Are Opportunity Zones a Tax Deferral Alternative to 1031 Exchanges?

With the passage of the Tax Cuts & Jobs Act (TCJA) in December 2017, we saw the elimination of Section 1031 exchanges for all types of property except real property. Included within the TCJA is Section 1400Z-2 which established an incentive for investing in Opportunity Zones (O-Zones). Recently, I have spoken with a number of taxpayers who have heard about Opportunity Zones and want to know if they are a viable alternative to a 1031 exchange. My answer is usually “it depends.” Here, I provide an overview of opportunity zones and their differences from 1031 exchanges.

Qualified Opportunity Funds

An investment under the O-Zone code provision and proposed regulations has to be into a qualified opportunity zone listed by the Community Development Financial Institutions Fund. Typically, the zones are areas where most of the population live well below the poverty level and the O-Zone provisions are obviously designed to encourage investment into Qualified Opportunity Funds (QOF) that have, in turn, invested in qualifying new or used property or qualified businesses after December 31, 2017. These investments may not fit the taxpayer’s property investment goals.

Much like Section 1031, the reinvestment window for a QOF investment is 180 days after the sale. However, unlike Section 1031, the taxpayer has to purchase shares of stock or partnership interest in a QOF invested in the O-Zone. The upside for the taxpayer is that unlike the typical 1031 exchange, which requires a reinvestment of 100% of exchange value for 100% gain deferral, the investor in an O-Zone only has to reinvest the capital gain portion and can draw out the basis on the sale of the relinquished asset. The trade-off for being able to pull out the cash is the obligation to comply with the myriad of rules designed to ensure that the QOF meets the O-Zone requirements.

Partial Ownership of Real Estate

When a taxpayer invests into a qualified opportunity zone, they are not purchasing a discrete, solely-owned real property interest (although the taxpayer could conceivably create their own QOF). Most often the investment will comprise ownership of stock or partnership interest in the QOF. This may be an issue for most taxpayers who are used to sole control of their investments. These are the same investors who are uncomfortable with TIC or DST ownership interests.

Potential for Capital Gains Deferral

Investing in an O-Zone results in something different than the potential 100% deferral of capital gains achieved with Section 1031 exchanges over the course of ownership of investment or business use property. With an O-Zone investment, the taxpayer can obtain a potential exclusion of capital gain up to 15% between the acquisition of the property during the 2018-2019 window and the end of 2026 (or the earlier sale of the QOF interest). The taxpayer may also achieve 100% capital gain exclusion if the investment is held for 10 years and sale occurs before 2047. Realistically, the gain will probably only be deferred for eight years or the end of 2026, and the gain will have to be reported on the taxpayer’s 2026 return.

Opportunity Zone Regulations

Finally, the proposed regulations for O-Zones are complicated and are still a work in progress. For example, there is still no clear definition of what “substantially all” means for purposes of the holdings of the QOF within the qualified O-Zone. There are ongoing annual certification requirements, strict timetables for reinvestment if a QOF investment is sold, a new set of forms for election of deferral and certification, minimum investment requirements for property types, etc.

Summary

While O-Zone investments are not a replacement for 1031 real property exchanges, they afford benefits to taxpayers who are willing to invest in the types of properties present in the designated zones and limit their gain deferral to less than the potential 100% deferral available in a 1031 exchange. Certainly, the Treasury will continue to refine the O-Zone regulations, and most likely a whole industry will emerge around these kinds of investments. The key for taxpayers is to learn of the pitfalls and the potential benefits, find advisors who know the rules, perform their due diligence and not to get lost in the O-Zone.