By: Benjamin Buckner
The like-kind (1031) exchange has long been the standard tax-deferral strategy for real estate investors. That was the case until the Tax Cuts and Jobs Act of 2017 (“TJCA2017”) codified Section 1400OZ, creating Opportunity Zones. Intended to spur economic development within distressed communities across the United States, Opportunity Zones (“OZ”) have provided a viable tax deferral strategy that should be considered when exploring a like-kind exchange or overall tax deferral of capital gains. While both strategies provide for tax deferral, each is unique in its characteristics, and the differences must be weighed by an investor to determine the best option for their circumstances.
The most visible contrast between the 1031 exchange and OZ investment is the property that is eligible for deferral. The TJCA2017 provided that like-kind exchange treatment would only apply to real property that is held for investment or used in a business. On the other hand, any type of property that generates a capital gain upon sale is eligible for gain deferral if invested into a Qualified Opportunity Fund (“QOF”). Replacement property in a 1031 exchange must be identified within 45 days, and the purchase of the replacement property must close within 180 days. Investment in a QOF must occur within 180 days with no advanced identification requirement. Further, proceeds from the sale of property in a 1031 exchange must be held by a qualified intermediary. This is not the case in an QOF investment, in which the investor will have access to the funds within the 180-day investment period. An investor in a QOF has the option to invest only the capital gain portion from the sale, while the entire proceeds from the sale must be reinvested into the replacement property in a 1031 exchange to achieve complete tax deferral.
1031 exchange and OZ strategies also differ in the initial basis of the investment. The basis of replacement property in a 1031 exchange will be the same as the original relinquished property in the transaction. The basis of property in a 1031 exchange will step up to fair market value at death. Investors in a QOF will take an initial basis of zero in their investment; however, the basis of the investment into a QOF is eligible for up to a 15% step up in basis if held for seven years.
Finally, 1031 exchanges and OZ strategies have different tax deferral terms. The capital gain invested in a QOF must be recognized on December 31, 2026, reduced by the step-up in basis allowed at the five- and seven-year holding period milestones. Note that the 5% step up applies to investments prior to December 31, 2019 and the 10% step up is applicable to investments made prior to December 31, 2021. Once the QOF investment has been held for 10 years and the investment is sold at a gain, the entire capital gain is not subject to taxation. The gain deferred in a 1031 exchange is recognized when the property is sold, unless another 1031 exchange is completed or the gain is invested in a QOF. Therefore, 1031 exchanges allow for indefinite gain deferral.
As such, there are many factors in play when choosing between 1031 exchanges and OZ investments. Each factor must be considered when determining the appropriate tax-deferral strategy for your investments. HPG is here to assist you with planning for these investments and weighing your options.