By Lance Growth
One of the hardest conversations with clients might be the disappointing fact that they can’t exchange the value of their business.
For years, savvy investors have used a 1031 exchange to shield themselves from burdensome capital gains tax. In the state of California, investors save an average of 33 percent when they utilize a 1031 exchange for the sale of an investment property by deferring their capital gains tax.
A 1031 exchange is a section of the U.S. internal revenue code that allows investors to defer capital gains tax on an exchange of like-kind properties held for business or investment. Even personal property was once exchangeable, however, due to the passage of the 2017 Tax cuts and Jobs Act, 1031 exchanges are now only applicable to real property. Though this minor change in wording has led to a dramatic change in what kind of assets can be exchangeable, the 2017 Tax Cuts and Job Act did however provide some measure of relief for the limitation added to a 1031 exchange through the introduction of Qualified Opportunity Zones.
A Qualified Opportunity Zone (QOZ) is an economically distressed community where investments, under certain conditions, may be eligible for preferential tax treatment. The distressed area may qualify as QOZ if the state’s Governor has nominated them for that designation and that nomination has been certified by the Secretary of the U.S. Treasury via their delegation to the Internal Revenue Service. The rules for a QOZ reads, if a taxpayer realizes an eligible gain, he/she may reinvests the gain within 180 days of disposition of the original asset (point of sale, in relation to real estate, this would be close of escrow of a tax payer’s relinquished property) into a Qualified Opportunity Fund (QOF) and defers the gain. The QOF conducts business, either directly by holding QOZ business property (QOZBP) or indirectly by holding QOZ stock or a QOZ partnership interest.
While 1031 exchanges have been limited to specifically focus on real property, this new rule not only allows taxpayers to defer that capital gain with the option to utilize an exemption, but the rule broadens the benefit beyond real property. The rule now includes capitals gains incurred from the sale of stock and business interest.
Many are looking to sell their real estate in conjunctions with their business. The most common example is the sale of a gas station or a franchise like Seven Eleven. However, the sale of the real estate and the sale of the business operating within the real estate must be separate transactions and only the real estate may receive the benefit of the 1031 exchange. Clients who have operated their business for years sometimes struggle with the concept that the building they own (normally through an LLC or a corporation) is actually separate from the business that not only operates from within the building but also owns the building. Clients are often left disappointed by the fact that a 1031 exchange will only provide preferential tax treatment for their capital gains for their real estate and not for their business. This is especially difficult for clients when the value of the business outweighs the value of the real estate.
Now, with QOZ’s, taxpayers are provided an option to receive beneficial tax treatment for the value of their real estate and business. People who own real estate and operate their companies within the real estate may no longer have to segregate the transaction when trying to take strategic tax maneuvers to protect their profits. With the introduction of QOZ’s, investors can now defer the gains accrued from both the real estate of the business and the business interest with an option to gain further exemptions on those gains.
This benefit is also a great incentive to investors who continually invest in the economy. One principle that governs a 1031 exchange is an incentive to sell. When people learn the amount of taxes they stand to pay due to the disposition of an asset, they are sometimes hesitant to sell due to the tax liability the will have to pay. A 1031 exchange allows those clients to defer those taxes with the requirement that they reinvest into a new property at equal or greater in value. As it relates to business interest, many investors have been discouraged to even sell their business due to the lack of tax benefits for the sale of their company. QOZ’s now provide taxpayers looking to sell their business and real estate a new incentive to continually invest into the economy. QOZ’s provide a further benefit that the tax-payer, unlike 1031 exchanges, only has to reinvest the amount of capitals gains into a QOZ.
Many traditionally do not view their capital gains in the itemized manner their CPA’s understand gains, but they view their tax liability in a broader sense as it relates to their business and the real estate owned by the business. With QOZ’s, they can now keep that view and invest the gains from the sale of their business, and the sale of their real estate into a single QOF and defer their capital gains tax and even gain eligibility for an exemption.
