Opportunity Zone Investment vs. 1031 Exchanges
By: Jan B. Brzeski and Kevin Zvargulis, CFA
The Tax Cuts and Jobs Act of 2017 included important provisions for individuals interested in real estate investment, and also for any investor owning assets that have appreciated significantly and wanting to redeploy some of their capital gains efficiently. This article outlines the Opportunity Zone (OZ) program included in the 2017 tax law, and contrasts it with the 1031 Exchange which is so well established among and heavily utilized by real estate investors.
Intent of Each Program
Each program has a different rationale, and understanding the original intent helps to understand, compare and contrast the two programs. The table below explains some of the arguments for each program. One feature both programs have in common is that they help spur transactions that might not otherwise take place, thus helping promote economic activity. Note that the information below reflects the understanding of the authors and is not based on official guidance from any government agency.
Opportunity Zone Investment--A Powerful New Incentive is Born
The 2017 tax law included a new incentive allowing investors to realize capital gains and invest those gains into businesses, including real estate, in designated low income/high poverty areas called opportunity zones (“OZ”). If executed well, investing through this program could be a very rare and precious opportunity for investors reluctant to realize capital gains because of the accompanying tax bill. Real estate investors have long enjoyed favorable tax treatment for capital gains through the 1031 exchange mechanism. For investors who currently have appreciated real estate assets, how then do the OZ program benefits compare to a traditional 1031 exchange?
The basic premise of the Opportunity Zone program is that it encourages investors who otherwise might not sell appreciated assets, to put their gains to productive use by investing in real estate or businesses located in designated lower income census tracts.
There are three tax benefits offered by the OZ program: (1) deferral of paying capital gains tax; (2) reduction in amount of tax owed on gains; and (3) tax-free appreciation.
Deferral. As long as investors hold their investment in the opportunity zone program, they can defer paying capital gains tax until 2026.
Reduction. Investors who hold their investment for five years receive a 10% reduction in the capital gains taxes they owe, and for those who hold their investment for seven years, a 15% reduction.
Tax-free Appreciation. If investors hold their investment for 10 years, any capital gain realized upon the sale of the investment is tax free.
In summary, the details of the OZ program are a bit complicated, but nevertheless this program is a compelling alternative for investors considering a 1031 exchange.
The traditional 1031 exchange allows investors with capital gains from appreciated real estate investments to sell those properties and reinvest the proceeds into other properties without triggering a taxable event. This provision allows investors to successively roll one real estate investment into another real estate investment, building a larger and larger portfolio, all the while deferring capital gains until such time the properties are sold for good. If the properties are never sold, or if every sale is followed by another 1031 Exchange, the investor may pass down the real estate portfolio to his or her children, who never have to recognize the gain for tax purposes.
The major difference between OZ investments and 1031 Exchanges is that the OZ program is not limited to real estate. The source of the capital gain can be from any appreciated asset, and the investment in the OZ itself can be in any type of business, not just real estate (though in practice the authors expect almost all OZ investments to be in real estate, given the way the rules are written). The 1031 Exchange, on the other hand, is limited to real estate - an investor sells one piece of real estate and reinvests in another. While the non-real estate aspects of the OZ program broaden the sources of capital as well as the investment opportunity set, both topics worthy of exploration, for the purpose of our discussion we are going to focus exclusively on real estate investors considering a 1031 exchange and how that option compares to an OZ investment.
OZ Investments Pertain to Capital Gains
It is important to note that the tax benefits of OZ investments only apply to funds sourced from capital gains. After selling an investment property, OZ real estate investors roll only their capital gain into an OZ investment, and then have the flexibility to consider other investment options with the remaining proceeds from the sale of their property. For example, if a real estate investor sells a building for $120, generating a capital gain of $20, he or she can reinvest the $20 portion in an OZ investment, not the entire $120. With a 1031 Exchange, the investor must roll the entire $120 into a new investment to enjoy the full tax benefit. For investors looking to diversify away from real estate the OZ program can provide a convenient off ramp. For investors focused solely on building scale in their real estate portfolio, the flexibility afforded by the OZ program may not be of interest.
