By Len Nitti, CPA, MST, Partner & Practice Leader of Real Estate at WilkinGuttenplan
When the Tax Cuts and Jobs Act was passed, a new tax deferral vehicle was created where taxpayers could defer paying tax on capital gains income by reinvesting these gains into Qualified Opportunity Zones (QOZ’s) through an investment into a Qualified Opportunity Fund (QOF). This new provision in the Internal Revenue Code has many taxpayers curious as to how they may be able to benefit from QOZ’s. With this curiosity, the question of whether QOZ incentives are better than Section 1031 exchanges for real estate reinvestments is often asked. The answer to this question is “it depends” on the specific facts and circumstances of your particular tax situation. This article will focus on the positives and negatives when comparing these types of tax deferred reinvestments to assist in drawing some conclusions.
Section 1031 exchanges, a concept of which most real estate investors are familiar, has historically been one of the more common techniques for deferring taxes on the sale of real estate investments by reinvesting into new real estate. One of the greatest advantages of 1031 exchanges is that the tax continues to be deferred until the taxpayer has a subsequent taxable disposition of the reinvestment property. QOZ deferrals on the other hand become taxable in 2026 unless an acceleration event occurs in which case the gain becomes taxable sooner. Another advantage over QOZ’s is that in a 1031 exchange there is no requirement that the reinvestment be made in an economically distressed area leaving more flexibility in acquiring a replacement property in many instances. There is also no timeline to take full advantage of Section 1031 tax deferrals where QOZ investments need to be held for at least 10 years to qualify for the maximum basis step up allowed under law.
Yet, QOZ investments do have many benefits as well. A big advantage of QOZ investments is that the reinvestment required to obtain the full benefit is only the funds relating to the taxable gain recognized. This solves the problem for many real estate investors who want to get cash out of a deal where a Section 1031 exchange requires a reinvestment of the full sales proceeds. QOZ investments also allow for several layers of basis step-ups. QOZ investments held for five years before 2026 qualify for a 10 percent basis step up against the original gain transaction and investments held for seven years qualify for an additional five percent step-up. Taxpayers who qualify for the full 15 percent end up only paying tax on eighty-five percent of their original gain. To qualify for full the 15 percent step-up the QOZ investment must be made during 2019. The final level of basis step-up provides the largest potential tax benefit to QOZ investors. Investments held for a minimum of 10 years qualify for a full basis step-up to eliminate 100 percent of any future gain in the QOZ investment.
For example, a taxpayer sells a property at a $10 million dollar gain and invests the full gain into a QOF during 2019. After five years, the taxpayer receives a $1 million basis step-up (10 percent) and after seven years the taxpayer would receive an additional step-up of $500,000. After considering the basis step-ups, the taxpayer would pay tax on $8.5 million of gain in 2026. Next, let’s assume that the taxpayer sells the QOF investment after holding it for at least 10 years for $15 million. The taxpayer can make an election to step-up the basis in the investment to $15 million and not pay any additional tax on the appreciation of the property.
For new construction or substantial rehabilitations, it is very difficult if not impossible to complete as part of a Section 1031 exchange as the construction activities need to be completed within the 180-day timeframe required by the tax law. These types of projects can be more easily accomplished through a QOZ/QOF investment since there is a longer timeframe to spend the funds invested into the QOF. QOF’s have 30 months after the date of acquisition to spend the working capital invested for these types of projects. Additionally, this period can be extended if there was a delay attributable to waiting for action by a governmental agency.
QOZ’s provide real estate owners with a powerful new tax deferral strategy. Deciding when to utilize this strategy compared to Section 1031 exchanges will take careful consideration to maximize the benefits and comply with the tax regulations. Please contact our office (732-846-3000) or visit our website at wgcpas.com if you have any questions or would like to explore QOZ benefits further.