Tax Strategies for Commercial Real Estate Investors: 1031 Exchanges & Opportunity Zones

1031 exchange capital gains opportunity zone tax strategies May 30, 2021

Note: Majestic Investment Group does not provide any financial, legal or tax advice. Each individual scenario is different, please consult a professionals, lawyers, CPA, or other advisors to decide which vehicle is the best choice for your circumstances.

Qualified Opportunity Zone vs. 1031 Exchange: Which is better?

Whether selling stocks, real estate, or a business, capital gain taxes is a looming concern for many investors. This blog discusses two ways the US Tax code provides to avoid or eliminate the capital gain taxes legally, i.e., Opportunity Zone and 1031 Exchange.

Section 1031 exchanges, also known as like-kind exchanges, have been used by Real Estate investors for many years to swap real estate assets without causing taxable profits. Now, the latest Qualified Opportunity Zone program offers yet another option for deferring and eliminating such taxable gains that can be applied on real estate, stocks, and business sale capital gains.

Both Opportunity Zone and 1031 are useful methods for reducing tax obligations and securing tax-favored investments. One is motivated by a national policy to encourage investment in specific areas, while the other is motivated purely by the interests of taxpayers. 1031 exchanges are centuries old, while the Opportunity Zone is just a few years old.

What Are 1031 Exchanges?

Section 1031 of the IRS tax code, the “1031 exchange.” allows investors to swap one like-kind investment for another like-kind. They are entitled to defer capital gains (or losses) that they would have to pay at the time of sale. Its primary goal has always been to allow taxpayers to keep their property savings while avoiding paying taxes on unrealized paper gains and losses. As a result, a like-kind exchange will result in no capital gain.

What Are Opportunity Zone Funds?

The new Opportunity Zone program is an investment vehicle developed under a provision of the Tax Cuts and Jobs Act of December 2017 to encourage investors to put money into economically disadvantaged communities, thereby spurring economic growth. Investing in these communities, known as Qualified Opportunity Zones (QOZ), will provide investors with immediate and long-term tax benefits. Deferral of gain, partial forgiveness of deferred gain, and full forgiveness of any additional future gains are all possible advantages if certain investment conditions are met.

Let’s compare these two capital gain tax saving strategies in a little more detail.

Comparison Between QOZ Investments And 1031 Exchange

1031 Exchange	Qualified Opportunity Zones
What gains are allowed to use 1031 or QOZ
1031 exchanges are currently restricted to mainly real estate. Raw land / farmland for improved real estate Oil & gas royalties for a ranch Fee simple interest in real estate Rental properties Rental ski condominium for a three-unit apartment building Mitigation credits for restoring wetlands	With the QOZ program, gain from the sale of any kind of asset can be placed into a QOF and receive the tax edges. Real Estate Business Sale Oil and Gas Stocks
What amount needs to be reinvested?
Need to reinvest all pay-off from the sale, including original principal	Need to re-invest ONLY Capital gains from the sale, no need to reinvest original principal
What is the minimum hold period?
No minimum hold period, can sale anytime from one 1031 to other, or exit 1031 completely (which may trigger a tax event)	10% step-up basis after 5 years hold. A minimum of 10 years hold is needed for full tax benefits.
Where can they invest?
Investors can invest in property in any place within the United States (if the property is domestic property) or internationally (if the property sold is international property)	Investments are restricted to the property in certain areas declared as Opportunity Zones.
Timeline to establish replacement or reinvest
Establish replacement property within 45 days of sale; all pay-off from the previous sale must be reinvested within 180 days.	Reinvest qualified capital gains within 180 days of realization
Tax Considerations
No tax till final sale; Appreciation is calculated from the original basis.	Tax-deferred until sale or 12/31/2026 Full exception after 10 years
Connection between parties
Exchanges could occur between connected parties.	Solely capital gains from exchanges between unrelated parties could qualify for the Opportunity Zone tax edges.
Passing to next generation
Heirs owe no capital gains tax	Heirs answerable for delayed capital gains tax, however not on appreciation A strategy can be created to split preferred interest and common interest within estate planning
Documentation
Documentation and filing: One-time Need to file a single IRS Form 8824 for the year of the sale of their property.	Documentation and filing: Annual Need to report annually through IRS Form 8996.
Fund Model
1031 exchanges don’t need the utilization of a fund. They actually forbid employing a corporation or a partnership as a vehicle through which to invest in property.	QOF investments require that the capitalist invests within the Opportunity Zone through the utilization of a legal entity that is taxed as a partnership.

Which Is Better : The Final Analysis

The 1031 exchange can provide deferral with no minimum hold period, an investor can stay indefinitely in that investment, but one has to reinvest all proceeds from the sale. While the QOZ program has a restricted deferral period that provides tax-free gains after a minimum 10-year hold and only needs to invest the gain, making the original principal immediately available.

CONCLUSION

Both 1031 like-kind exchanges and QOZ real estate investments have pros and cons based on individual scenarios. Which program is better would depend on the goals, priorities, and tax planning strategies of each investor. The 1031 exchange is the better choice if an investor’s primary aim is to delay taxes forever and never access the investment capital; but, if an investor wishes to realize investment gains at any point during their lifetime, a QOZ Fund is the better option.

Finally, just like any other investment or estate planning decision, the decision isn’t made solely based on tax considerations but also based on how the investor needs to access and utilize the gain.

Majestic investment groups have had experience in investments via 1031 exchanges and

References :

IRS: 1031 Exchanges (may not be up-to date, please do your own research)

https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips

https://www.irs.gov/pub/irs-news/fs-08-18.pdf

https://www.irs.gov/pub/irs-pdf/f8824.pdf

IRS: Qualified Opportunity Zone

https://www.irs.gov/credits-deductions/businesses/opportunity-zones

https://www.irs.gov/credits-deductions/opportunity-zones-frequently-asked-questions

OZ Interactive Maps:

https://www.enterprisecommunity.org/opportunity360/opportunity-zone-eligibility-tool

Tax Strategies for Commercial Real Estate Investors: 1031 Exchanges & Opportunity Zones

What Are Opportunity Zone Funds?

Comparison Between QOZ Investments And 1031 Exchange

Which Is Better : The Final Analysis

CONCLUSION

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