When the Tax Cuts & Jobs Act (TCJA) was passed at the end of 2017, it eliminated Section 1031 exchanges for all types of property except real property. Buried deep within the act, you’ll find Section 1400Z-2, which established so-called “Opportunity Zones” as an alternative to 1031 exchanges.
O-Zones, designed to spur private investment in distressed communities throughout the country, offer similar investment and tax opportunities, but with some important and critical differences.
The program is receiving a strong push from the U.S. government, and many states are already approved. As a result, more than 3,500 census tracts have been awarded O-Zone status.
Whether an O-Zone is a viable alternative to a 1031 exchange for you depends on several factors, including your tolerance for risk and desire for immediate cash flow. To help you decide, here’s an overview O-Zones and how they differ from 1031 exchanges.
An Opportunity Zone Fund is an investment vehicle with the goal of investing at least 90% of its capital into a Qualified Opportunity Zone. What is a qualified opportunity zone?
The “Investing in Opportunity Act” portion of the TCJA is a program created to incentivize private capital investments in projects crucial for revitalizing distressed communities. These projects are located in “zones” that continue to struggle to recover from the 2008 crash, and where a majority of the population lives well below the poverty level. To stimulate private participation in the program, taxpayers who invest in O-Zones qualify for capital gains tax incentives available exclusively through the program.
Much like Section 1031 exchanges, the reinvestment closing window for O-Zones is 180 days after the sale of your relinquished property. Unlike 1031 exchanges, you must purchase shares of stock or a partnership interest in a qualified opportunity fund that is invested in the O-Zone. A key difference:
This makes O-Zones sound like an excellent alternative to 1031s, but there is a trade-off: you must comply with a myriad of rules to ensure the qualified opportunity fund meets O-Zone requirements.
Another key difference is your ownership stake in an O-Zone. When you invest into a qualified opportunity zone, you are not purchasing a discrete, individually owned real property interest.
Instead, as mentioned earlier, you invest in ownership of stock or partnership interest in the qualified opportunity fund. For investors who want or are accustomed to owning real estate and having sole control of their investments, this could be an issue.
With a 1031 exchange, you have a potential 100% deferral of capital gains. O-Zones are different. They have tiered capital gains tax benefits tied to investments at three timeframes: 5 years, 7 years, and 10 years. There are three levels of tax benefits:
Individuals, C-corps including REITS and RICs, S-corps, partnerships, and certain other pass-through entities, as well as certain estates and trusts, may invest in O-Zones.
As with any investment, there are risks to investing in O-Zones. It’s essential to seek the assistance of competent financial, legal, and tax advisors to help evaluate whether an O-Zone is a good investment for you.
Because O-Zones are a relatively new program, the regulations are still a work in a progress.
The fact that O-Zones are structured as pool funds, not single assets, makes the process more complicated than that for 1031 exchanges. There are continuous annual certification requirements, new forms for election of deferral and certification, strict timetables, and minimum investment requirements predicated on property type, etc.
Whenever taxpayers have two options to achieve a single goal, it’s inevitable they want to know “which one is best for me?”
It’s important to understand that O-Zone investments are not the same as 1031 exchanges.
Making an investment in O-Zones is new, uncharted territory and it can be tricky. Yes, the capital gains tax is deferred, but you must eventually pay it after a 10% or 15% reduction that is tied to the length of the investment.
For that reason, we believe O-Zones should be regarded as having a higher risk than investing in stabilized real estate. And if you are seeking immediate cash flow, keep in mind that most O-Zone projects like developments or rehab projects do not pay distributions for a period of time. On the other hand, they can afford benefits to taxpayers who are willing to invest in the types of properties found in designated zones and limit their gain deferral.
If you’re an accredited investor and would like to see an Opportunity Zone Fund that is currently available, you can view it here.
Please do note, that depending on when you’re reading this article, the fund above may no longer be available, so to get access to our current funds or learn more about investing in O-Zones, contact us today!
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