7-year Deferral vs. Indefinite Deferral
To further sweeten the incentive, the OZ program not only defers the recognition of capital gains, but it can also provide a reduction in capital gains taxes depending on the length of time one is invested. Investments held for 5 years receive a 10% reduction. Investments held for 7 years receive a 15% reduction. There is no equivalent tax reduction with a 1031 Exchange.
Furthermore, an OZ investment does not preclude an investor from deploying the non-capital gain portion of an asset sale into real estate. In fact, the OZ program may give people considering a 1031 exchange much appreciated breathing room when making a subsequent real estate investment. A 1031 exchange has a notoriously short time frame, 45 days from the date of sale, in which an investor must identify an exchange property. The subsequent purchase must then be completed within the next 135 days (180 days from the date of sale of the relinquished property). The OZ program, on the other hand gives investors 180 days to invest in an OZ fund. The OZ fund then has 6 months or until the end of the year, whichever comes first, to identify one or more investment properties. Following identification, investors have a 31-month period to fully deploy their capital.
Tax Free Appreciation
Arguably the most compelling feature of the OZ program is that if the investment in the OZ is held for 10 years, the tax basis for that investment upon sale is increased to the fair market value at the time of sale. The investment therefore generates zero capital gains and zero capital gains tax. Investors cannot hold their OZ investment indefinitely. The provisions do require that investors exit their OZ investment by December 31, 2047, certainly a reasonable period of time to dispose of the assets. Upon disposition an investor is free to reinvest the proceeds in real estate or any other asset class.
On the other hand, while a 1031 Exchange does allow investors to indefinitely roll capital gains into future investments, there is no analogous step up in basis that allows investors to avoid gains altogether, at least while the investor is alive. Once a 1031 Exchange investor sells his or her real estate assets, he or she will realize gains and will have to pay taxes on those gains. Thus, the OZ program is better for investors that may want to shift assets into and later out of real estate. The 1031 Exchange mechanism tends to attract more and more of an investor’s net worth into real estate, without any good mechanism to get it back out of that asset class.
Given the way the regulations are written, an investor should be able to shield income on their OZ real estate investment with depreciation expense, however, whether or not depreciation recapture will be exempt from capital gains tax if the asset is held for 10 years is unclear at this point. Depreciation is an expense that lowers income for tax purposes, but also lowers the tax basis on real estate, potentially increasing capital gains. The current OZ regulations state that for OZ investments the tax basis is written up to fair market value upon sale, resulting in zero capital gain, which hints that taxes on depreciation recapture may be exempt. However, as written, the OZ regulations do not address depreciation recapture directly, thus highlighting a certain amount of regulatory uncertainty that is an undesirable characteristic of the OZ program. The long-established 1031 Exchange mechanism, on the other hand, does allow investors to shield current income with depreciation expense, and can avoid depreciation recapture as long as they continue to exchange property in 1031 Exchanges.
Development vs. Buy & Hold
OZ real estate investments must be ground up construction projects or heavy renovations meeting specific criteria. It was the intention of Congress that the OZ legislation would spur economic growth in lower income areas. For this reason, investors cannot simply buy and hold or lightly renovate apartment buildings. The legislation requires the property purchased be “substantially improved.” Substantial improvement is defined as spending as much money on capital improvements as the value of the buildings on the property at the time of purchase. If an investor purchases an OZ property for $100, with $60 being attributable to the value of the land, and $40 being attributable to the value of the building, then $40 must be spent improving the property over a 31-month period.
On the continuum of real estate investment risk, ground up construction is typically quite risky and complex, requiring a high level of sophistication. It has the potential to create a great deal of value and to destroy a great deal of value. Investors considering the OZ program must either have development expertise themselves, or partner with someone who does. For investors who choose to partner, choosing the right person to work with is paramount. Almost every real estate development encounters unexpected problems, delays and/or cost overruns. Another option for investors is to passively invest in an institutional fund. Institutional funds are professionally managed but also come with layers of hidden fees. 1031 exchanges do not have a substantial improvement requirement and can be as complex as ground up construction or as uncomplicated as a cash-flowing duplex. For investors with no appetite for ground up construction, 1031 exchanges are a preferable option.
