Opportunity Zones: A Good Alternative to 1031 Exchanges?


posted on February 7, 2019

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.

What are opportunity zone funds?

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.

How do O-Zones differ from 1031 exchanges?

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:

  • 1031 exchanges require the entire sale proceeds from the relinquished property to be reinvested into a new property within those 180 days and that exchange property must be identified within 45 days.
  • O-Zones require only that you roll into a fund the amount of the gain (capital gains) from the sale of the relinquished property within the 180 days and you may take out of the proceeds your original investment (the basis).

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.

Potential capital gains deferral

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:

  1. Temporary deferral of capital gain taxes on gain invested in a fund until you exit the fund or December 31, 2026, whichever occurs first.
  2. Deferred capital gains resulting from fund investments held a minimum of 5 years receive a 10% reduction in the amount taxed and a 15% reduction for an investment held at least 7 years.
  3. If you hold the investment for 10 years, the capital gains accrued only on the fund investment itself (the property profit) receive a full step-up in basis, or a 100% capital gain exclusion, for the 10-year period. In this scenario, the sale must occur before 2047.

Who is eligible?

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.

O-Zone regulations

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.

The next step

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!

Disclaimer

The information contained on this page is not an offer to purchase, which can only be done through the private placement memorandum which includes a description of risks and benefits. 
Real estate brokerage services are provided by Turner Investment Corporation. Securities are offered through McDermott Investment Services, LLC,a registered Broker/Dealer, Member FINRASIPC, and MSRB. McDermott Investment Services, LLC and Turner Investment Corporation are separate entities.
Investment real estate, including securitized real estate, comes with substantial risks, including but not limited to; the absence of guaranteed income; lack of liquidity; the risks of owning, managing, operating and leasing properties; possible conflicts of interest with managers and affiliated persons or entities; the risks associated with leverage; tax risks, including possible changes in tax law; declining markets and challenging economic conditions; on-going fees; and known or unknown regulatory challenges. Finally, it should be understood that the ultimate risk of investing in real estate could include the total loss of principal investment.

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