7 years, the investor’s cost basis is reduced by 15%
- This is the big one, if the investment is held for a minimum of 10 years, capital gains taxes are eliminated entirely.
From this description, it is easy to see that an opportunity zone investment can provide a major tax benefit. But, for individual investors, it can be difficult to find an investment vehicle through which to allocate this capital. For most, an investment in an opportunity zone fund, sometimes called a qualified opportunity fund or QOF, may be their best bet as they are offered by a number of investment companies.
In many ways, the reinvestment of taxable gains into a QOZ program is a win-win for both the investor and the community. The investor wins because they get an opportunity to reduce their tax liability and the community wins because investment funds are redirected into economically distressed communities that can use them to make substantial improvements that will hopefully drive economic development on behalf of all citizens.
1031 Exchange vs. Opportunity Zone Program
We have established that both a 1031, like-kind exchange and a QOF investment can be excellent ways to defer or eliminate capital gains taxes on the profitable sale of an investment property. But, there are key differences between these two approaches that investors should be aware of:
- Location: Opportunity Zone properties are located in specific census tracts in the United States so an OZ investment must be made in one of them. A 1031 Exchange investment can be made anywhere, as long as the replacement property qualifies as a like kind property to the one that was sold (specifics outlined in IRC section 1031).
- Property Types: 1031 Exchange rules are fairly specific about what qualifies as a replacement property, but Opportunity Zone rules provide much more leeway about what can be purchased – including personal property.
- Structure: In a 1031 Exchange, the entity that sold the Relinquished Property must be the same as the entity acquiring the Replacement property. In a Opportunity Zone investment, investors have additional flexibility with regard to structure. For example, the selling entity could be a partnership and the new investment entity could be an individual.
- Timing: In a 1031 Exchange, proceeds from the sale of the Relinquished Property must be used to purchase the Replacement Property within 180 days. In some cases, the Opportunity Zone investment may not be subject to the same time requirements.
It is important to note that these are two very different transactions and the rules for both can be complex. For specific advice and action plans, it is always best to consult an expert in the field such as a CPA, tax attorney or, in the case of a 1031 Exchange, a Qualified Intermediary. These individuals can provide transaction specific advice that is outside the scope of this article.
When to Perform a 1031 Exchange vs. When to Invest In an Opportunity Zone
The circumstances surrounding every transaction are unique so it can be difficult to make a blanket statement about when to do a 1031 Exchange versus when to invest in an opportunity zone. But, there are a number of factors that investors should consider:
- Asset Being Sold: The rules for a 1031 Exchange are specific that the asset being sold must be a property that is held for “productive use in a trade or for business or investment.” Opportunity Zone rules are broader in that the asset does not necessarily have to be a property, it could be stocks, bonds, or collectibles.
- Gain: 1031 Exchange rules require investors to reinvest the total value and equity into a new property. Opportunity Zone rules only require the reinvestment of the gain.
- Reinvestment Options: 1031 Exchange funds must be reinvested into a like kind property and there are strict identification rules such as the three property rule or 95% rule. Opportunity Zone funds can be reinvested into any qualified opportunity fund.
- Identification: 1031 Exchange rules require the advance identification of the Replacement Property within 45 days of the sale of the Relinquished Property. Opportunity Zone funds do not require the same type of advance notification.
- Tax Deferral: 1031 Exchange Investors can defer capital gains taxes indefinitely. Opportunity Zone Investors can defer their gains until 2026, at which point the transaction could become taxable. NOTE: The 10 year holding period for the elimination of tax liability was ten years from the creation of the program.
- Improvements: Once purchased, 1031 Exchange investors are not required to make additional improvements to the property. Opportunity Zone investors must make substantial improvements to the property, which may require additional funds. After all, the point of directing Opportunity Zone funds to low income areas is to improve them.
- Sales: As long as they continue to reinvest their funds into like kind properties, 1031 Exchange investors can buy and sell properties indefinitely, deferring gains along the way. An Opportunity Zone investment is a one time deferral.
So, perhaps an easy to sum this up is that investors with a property to sell, who know that want to buy another property are probably a better fit for a 1031 Exchange. Investors who have gains on non-property assets and prefer a bit more flexibility for reinvestment may be a better fit for an Opportunity Zone. But, it should be stressed again that every investor’s needs are unique. It is always a best practice to consult with a financial advisor or tax attorney to get outside advice on suitability.
Summary of 1031 Exchanges vs Opportunity Zones
One of the major benefits of a commercial real estate investment is the tax treatment of it. With regards to the taxes that must be paid on a profitable sale, there are two programs that are particularly beneficial to investors, the 1031 Exchange and the Opportunity Zone.
A 1031 Exchange is a program that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into another property that is “like kind.”
An Opportunity Zone is an economically disadvantaged area that was identified as part of the passage of the Tax Cuts and Jobs Act of 2017. As part of the bill investors were incentivized to invest capital in these zones in return for a reduction in capital gains taxes. If the investment was held for 10 years, taxes were eliminated completely.
Although the outcome is the same, these two programs have their own nuances. For example a 1031 Exchange requires the sale of a property, but an Opportunity Zone investment can come from the sale of a number of different assets that have a capital gain – like stocks or bonds.
In order for investors to determine if they should do a 1031 Exchange or Opportunity Zone, they should consider a number of factors including: the asset being sold, the amount of the gain, and whether or not they want to reinvest the sales proceeds into another property.
If there is any question about the suitability of these transactions, investors should consult a financial advisor, CPA, or tax attorney.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
