How to Compare Opportunity Zones and Similar Exchanges
Reposted with permission from constructionexec.com, April 5, 2019, all rights reserved. Copyright 2019.
Much has been written about the newly created opportunity zones and the tax advantages that accompany them under Section 1400Z of the Internal Revenue Code. In fact, further regulatory guidance is likely because of the myriad questions that remain. With taxpayers (particularly those involved in real estate) regularly seeking tax efficient strategies for owning, holding and ultimately disposing of real estate, however, the opportunity zones understandably warrant considerable attention. The benefits they provide are unlike the traditional strategies that taxpayers have generally employed, and can be a useful tool.
While it is frequently noted that comparisons are odious, a meaningful question is how the opportunity zones compare with like-kind exchanges under Section 1031 of the Internal Revenue Code. Like-kind exchanges have been an invaluable—and favorite—tax deferral staple for decades for taxpayers owning real property held either for trade or business purposes or for investment purposes. Since opportunity zones involve a substantial real estate component, the question of comparison is natural. The opportunity zone may be the new kid on the block, but it does not by any means affect the merit and prudence of pursuing a like-kind exchange in the appropriate circumstances. To understand that, the below comparison of the two strategies may be helpful.
Section 1031 relates only to real estate. (Prior to the Tax Cuts and Jobs Act passed in December 2017, the reach of Section 1031 also extended to assets other than real estate.) The quality of the real estate is not an issue. Thus, for example, raw land can be exchanged for an apartment complex, or an office building can be exchanged for a retail center. What is important is that the relinquished property (i.e., that property being sold) be exchanged for replacement property, which is also real estate. In contrast, acquisition of an interest in a “qualified opportunity fund” can involve reinvesting proceeds not only from the sale of real estate (as in a like-kind exchange) into the fund, but also from the sale of other assets (such as stock).Thus, there is no real property requirement that is analogous to that for a like-kind exchange.
Section 1031 arguably involves only one kind of deferral: deferring what would likely be a long-term capital gain if the property had been sold in a traditional taxable sale. While Section 1031 is routinely called a deferral, in actuality, deferral can be indefinite if the replacement property is held until death (where there may be a step up in tax basis), irrespective of the number of exchanges that may have been consummated along the way. In contrast, there are various sunsets on the period of time the taxes can be deferred with an opportunity zone program.
To get the full benefit of Section 1031 (i.e., deferral of all of the gain which would otherwise be recognized on the sale of the relinquished property), the entire sales price from the relinquished property disposition (with certain adjustments, like commissions) must be reinvested in the replacement property. In contrast, qualified opportunity funds are predicated not on reinvesting the sales price but rather merely the gain. One can see how this would make a difference if, for example, a taxpayer were selling raw land for $1,000,000 with an $800,000 basis, and therefore a potential gain of $200,000.With Section 1031, the taxpayer has to invest the full $1,000,000 in order to defer taxation on the $200,000 inherent gain. However, with a qualified opportunity fund, only $200,000 needs to be reinvested. The principal of $800,000 can therefore be pocketed without taxation. This would appear to be an immediate advantage to the opportunity zone. However, there is a comparable yet frequently unrealized way to access cash from exchanges.
There are a whole host of other considerations for opportunity zones and comparisons to exchanges, but the foregoing are some of the more prominent ones. Certainly both strategies require due consideration from taxpayers.