OZ investments are restricted to Opportunity Zones. By definition Opportunity Zones are lower income neighborhoods, many of which without the tax incentive, would receive little attention from investors. Investors taking advantage of a 1031 exchange, on the other hand, are not so geographically limited. A 1031 exchange allows investors to invest anywhere in the United States or even abroad as long as they do not exchange a U.S. property for a foreign property or vice versa. At first glance the OZ program presents attractive tax incentives, but an OZ investment should be carefully considered.
Investments should never be made solely on the basis of a tax incentive. Any investment, whether it is an OZ investment, or not, must stand on its own merits. That being said there are opportunity zone neighborhoods that are attractive places to invest, regardless of the OZ program, and this is where investors should focus their attention. Examples include Long Island City, Queens, where Amazon is developing its new headquarters and many parts of Hollywood or areas around University of Southern California in Los Angeles.
OZ Qualification Rules and Tests
The OZ program has complexities that a 1031 exchange does not. Upon realization of a capital gain the OZ program requires investors transfer their money to a separate entity called a Qualified Opportunity Fund (QOZ), within 180 days. The QOF then has six months to invest 90% of its assets into a project level entity, that will buy and develop the real estate. Upon transferring funds to the project level entity, the project level entity must have a detailed development plan, including the exact address of the property to be purchased. The project level entity then has 31 months to substantially improve the purchased property in accordance with the business plan. After 31 months 70% of the assets of the project level entity must be qualifying assets, i.e. substantially improved real estate. With a 1031 exchange, there are fewer complexities. Sellers have to identify an exchange property within 45 days from the date of sale. They then have 180 days from the date of sale to purchase the exchange property.
Below is a table summarizing the key differences between an opportunity zone investment and a 1031 Exchange:
The Opportunity Zone regulations are nuanced. For the purposes of summarizing the program in the table above we make some simplifying assumption as well as assumptions based on our understanding of how the IRS is likely to interpret the law. Additional guidance from the IRS is expected to be released in the first half of 2019.
Assumption #1. In order to qualify for the working capital safe harbor provision, which in our view is a necessary qualification, investors must provide a detailed business plan. To be consistent with intent of Congress it is our view that a detailed business plan for real estate projects will require investors to specify a property address.
Assumption #2. The above table assumes that investors place their money into an OZ fund, which in turn invests in a project level entity. OZ funds can own OZ assets directly without investing through a separate entity. Doing so alters certain aspects of the program.
Assumption #3. We assume above that the IRS will allow OZ investors to take depreciation expense and not assess taxes on depreciation recapture.
Issues and Risks to Consider
The table below lists some of the main issues and risks of both the 1031 Exchange and OZ investment programs.
Many seasoned real estate investors pursue a 1031 Exchange virtually every time they sell a property. In many cases they have pursued a series of 1031 Exchanges and so their cost basis dates back to a prior property. Their very low cost basis increases the incentive to avoid realizing a capital gain. In most cases, we believe that these investors will continue to pursue 1031 Exchanges because of their familiarity with the process and rules, and the fact that no major construction needs to be involved with a 1031 Exchange. One special case may be investors who run out of time to pursue a 1031 Exchange carefully. These investors may choose to invest in a Qualified Opportunity Fund (QOF) with a reputable fund managers because in effect it increases the amount of time available to redeploy the capital. Furthermore, investors who prefer to take a more passive approach to their re-investment may like this aspect of many QOFs.
The Opportunity Zone investment option is ideal for those investors and business owners who like real estate investing and are interested in increasing real estate as a percentage of their portfolio. As long as the investor has a tolerance for redevelopment and construction, and has vetted the fund manager and underlying developer thoroughly, the QOF option offers a very attractive option.