Several countries have, from time to time, attempted social justice projects aimed at improving poorer neighborhoods by attracting investment money into designated areas. For the U.S., these neighborhoods are known as “Opportunity Zones.”
The most recent, and unquestionably the most ambitious iteration of the opportunity zone concept in the US is a designation created by a provision in the Tax Cuts and Jobs Act of 2017.
This provision allows for certain investments in lower income areas to be tax-advantaged. The main idea underlying opportunity funds is to make it attractive to put cash to work that would otherwise be locked away as the asset holder seeks to avoid triggering a capital gains tax.
The current opportunity zones were proposed by US Senator Tim Scott and were endorsed and promoted by social media mogul Sean Parker’s Economic Innovation Group.
This current version of Opportunity Zones is unique in many ways, not the least of which is that it is far more expansive than anything previously attempted. In fact, states have been allowed to designate up to 25% of low-income census tracts as Opportunity Zones. This means a potential for billions in capital to flow to these areas as funds are required to put at least 90% of their capital into opportunity zone projects.
By investing in Opportunity Zones through a Qualified Opportunity Fund, capital gains tax may be deferred on an appreciated asset sale until 2027. Investors may be able to reduce their original capital gains tax liability by up to 15%, and possibly avoid paying ANY tax at all on gains from their Opportunity Fund investment if they hold the investment for 10 years or more.
As Opportunity Zones have come increasingly into the spotlight, it has become obvsious they may actually have several advantages that make them preferable to one of the most popular capital gains tax reduction vehicles –“1031 Exchanges.”
A 1031 deferred exchange, sometimes referred to as a “like-kind” exchange, allows you to defer all capital gains taxes if you reinvest the proceeds in a new property or portfolio of properties that have equal or higher value and maintain similar or higher loan amounts. For many years, 1031’s have been a one of the most highly preferred tax efficient strategies available to real estate investors.
I am often asked which strategy I consider to be the best method to reduce or eliminate capital gains tax.
While the decision to choose an Opportunity Zone over a 1031 exchange depends on your unique situation, I tend to believe that OZ’s hold more promise for greater tax advantages, and greater return on your investment as well.
Timelines are critical to both 1031 exchanges and opportunity zones. However, 1031 exchanges are saddled with much stricter and more specific timeline requirements.
In a 1031, you have 45 days to identify the property or properties you intend to buy and must close on that deal within 180 days. You must re-invest both principal and capital within 180 days of the sale to realize the tax savings. Since a 1031 Exchange is technically a “swap” of one property for another, it is not considered a pure sale, which would normally constitute a taxable event.
As you can imagine, a limiting factor of 1031 exchanges is that it is often nearly impossible for it to happen as a straight swap as it’s difficult to find other investor with whom to swap properties. Getting around this requires initiation of a non-simultaneous or “Starker” exchange which must go through a paid qualified intermediary, creating more time-consuming paperwork.
Unlike 1031 Exchanges, Opportunity Funds require investors to reinvest only their capital gain (not the principal) within 180 days in order to qualify for tax benefits. There are no requirements regarding the initial principal.
As I mentioned, 1031 exchanges require the use of a “Qualified Intermediary” (QI) to facilitate the deal. This mandated intermediary often charges more than $1,000 and the use of such a third party also tends to increase the amount of paperwork headaches.
Opportunity Zones allow participants to place the investments directly, without the use of an intermediary. This saves a considerable amount of money, time, and frustration.
1031’s are Limited to Real Estate Only
In a 1031 exchange, only real estate can qualify for tax advantages. This narrows their usefulness somewhat, especially when you consider all the many types of transactions with potential to trigger capital gains taxes.
While a 1031 Exchange may be a more useful option for investors who want to defer capital gains tax payments indefinitely, an Opportunity Fund offers investors a way to defer and reduce capital gains tax liability for both real estate and non-real estate investments. A qualified opportunity fund can include gains recognizable from taxable exchanges such as: the sale of stocks or bonds, the sale of a property, or the sale of an interest in a partnership. This could be HUGE for business owners who want to sell their businesses and retire without losing so much money to tax.
OZ tax benefits do, however, exist only for a finite amount of time. Most Opportunity Zone funds will close by 2020, though the investors can continue to enjoy the benefits of those funds for a decade or longer.
Also, be aware that Opportunity Funds must adhere to restrictions regarding the types of real estate assets that can be included within the funds.
1031’s Generally Offer No Reduction In Capital Gains Taxes
With a 1031 Exchange, there is no capital gains reduction available unless it is through a step up in basis upon death, which is an unusual circumstance.
Contrast this with Opportunity Zones where capital gains tax on the initial investment is reduced by 10% after 5 years. After 7 years, capital gains tax is reduced through a step up in basis. 15% reduction is possible as long as money is invested by December 31, 2019.
1031’s Will NEVER Eliminate Your Capital Gains Tax, But Opportunity Zone Investments CAN
With a 1031 Exchange, an investor will owe tax upon the final sale of the asset. With an Opportunity Zone fund, you could possibly ending owing ZERO CAPITAL GAINS TAX. If the Opportunity Zone investment is held for at least 10 years, an investor can expect to owe ZERO capital gains tax on any appreciation of the initial opportunity fund investment when the investment is sold.
1031 Exchanges Have Less Flexibility in the Investment Structure
1031 Exchanges were designed as single asset swaps. Although multiple properties can be supported through certain structures, this option may prove unnecessarily expensive and frustratingly complex, requiring a great deal of professional expertise.
Opportunity Zones, on the other hand, are well-suited to supporting a pooled fund that invests in multiple assets without all the added hassles and red tape.
So, you can see why I think that, for many investors with looming capital gains tax issues, Opportunity Zones are simply a better way to gain tax advantages along with exceptional ROI.
Contact me if you have questions or would like to further discuss the advantages of Opportunity Zone Funds.
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