Outrunning the Tax Man: Opportunity Zones vs. the 1031 Exchange
The 2017 Tax Cuts and Jobs Act (“TCJA”) made a significant change to the 1031 Exchange (or Like-Kind Exchange), limiting deferral of capital gains strictly to those capital gains realized upon the sale of real estate assets (and repealing deferral of capital gains from the sale of personal property assets). Before the TCJA, the 1031 Exchange was the main vehicle that allowed taxpayers to roll over capital gains into other like-kind property. However, the TCJA created a similar capital gains tax deferral opportunity (and potential exclusion) for taxpayers who invest in Opportunity Zones. Are Opportunity Zones a viable alternative to the 1031 Exchange?
The long-standing 1031 Exchange, defined under Section 1031 of the Internal Revenue Code (the “Code”), allows taxpayers to defer paying capital gains tax when business or investment property is sold so long as another “like-kind property” is purchased with the proceeds from the sale of the first property. The 1031 Exchange allows for a series of rollovers, indefinitely deferring capital gains tax. See the Quick Comparison below for information on timing, identification of properties, or use of property.
New to the Code are “Opportunity Zones” which are distressed and low-income communities throughout the US that are designated as Qualified Opportunity Zones by the U.S. Department of Treasury. Taxpayers can defer, and potentially eliminate, some capital gain taxes by investing the capital gain proceeds into a Qualified Opportunity Fund (a “Qualified Fund”) within 180 days of the sale of the original asset. A Qualified Fund is required to have 90 percent of the Qualified Fund assets invested in Opportunity Zones. The U.S. Treasury approved 120 Opportunity Zone designations throughout the State of Wisconsin. They represent 44 counties, 60 municipalities and 2 tribal reservations. Click here for Wisconsin Opportunity Zones and Opportunity Zones throughout the US.
Incentives for taxpayers to invest in Qualified Funds are the capital gains tax reduction and potential exclusion. However, these incentives are strictly based on the holding period of the investment. A taxpayer can obtain a potential exclusion of capital gains tax of up to 15 percent if the investment is held for at least seven years. Capital gains tax on the initial investment is reduced by 10 percent after five years and an additional 5 percent after seven years through increases in the basis of the initial investment. Taxpayers who hold the investment for at least ten years can expect permanent exclusion for any gains realized on their initial qualifying investment in a Qualified Fund. See the Quick Comparison below for information on timing, qualified assets, investment structure, etc.
Opportunity Zones may be a viable alternative to the 1031 Exchange but they are not a replacement. Whether to elect the 1031 Exchange or to invest in an Opportunity Zone depends on the individual. A 1031 Exchange may be more valuable to an active real estate investor who has a capital gain solely from a real estate sale, intends to pass assets through inheritance in the near future, and does not need access to the invested principal. On the other hand, Opportunity Zones may be more attractive to a passive investor who has a capital gain from any appreciated asset sale (including stocks, bonds, or real estate), does not intend to pass assets through inheritance in the near future, and needs access to the invested principal. See the Quick Comparison of the 1031 Exchange and Opportunity Zone below.
Quick Comparison of 1031 Exchanges and Opportunity Zones
|1031 Exchange||Opportunity Zone|
|Reinvestment||An investor must reinvest the principal and capital gain within 180 days of sale to qualify.
|An investor must reinvest the capital gain within 180 days of sale to qualify.|
|Intermediary||A qualified intermediary is often required.||An investor may make Qualified Fund investments directly, eliminating the need for an intermediary.
|Qualified Asset||Capital gain from the sale of real estate only.||Capital gains from sales of real estate or another investment (includes personal property) can qualify.|
|Use of Property||Must be like-kind property.||Does not have to be like-kind property.|
|Identification of Property||Replacement property must be identified in 45 days. Number of replacement properties are limited.||No requirement.|
|Investment Location||Investment can be made anywhere in the US.||Investments are limited to Qualified Opportunity Zones.|
|Investment Structure||Investment is a single, asset-for-asset swap.||Investment is in a pooled fund which invests in multiple assets|
|Time||No time restrictions as long as held for investment.||Restrictions of 5, 7, or 10 years.|
|Related parties||Sale to related party is not prohibited but a 2-year holding period post-sale is required.||Capital gains from a sale to a related party may not be deferred.|
|Sole-Ownership Capabilities||Investment property may be solely-owned by investor.||Investment must be made in a Qualified Fund, which must be a corporation or entity taxed as a partnership.|
|Capital Gains Tax Deferral||Capital gains tax payments for the initial investment may be deferred indefinitely. However, other issues may arise with a series of rollovers, like depreciation recapture, additional tax on boot, etc.||Capital gains tax payments may be deferred until April 2027.|
|Capital Gains Tax Reduction||Not available during investor’s lifetime – stepped-up basis only permitted upon investor’s death.||Capital gains tax on initial investment is reduced by 10% after 5 years and by another 5% after 7 years (15% total) through stepped-up basis.|
|Capital Gains Permanent Exclusion||Not available.||Investors who hold the investment for at least 10 years can expect permanent exclusion for any gains realized on their initial qualifying investment in a Qualified Fund.|
This article is for informational purposes only and not for the purpose of providing legal advice. We strongly encourage you to discuss these strategies with your attorney and tax advisor to determine which course of action would best suit your needs and objectives.