QOZ’s are a great tax benefit but they are not without possible concerns. When a taxpayer is conducting a 1031 exchange, the taxpayer has 180 days to reinvest their funds into their replacement property(s). During this 180-day period, the funds must be held with a qualified intermediary. This requirement is in strict relation to the rule that a client can never be in constructive receipt of funds. Misinformed clients often request to begin the process of a 1031 exchange after they have sold their relinquished property, closed escrow and received a check.
Many receive unfortunate news that they are now disqualified from conducting a 1031 exchange because they are in direct receipted of the funds. Further exploration of the rule regarding constructive receipt has created a bit of a controversy in the 1031 exchange industry. Courts have argued whether or not a client, contacting the accommodator and directing the accommodator to distribute funds to the client or to areas that are not related to reinvesting of funds into the replacement property. The issue surrounding this particular scenario amplifies the word “constructive.” If a client directs a qualified intermediary to take action with the funds outside of the exchange and the qualified intermediary complies, does that reflect the client’s control over the qualified intermediary, and given the fact the qualified intermediary has control of the funds, is the client in constructive receipt of those funds? This entire example is meant to display the great lengths the rules are structured to keep the funds out of the client’s hands.
With QOZ’s, these restrictions are nonexistent. Under the rules of the QOZ, similar to the 180-day rules of a 1031 exchange, a client is required to reinvest funds into the replacement property, however, unlike a 1031 exchange, a client can receive those funds during the 180-day period.
This issue raises concern because some people want to execute a number of actions to disburse funds for reasons such as to pay off credit cards, pay off family members, or old debts that have absolutely nothing to do with the properties involved in the 1031 exchange. Due to the lack of regulations, clients within QOZ now have that ability to access funds during the 180-day period. A concern with this flexibility provided by QOZ might be that people spend funds recklessly with the intent that they regain funds before their 180-day period and find themselves unable to reinvest funds needed to defer all of their capital gains tax they originally hoped to defer.
Another issue with QOZ’s is the ability for anyone to self-certify and create their own QOF. Though the rules clearly advise anyone setting up a fund to make sure they have an experienced financial advisor, CPA, and expert in the field they plan to invest in such as real estate or business, this advice is simply best practice advice and not a mandatory rules when creating a QOF.
As is stands, in order to invest in a QOZ, a taxpayer must first invest in a QOF. The term “qualified opportunity fund” means any investment vehicle, which is organized as a corporation or a partnership. The corporation or partnership must be created for the purpose of investing in QOZ property and that fund must hold at least 90 percent of its assets in qualified opportunity zone property. An individual can follow these rules and simply self certify.
Though it is recommended, not all QOF are going to have tax experts, financial advisors, experienced professionals to give the investors in these funds guidance as to their investments relates to the more nuanced rules of QOZ’s. The ability for an individual to self certify will cause a gross discrepancy amongst the kind of QOF’s. Institutional investors with the resources to obtain and coordinate experts who can help navigate taxpayers through this new tax benefit will be positioned to address unforeseen issues that may arise. However, less seasoned investors who are simply starting a fund because they heard this was a great way to lessen their tax burden may not take the proper steps when issues arrive and may possibly expose taxpayers to the very taxes they hoped to avoid.
As with anything, there are many areas of concern but the concerns do not outweigh the benefit of QOZ’s. The fact remains this is a great opportunity for the low-income areas that are traditionally left out of the growth and increased vitality of an economy during recovery. The passing of QOZ gives investors an amazing tax benefit with the hope that they go into these low-income areas and make significant investments.
1031 exchange is an amazing tax benefit that helps millions of investors protect their capital and provides incentives to reinvest back in the economy. With the passing of QOZ, those same investors are not able to protect their capital on a broader level, but they can also gain eligibility for exemption. Of course, there will be some scenarios where a 1031 exchange still makes better sense for a taxpayer’s strategic tax planning goals, but with the introductions of QOZ’s, taxpayers now have more options to better protect their capital and reinvest into the economy.
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