For investors who sold off assets at the start of the pandemic, significant taxes owed on capital gains can be a cause for concern. In addition to extending the tax filing deadline this year, the IRS announced some relief for investors who reinvest their capital gains into Qualified Opportunity Zone (QOZ) funds. The notice from the IRS extended the deadline to reinvest in QOZ funds to December 31, 2020, allowing investors to take advantage of opportunity zone tax benefits.
In addition to other tax incentives, like 1031 Exchanges, QOZ funds are an investment tool that can help reduce or defer tax payments. However, there are certain advantages that can make these investments an even more appealing alternative.
This tax incentive became available to real estate investors after the Tax Cuts and Jobs Act of 2017 (TCJA) was passed. Like existing tax incentives, the QOZ provisions permit investors to reduce their taxes by investing in certain areas designated as disadvantaged or underdeveloped. This law, gives investors significantly more flexibility in taking cash out of sales and avoiding taxes on appreciation of certain qualified assets.
What’s more, limits placed on 1031 Exchanges make QOZ funds even more attractive as an alternative.
Real estate investors with sufficient capital to hold investment properties for 10 years are best poised to take advantage of QOZs, which reward investments in property or operating businesses located in designated areas. Like transactions under the well-established tax-free like-kind exchange provisions under Section 1031 (a 1031 Exchange), the QOZ provisions allow a taxpayer to roll over an investment from a sale of a gain property. But the QOZ provisions offer significant additional flexibility.
1031 Exchanges allow investors to convert their investment in one asset to an investment in another asset so long as the assets are of “like-kind.” Prior to the TCJA, many types of property could qualify for like-kind exchange treatment. In fact, part of the regulations covering 1031 Exchanges focus on exchanges of cattle. However, changes made by the TCJA now limit 1031 Exchanges solely to real estate. Still, 1031 Exchanges allow significant flexibility in the types of real estate that can be exchanged. For example, vacant land can be exchanged for an apartment building.
To obtain the maximum tax benefit from a 1031 Exchange, the taxpayer must reinvest the entire proceeds from the sale of real estate. This includes the taxpayer’s initial capital investment, amounts used to pay off debt encumbering the property and any appreciation in the value of the property. Any cash taken out (or deemed taken out by repayment of debt) of the transaction from the sale proceeds results in tax up to the amount of gain realized on the transaction.
For example, if an investor has a tax basis of $5 million in a real estate deal and sells the real estate for $7 million, then the first $2 million ($7 million sale price minus $5 million tax basis) in cash taken out of the deal triggers tax.
However, if all of the proceeds from the sale of real estate are reinvested, then a 1031 Exchange allows the taxpayer to defer the entire built-in gain in the property sold until the taxpayer sells the property acquired with the proceeds of the 1031 Exchange and fully cashes out.
The taxpayer can fully eliminate the gain on 1031 Exchange property only at death, at which time the tax basis in the property is adjusted to fair market value.
Qualified Opportunity Zone transactions are similar to 1031 Exchanges in that they require the taxpayer to reinvest proceeds from the sale of an asset into certain types of property. In a QOZ deal, the taxpayer rolls over its gain from the sale of a capital asset by investing in a business or in property located in areas designated as Qualified Opportunity Zones. But QOZ deals offer many comparative advantages:
To obtain the maximum tax benefits from QOZ funds, the taxpayer must hold its QOZ investment for ten years, but the taxpayer will recognize a portion of the gain from the initial sale in 2026.
At that time, the amount of gain recognized is reduced by 10% if the QOZ investment has been held for five years and by an additional 5% if the QOZ Investment has been held for seven years. If the value of the QOZ investment has declined by 2026, then the amount of gain recognized is similarly reduced. Since tax is being paid at that time, the taxpayer’s tax basis in its QOZ investment then increases to fair market value in 2026.
Going forward, if the taxpayer sells the QOZ investment within ten years of its initial purchase of the QOZ investment, then tax is due only on the additional appreciation after 2026. However, if the taxpayer continues to hold its QOZ Investment for the full ten year period, then the taxpayer recognizes no taxable gain on the sale of its QOZ investment, effectively eliminating any tax on the appreciation in the QOZ investment from the time of purchase through the time of sale.
Because of the 10-year holding period needed to realize the maximum tax benefits from a QOZ deal, real estate is a particularly attractive asset class for QOZ deals due to the long-term investment return horizon for most real estate deals. Similarly, changes made in the TCJA now limit 1031 Exchanges solely to real estate. Therefore, the balance of this discussion will focus on investors looking to reinvest sale proceeds into real estate. While the target investment is the same, QOZ funds can offer investors certain benefits that 1031 Exchanges cannot.
As noted above, a taxpayer can only defer the entire gain on sale in a 1031 Exchange if the taxpayer reinvests all sale proceeds from the sale into a new property. In other words, the taxpayer cannot cash out any portion of its investment without paying current tax. In contrast, QOZ deals only require that the taxpayer reinvest the proceeds from the sale transaction to the extent of the gain that would be recognized from sale. That means the taxpayer in a QOZ deal can cash out its investment to the extent of its tax basis in the asset sold without paying tax.
