Many investors ask whether they should use Code Section 1031 to defer tax gains or defer gains by investing in Opportunity Zones (OZ). The answer is that there is not one right answer for all clients. Many sophisticated real estate investors continue to use Code Section 1031 despite the benefits associated with OZ. Let’s explore the advantages and disadvantages of each provision.
Under Code Section 1031, gain is deferred if relinquished property is disposed of and, within 45 days, replacement property is identified and that replacement property is actually acquired within 180 days of the date the relinquished property is sold. To the extent amounts are not reinvested, either because cash is retained from the transaction or debt is reduced, generally the gain is fully taxable until all gain is recognized. To many investors' surprise, there is no proration of gain which includes a recovery of basis on cash reduced like an installment sale. However, if the Section 1031 transaction is successfully completed, all gain is deferred until such time as the replacement property is disposed of or sold. Many sophisticated real estate investors conduct serial 1031 exchanges to continuously defer their gain either until they time out at their own choosing or ultimately if the investor passes away, the gain is eliminated through a stepped up basis at death. In some instances, the estate tax that is due could be greater than the income tax that is deferred under Section 1031.
Under the OZ rules, if an asset is sold in 2018 or 2019, capital gain is not recognized if it has been contributed to a Qualified Opportunity Zone Fund (QOF) within 180 days. Generally, the QOF has, at most, 180 days to acquire property directly or through a subsidiary indirectly in the OZ. The OZ rules, unlike Code Section 1031, only require that the gain portion be reinvested and therefor the basis can be retained by the investor. However, the deferred gain is recognized on Dec. 31, 2026. If the QOF is held for at least seven years, 15% of the gain is forgiven and if the QOF is held for at least five years, 10% of the gain is forgiven. If the QOF is held for at least 10 tax years, the tax basis in the QOF interest which is initially zero is stepped up to fair market value at disposition.
Therefore, some sophisticated real estate investors prefer Code Section 1031 because it is up to them when and if they recognize gain. Under the OZ rules, at least a portion of the gain deferred from 2018 or 2019 will be recognized on Dec. 31, 2026. Nevertheless, OZ rules provides the potential benefit of allowing the investor to permanently exempt the gain on the OZ investment which is much more beneficial than Code Section 1031. For this reason, it is very difficult to say that one is always preferable to the other.
Under Section 1031, the basis of replacement property is generally the basis of relinquished property increased by liabilities assumed by the taxpayer, money paid and gain recognized, and decreased by money received, liabilities assumed by another party and loss recognized.
Conversely, if cash attributable to a deferred gain is invested in the QOF, the investors’ basis in the QOF is initially zero. This basis can be increased by an allocable share of the investors debt under Code Section 752 but it's certainly possible that the basis will be significantly less than fair market value. After holding the QOF interest for at least 10 years, its basis can be adjusted to fair market value.
CONSEQUENCES OF DEATH
If an investor dies after replacement property received in a Code Section 1031 exchange, the basis is stepped up to fair market value at the date of death or at the alternative valuation date typically six months later.
In contrast, the basis of a QOF is reduced by any 2018 or 2019 deferred gain yet to be recognized. The deferred gain is treated as "income with respect to a decedent" or IRD and the step-up is eliminated to that extent of the IRD. Death of the QOF investor is generally not an inclusion event which accelerates the gain at the time of death.
TREATMENT OF PARTNERSHIPS OR LLCS
Generally, under Code Section 1031, if the relinquished property is held by a partnership or LLC, only the partnership or LLC can engage in a Code Section 1031 exchange. If the relinquished property is owned by the taxpayer or a single member LLC, the replacement property may not be owned by a partnership, LLC or corporation. However, under the OZ rules, either the partnership or LLC can invest in the OZ investment or the partners or members may do so. The partnership or LLC has 180 days from the date of disposition of a capital asset to make a cash investment in a QOF. If that fails, then the partners or members has 180 days from the partnership's or LLC's year end to make an investment.
TYPE OF INVESTMENTS
Under Code Section 1031, gain can only be deferred if the relinquished real estate property is like kind to the replacement property. Any non-like kind property or "boot" is taxable to the extent of the fair market value of the boot. Only real estate may be exchanged for real estate in a Code Section 1031 exchange. With OZ investments, any capital asset can be disposed of and the QOF may invest in either real estate or business interests in an OZ. In addition, the QOF can dispose of its asset in the OZ and has up to one year to reinvest in another qualified OZ property or business. Clearly OZs offer the ability to diversify beyond like kind property.
STATE TAX CONSEQUENCES
Generally, every state conforms to Code Section 1031, although not all states have a preferential rate for capital gains. Therefore, a gain that is deferred for federal income tax purposes is typically deferred for state income tax purposes. However, approximately two-thirds of the states automatically conform to the OZ rules. Many larger states such as New York and California have not conformed to the OZ rules. Therefore, the gain recognized on the sale of the capital asset in 2018 or 2019 and the gain on the disposition of the QOF of 10 years would also be fully taxable.
USE OF THE MONEY
Under Code Section 1031, the taxpayer has 45 days to identify replacement property and 180 days to acquire replacement property. Proceeds from the relinquished property must be held by a qualified intermediary and the taxpayer's ability to use the funds is limited in that the taxpayer may not use, pledge or borrow the proceeds from the sale of the relinquished property. No similar restrictions apply to OZs. The taxpayer can use and invest sales proceeds prior to investing in an OZ fund.
PURCHASES FROM RELATED PARTIES
Under Code Section 1031(f)(4), Code Section 1031 is generally unavailable if the replacement property is acquired from a related party and the taxpayer sold the relinquished property to an unrelated buyer. Under the OZ property rules, the QOF may not purchase property from a related part