Over the years, we have met many clients looking to become savvy real estate investors. Often times, the most commonly used tax deferral program has been the 1031 Exchange. However, in 2017 Congress passed the Tax Cuts and Jobs Act. The Tax Cuts and Job Acts was the introduction of a new tax advantage, the Opportunity Zone. The goal of Opportunity Zones is to encourage long-term investments, specifically in low-income urban and rural areas throughout the country and bolster the economy. An Opportunity Zone is an economically distressed urban or rural community that has been identified by certain local, state, and federal qualifications. Additionally, localities can qualify as Opportunity Zones if they have been previously nominated for the designation by the state. If the localities have been nominated, then they will need to be certified by the Secretary of the U.S. Treasury.
Tax Benefit #1: Temporary Capital Gains Tax Deferral
The first tax benefit that investors can enjoy is a temporary deferral of inclusion in taxable income. This deferral is only applicable for capital gains that are reinvested in an Opportunity Fund. Additionally, the deferred gain must be recognized before the opportunity zone investment expires or before December 31, 2026.
Tax Benefit #2: Step-Up In Basis For Capital Gains
The second tax benefits that investors can enjoy is a step-up in the basis for capital gains that are reinvested in an Opportunity Fund. It is important to note that the basis is increased by 10 percent should the investment in the Opportunity Fund be held by the taxpayer for at least five years. If the investment is held for at least seven years, then the basis will increase by an additional five percent. The step-up basis increase can help investors exclude up to 15 percent of the original gain from taxation.
Tax Benefit #3: Permanent Exclusion
The third tax benefit that investors can enjoy is a permanent exclusion from taxable income on capital gains from the sale or exchange of an investment in an Opportunity Fund. Assuming the initial investment is held for at least 10 years. It’s important to note that this exclusion only applies to gains accrued after an investment has been made in a Qualified Opportunity Zone.
For many years, savvy real estate investors have used the 1031 Exchange for its tax efficient benefits. However, Opportunity Zones are strategically designed to reward long term investments by deferring capital gains taxes. Investors are able to defer their unrealized capital gains by reinvesting the monies earned into an Opportunity Fund. The investors are then taxed on only 85 percent of the original investment, as well as proceeds (if they decide to stay in the fund for up to seven years). If the investment is held for more than 10 years, then the investors are only responsible for paying taxes on the original investment. Holding onto the investment for more than 10 years is often the more cost-effective option.
Below are the timelines for the step-up basis for property held for specific time periods:
- Property held fewer than 5 years: Deferred payment of existing capital gains until the date that the Opportunity Fund investment is sold or exchanged.
- Property held 5 – 7 years: The above benefits are enjoyed and 10 percent of tax on existing capital gain is canceled.
- Property held 7 – 10 years: Deferred payment of existing capital gains until December 31, 2026 or the date that the Opportunity Fund investment is sold or exchanged (whichever comes first) and 15 percent of tax on existing capital gain is canceled.
- Property held greater than 10 years. — The benefits of 7 – 10 year investment are enjoyed and investors pay no capital gains tax on the Opportunity Fund investment.
Any capital gains realized by an investor within 180 days before an Opportunity Fund investment, are still eligible for the tax benefits of investment in Opportunity Funds.
The largest difference between 1031 exchanges and Opportunity Zones is that during 1031 Exchanges the entire proceeds of the sale must be reinvested while an Opportunity Zone offers an investor the opportunity to not have to roll over the entire gain. However, only the rolled over portion will be eligible for tax advantages.
As always, if you have questions regarding 1031 Exchanges or Opportunity Zones, please reach out to your trusted Real Estate Advisor. We have recommendations for our favorite Asset Exchange Companies to better suit your needs.