Take this example of opportunity zone tax benefits at work: Assume that an investor holds a property with a tax basis of $1 million and sells the property for $1,750,000, resulting in a realized taxable gain of $750,000. If the investor uses a 1031 Exchange to defer the gain on the sale of the property, then the investor needs to reinvest the entire $1,750,000 of proceeds in real estate. If the investor wants to take out cash of $1,000,000 and only reinvest $750,000, then the investor would have to pay tax on $750,000 of gain (the lesser of the gain realized or the amount of cash taken), meaning that the investor only ends up with $850,000 in cash. If the same investor uses a QOZ deal to defer the gain on the sale of the property, then the investor only needs to invest $750,000 in the QOZ deal. The investor may keep the remaining $1,000,000 without paying any tax.
This ability to cash out in a QOZ deal is particularly attractive given the expanded scope of the assets that can be sold on the front end of a QOZ deal. After the TCJA, only gain from the sale of real estate can be deferred through a 1031 Exchange, so an investor looking to sell a non-real estate asset and invest the profits in real estate cannot benefit from a 1031 Exchange.
In addition, many real estate investments also include both real property (which qualifies for a 1031 Exchange) and personal property, and any gain attributable to the personal property may no longer be rolled over in a 1031 Exchange after the TCJA. Thus, the sale of a real estate asset that includes personal property requires payment of some current tax even with a 1031 Exchange.
QOZ deals have no such limitation. Capital gain from the sale of an asset may be rolled over into a QOZ deal. For example, gain from the sale of appreciated securities could be invested in QOZ funds. Given the cash out opportunity with non-depreciable assets, this essentially allows the taxpayer to cash out its entire initial investment in the asset sold.
Thus, QOZ deals offer taxpayers looking to invest in real estate the opportunity to defer gain on the sale of any capital assets (not just real estate) while also retaining a portion of the sale proceeds from the investment they are liquidating to make their new real estate investment—two potentially significant advantages over 1031 Exchanges.
Many taxpayers invest in real estate through entities taxed as partnerships, such as limited liability companies or limited partnerships (“Real Estate Entities”). For investors to roll over the gain from the sale of property by a Real Estate Entity requires significant planning and careful structuring.
At the most basic level, the Real Estate Entity must engage a third-party to hold the proceeds from the sale of the real estate unless the Real Estate Entity can purchase new property at the exact same time as it sells the old property, an unlikely occurrence. Further, if the Real Estate Entity reinvests the sale proceeds, then all investors in the Real Estate Entity are effectively required to invest in the same new real estate asset.
If only certain investors want to roll over their investment and other investors want to cash out of their investment or if investors want to reinvest in different properties, then significant additional structuring is required. The validity of some of these restructuring techniques has been challenged by the IRS and state tax authorities, with the California tax authorities being the most aggressive in doing so and with some success.
None of these additional costs, complications, or risks arise when a Real Estate Entity reinvests the proceeds from the sale of its real estate in a QOZ deal. First, the Real Estate Entity itself may simply reinvest the portion of the sale proceeds representing the gain from the sale directly into a QOZ deal simply by making a capital contribution to a QOZ fund.
As noted above, the Real Estate Entity could then distribute to its investors any cash representing its remaining tax basis in the property it sold or it could choose to invest those proceeds in the QOZ deal as well or in another investment.
Second, simply by filing an election with its tax return for the year it sells its real estate investment, the Real Estate Entity can allow each investor to choose whether to take advantage of a QOZ deal or to cash out of its investment.
If the investor wants to defer its gain by investing in a QOZ deal, then the investor simply invests an amount equal to its share of the Real Estate Entity’s gain from the sale of its real estate in a QOZ deal within 180 days after the end of the taxable year in which it sells the real estate.
Clearly, QOZ deals offer investors in real estate partnerships significant benefits in flexibility and simplicity over 1031 Exchanges—so long as the investor is willing to invest in real estate (or other business property) located in a qualified opportunity zone.
Changes made by the TCJA have limited the ability of taxpayers to benefit from 1031 Exchanges. In addition, 1031 Exchanges have always limited the ability of real estate investors to cash out of existing deals on a tax-free basis, and they may require additional structuring to achieve the goals of all partners in a real estate partnership.
The Qualified Opportunity Zone provisions offer significant added flexibility to a real estate investor so long as the investor is willing to limit the location of its investment to a Qualified Opportunity Zone.
While additional regulations on Qualified Opportunity Zones remain to be issued, and others need to be finalized, real estate investors should carefully consider the new “opportunities” presented by QOZ funds. And for those who have sold off assets during COVID-19, opportunity zone tax benefits can be another helpful tool for managing the crisis.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Investing in Residential & Multi-Family Real Estate and Due Diligence in Real Estate Deals. This is an updated version of an article originally published on February 15, 2019.]
©All Rights Reserved. July, 2020. DailyDAC™, LLC d/b/a/ Financial Poise™
Adam J. Grais advises businesses and their owners on structuring transactions and in addressing complex federal income tax issues. He represents individuals, closely held businesses, startup companies and family offices. Other law firms frequently turn to Adam as co-counsel for their clients’ tax matters and as a consulting expert witness. During his career, Adam has…