Unlocking Tax Deferral: Leveraging Opportunity Zones & Mastering 1031 Exchange Property Identification

Posted on March 27, 2024

As we navigate the complexities of the current tax landscape, astute investors and tax professionals are increasingly turning their attention to the strategic benefits of Opportunity Zones and the intricacies of 1031 exchanges. These two mechanisms offer compelling avenues for tax deferral and capital growth, yet they require a nuanced understanding to leverage effectively.

Opportunity Zones, designated as economically distressed communities, present a chance for investors to spur development while potentially reaping tax advantages. Meanwhile, the 1031 exchange process allows for the deferral of capital gains taxes through the careful identification and exchange of like-kind properties.

If you haven’t already check out our specific article on 1031 exchanges.

1031 Exchange Replacement Property Options

Fee Simple (Direct)

  • Advantages
    • Active Ownership (disposition control)
    • Ability to complementary tax mitigation strategies (Cost Segregation)
    • After-tax equivalent yields
    • Estate planning
  • Disadvantages
    • Diversification can be a challenge due to higher price entry point. No certainty of close.
    • Landlord headaches
    • Financing

Delaware Statutory Trusts (DST)

A DST is a separate legal entity created as a trust under the laws of Delaware in which each owner has a “beneficial interest” in the DST for federal income tax purposes and is treated as owning an undivided fractional interest in a property or portfolio of properties. A trustee (typically an affiliate of the sponsor) manages, administers and operates the trust for the benefit of the investors pursuant to a Trust Agreement. A Delaware Statutory Trust (DST) also meets the criteria to qualify for a 1031 Exchange.

  • Advantages
    • Meet 1031 Exchange criteria
    • Passive Ownership
    • Access to professionally managed assets
    • High current and after-tax equivalent yields
    • Estate planning
    • Limited personal liability
    • Monthly cash flow distributions
    • Diversification (asset class, geographic, tenant)
    • Lower minimums (Boot)
  • Disadvantages
    • No disposition control
    • Potentially longer holding period

A DST and fee simple transactions can be combined to overcome certain investor obstacles. DST combined with Fee Simple provide multiple benefits for exchangers / investors:

  • Avoid taxable gain on boot
  • Avoid financing obstacles
  • DSTs make great back up properties

What Is a Qualified Opportunity Zone?

A Qualified Opportunity Zone (QOZ) is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. The goal of QOZs is to foster economic growth and revitalization in areas that need it most. These zones were created under the Tax Cuts and Jobs Act of 2017 and are defined by census tract data. To qualify, areas must be nominated by states and certified by the U.S. Treasury Department.

When Might a Qualified Opportunity Zone Be Used?

Investors might consider a QOZ when they are looking to reinvest capital gains from a prior investment. By investing these gains into a Qualified Opportunity Fund (QOF) that is dedicated to generating economic growth within a QOZ, investors can defer and potentially reduce their tax obligations on the reinvested gains. Additionally, if the investment in the QOF is held for at least ten years, any appreciation on the QOF investment may be exempt from capital gains taxes.

High Level Thoughts on Qualified Opportunity Zones

Here’s how it works:

  1. Designation of Zones: States, territories, and the District of Columbia nominate low-income community census tracts to be designated as QOZs. The U.S. Treasury certifies these nominations.
  2. Qualified Opportunity Funds (QOFs): Investors who wish to take advantage of the QOZ program must invest through QOFs. A QOF is an investment vehicle organized as a corporation or partnership that holds at least 90% of its assets in QOZ property.
  3. Tax Incentives for Investors:
    • Deferral of Capital Gains: Investors can defer taxes on prior capital gains invested in a QOF until the earlier of the date on which the investment is sold or exchanged, or December 31, 2026.
    • Step-Up in Basis: If the QOF investment is held for at least 5 years, there is a 10% exclusion of the deferred gain. If held for at least 7 years, the exclusion increases to 15%.
    • Permanent Exclusion: If the investor holds the investment in the QOF for at least 10 years, they are eligible for an increase in basis of the QOF investment to its fair market value on the date that the QOF investment is sold or exchanged, which can result in no capital gains tax on the appreciation of the QOF investment.
  4. Investment Requirements:
    • Substantial Improvement: The QOF must substantially improve the property, which generally means that the QOF must double the basis of the property after purchase within a 30-month period.
    • Original Use: Alternatively, the original use of the QOZ property must commence with the QOF.
    • Income-Producing: A QOZ business must derive at least 50% of its gross income from the active conduct of a business within the QOZ.
  5. Compliance and Reporting: QOFs must self-certify by filing Form 8996 with their federal income tax return. They must also meet semi-annual testing to ensure compliance with the 90% asset requirement.
  6. Economic Impact: The program is designed to direct resources to areas that have been identified as needing investment to improve economic prospects, which can lead to job creation and community development.

Investors and fund managers must navigate a series of regulations and requirements to ensure that their investments qualify for the tax benefits associated with QOZs. The IRS provides detailed guidance on these rules, which are subject to change and may require careful monitoring to maintain compliance.

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