Are Qualified Opportunity Zones the New Like-Kind Exchanges?
The real estate investment market was presented with a new tax-saving opportunity when Congress passed the Tax Cuts and Jobs Act in December 2017. The qualified opportunity zone (QOZ) program allows taxpayers to defer gain recognition when they invest their capital gains into economically depressed land tracts called “opportunity zones.” With their tax savings, investment dollars go further, and taxpayers are given a chance to pursue other business ventures.
But gain deferral as a tax incentive is nothing new. Like-kind exchanges under Section 1031 of the Tax Code were first introduced in 1954 and persist to this day. They allow taxpayers to defer capital gain recognition on the sale of real estate if they invest their proceeds in similar property within a specific time frame. Now that QOZ investment is an option will like-kind exchanges fall by the wayside?
Where QOZ Investment Wins
QOZ investment differs from like-kind exchanges in a few key areas, and many of these differences make QOZ investment the more appealing option.
Like-kind exchanges are only available to businesses, but both individuals and businesses can invest in QOZs.
Amount Needed to Invest
To receive the full gain deferral under Section 1031, taxpayers must reinvest their entire sales proceeds into the replacement property. QOZ investment only requires taxpayers to invest their gains, which allows them to utilize the remaining proceeds however they wish.
Types of Sales Eligible for Gain Deferral
Under Section 1031, taxpayers can only defer gains from real property sales. In the QOZ program, taxpayers can defer gains from almost any capital asset sale, including real estate, personal property, stocks, and bonds.
Taxpayers who hope to defer gains using a like-kind exchange can only invest their proceeds into real estate. The QOZ program allows taxpayers to invest in any business venture that meets the definition of a qualified opportunity fund.
Permanent Gain Exclusion
Taxpayers can permanently exclude 10% of their gain (via basis adjustment) if they invest in a QOZ before December 31, 2021, and they hold their investment for at least five years. Gains deferred from like-kind exchanges can continuously be deferred, but they will only be permanently excluded at death.
Elimination of Appreciation Within the Investment
If taxpayers hold their investment in a QOZ for at least 10 years, they can eliminate the gain on any appreciation that occurred within the QOZ. Real property appreciation can be deferred under Section 1031 but never eliminated (except at death).
Why We Expect Section 1031 Exchanges to Hold Steady
Even with the deck stacked against it, it is likely Section 1031 exchanges will remain the preferred investment mechanism for most property owners. The industry understands them. Real estate investors have participated in Section 1031 exchanges before, so they are familiar with the requirements, appreciate the deadlines, and have prior relationships with qualified intermediaries, appraisers, and tax professionals. QOZ investment is completely untested, and there is little time to get familiar with it. The QOZ program expires on December 31, 2026, and the 10% gain elimination is only available for investments made before December 31, 2021.
Although QOZ investment will take some commitment to understand and implement, it may still be a good option. We encourage you to read as much as you can about the program and understand its requirements. The IRS recently released final regulations for the QOZ program, so we have the fine print at the ready and know what the IRS will be looking for. There will be a learning curve, but if you can push past the uncertainty and work with a professional you trust, the program can offer you tax-saving opportunities you cannot get with Section 1031.
If you have any questions about the QOZ program or want to see if it can fit into your tax plan alongside like-kind exchanges, Klatzkin can help. For additional information, call us at 609-890-9189 or click here to contact us. We look forward to speaking with you soon.