The tax code provides many tax provisions to incentivize taxpayers to invest capital in ways which achieve desired social outcomes. Internal Revenue Code Section 1031 helps businesses expand into more space and increase the capacity of investment properties nationwide. Section 1031 exchanges also help add to the supply of housing units, increase industrial space capacity, upgrade properties into more energy efficient offices and provide many other benefits which increase the supply of real property held for investment or used in a business.
SECTION 1400Z-1, 1400Z-2
A new section of the tax code, IRC Section 1400, more commonly referred to as the Opportunity Zone (OZ) provision, provides tax incentives on deferred gains along with the potential for tax exclusion for new gains on assets held at least 10 years. These new tax incentives are available to taxpayers who invest in designated Opportunity Zones by investing in what is called an Opportunity Zone Fund (OZ Fund) in areas that are depressed economically. The areas have been identified for tax benefits to attract new infusions of capital seeking to revitalize communities that have not experienced as much economic growth as the rest of the country.
Deferred gains invested in an OZ Fund by the end of 2021 that are held for five years, qualify for a 10% reduction of the deferred gain. Deferred gains held for another two years, for a total of seven years, receive a 15% reduction in the deferred gain. At the end of 2026, capital gain taxes are due on the remaining 85% of the deferred gain. Unlike a 1031 exchange, OZ funds do not allow permanent deferral of capital gain. Investors who opt to defer gain and invest in an OZ Fund and hold for 10 years receive 100% tax exclusion on any new gain in the OZ Fund investment. To put it a different way, the investor’s basis in the OZ Fund held 10 or more years will equal the fair market value on the date the investment is sold. Reflected below are some possible ways investors can take advantage of OZ investments in conjunction with 1031 exchanges along with two approaches that will not qualify.
1. 1031 Exchange into OZ: Fallback approach
First off, keep in mind the 1031 exchange requirements and OZ rules are separate provisions and taxpayers must adhere to the rules for each of these tax codes separately. However, an OZ can be a fallback position for 1031 exchange investors. Here is how this can work: An investor initiates a 1031 exchange and does not find suitable replacement property within 45 days or changes their mind within 45 days and decides to invest money into an OZ instead of like-kind real property in a 1031 exchange. The investor notifies the qualified intermediary that they haven’t identified any replacement property and want 1031 exchange proceeds back on day 46. The qualified intermediary releases exchange proceeds to the investor on day 46. Now, the investor has 135 more days (up to 180 days from the sale of relinquished
property) to invest proceeds into an OZ Fund. One big benefit of changing strategies is from a 1031 exchange to OZ, the investor only needs to invest the gain (not all net proceeds like needed for full deferral in a 1031 exchange) into the OZ Fund.
2. 1031 Exchange and OZ Combined: OZ investment added to a 1031 exchange property
First, the entity (which must be a regarded entity like partnership or corporation, not a disregarded entity for federal tax purposes) completes a 1031 exchange into a qualifying like-kind replacement property. Next, after the 1031 exchange is complete, the entity elects for OZ Fund status. After this, new OZ Funds coming from deferred capital gain from other sources or from syndicated funds are used to substantially improve the 1031 replacement property. As a result, the gain in the 1031 exchange is deferred past 2026 (until the regarded entity sells in a later taxable sale) and separately the gain deferred in the OZ Fund used for improvements qualifies for favorable OZ tax treatment.
3. 1031 Exchange or OZ (or both)
When an investor sells a relinquished property held for investment, they have three options involving 1031 exchanges and OZ. A) Initiate a 1031 exchange and obtain tax deferral under the 1031 exchange rules and requirements. B) Invest the capital gain into an OZ Fund under the OZ rules and requirements. C) Take advantage of both tax strategies and split the exchange proceeds, allocating some funds to a 1031 exchange and investing the remaining proceeds into an OZ Fund. Using this third combined 1031 exchange and OZ strategy, the basis of the relinquished property should be split pro rata with some gains attributed to the 1031 exchange and some gains going towards the OZ Fund.
WHAT DOES NOT WORK
- An investor cannot do a 1031 exchange into an OZ Fund as replacement property. The OZ Fund is a fund, and not qualifying like-kind real property needed to obtain 1031 exchange tax deferral under §1031. Under §1031, only real property held for investment or used in a business qualifies for tax deferral.
- An investor cannot initiate a 1031 exchange, identify property in 45 days, and not purchase all the identified property and then decide to later invest remaining exchange proceeds into an OZ Fund after the 1031 exchange is over. Section 1.1031 (k)-(g)(6) specifies an investor must generally acquire all replacement property they are entitled to (i.e. all property identified within the Identification Period) or wait until day 181 (the expiration of the Exchange Period) to receive 1031 exchange proceeds from the qualified intermediary. If an investor receives proceeds from the qualified intermediary on day 181, they are outside the 180-day reinvestment time required by OZ rules and not eligible to invest into an OZ Fund.
The law and tax benefits around OZ Funds are complex and evolving. All investors should seek the advice of their legal and tax advisors before investing. The tax-related information contained herein should not be construed as tax or legal advice and should not be relied upon in making any business, legal or tax-related decision.