Investors who utilize Section 1031 (aka “Like-Kind”) Exchanges for the tax benefits they provide should consider a new option for sheltering real estate capital gains: Qualified Opportunity Zone Funds (QOZF). These funds have arisen as a result of the Tax Cuts and Jobs Act of 2017, which designated Qualified Opportunity Zones to promote investment in economically distressed areas. While 1031s remain a useful tool, QOZFs have many tax and other advantages compared with 1031s:
Diversification
A 1031 is generally a single-asset structure, and real estate is the only asset that now qualifies. However, a QOZF can invest in multiple real estate assets as well as businesses, through various structures. Because some QOZFs consist of a portfolio of assets they offer investors geographical and sectoral diversification as well.
Ease of Investing
1031s can be cumbersome and problematic because their execution requires the use of a qualified intermediary, identification of replacement property within 45 days and a closing within 180 days. All of the administration can be very difficult and time consuming. On the other hand, an investor simply contributes his or her capital gain directly to a QOZF within 180 days of their sale or exchange and file an easy election within their tax return. The investor no longer has to be burdened with following the rigid 1031 rules and directly owning real estate.
Economic Benefits
An investor has to die in order to eliminate the capital gains associated with a 1031. Furthermore, investors in 1031s can face depreciation recapture on disposal of assets, or be confronted with taxes on the portion of the replacement property that does not meet the like-kind exchange criteria. By contrast, a QOZF can offer a 10% or 15% reduction in the deferred capital gains, depending on the holding period of the QOZF interest. Furthermore, if the QOZF interest is held for at least 10 years the investor would pay no tax when it is sold. QOZF investors also retain access to their principal (or basis) amount, as opposed to the Section 1031 requirement that the principal must be rolled into the replacement property.
A 1031 Can be Combined with a QOZF Investment
An investor who disposes of an asset under a 1031 and is unable to find a qualifying replacement property of equal or greater value would reap considerable benefits from investing the taxable gain generated by the difference into a QOZF. For instance, if an investor needs a replacement property worth $10 million but is only able to locate a quality property worth $7 million, then the investor will have a capital gain on a portion of their investment. If instead this taxable gain were put into a QOZF, then all gains would be deferred. The investor would thereby receive the benefits of both a 1031 and a QOZF investment.
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