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Many clients have inquired about 1031 exchanges, a process that allows a seller to defer paying capital gains tax on a sale by investing the entire sale amount into the purchase of another property. Another more recent method to defer capital gains tax is to invest in a Qualified Opportunity Zone (QOZ), designed to spur development in low-income neighborhoods through socially-minded investments. Local governments are encouraging this type of development using tax benefits.
An investment in a QOZ allows for a reduction in the amount of capital gains tax paid on the sale of a previous property, based on the term of the investment. The two processes are very different, and have different requirements and consequences. Below is a list of some of the benefits and drawbacks to each of these investment strategies and an example of each scenario.
The 1031 Exchange process is quite strict:
1) Neither the property you sold (“relinquished property”), nor the property you purchase (“replacement property”) can be used as a primary residence.
2) Both the relinquished and replacement properties must be within the U.S.
3) You only have 45 days to identify replacement properties.
4) You have 180 days to close on the replacement property.
5) A qualified Intermediary is required to conduct the transaction and accept all funds on behalf of the seller.
6) The name of the seller on title and the name on the tax return must be the same. An exception to this would be a single member LLC, where the single member’s name may be on the tax return, and the LLC name on title.
Qualified Opportunity Zone:
Conversely, because the QOZ rules are quite new, they are fairly broad and undefined causing some confusion and varying interpretations. With a 1031 exchange, the seller invests all proceeds from the sale of the previous property, but with a QOZ, the seller of the property will only re-invest the capital gains from the previous sale. This means, if you purchased a home for $1,000,000 and five years later it’s worth $2,000,000, you now have $1,000,000 to invest.
Additionally, with a 1031 exchange, capital gains are realized once you sell the property using a normal market transaction. With a QOZ, you get a reduction of the tax on the capital gains realized. The only major similarity between the two methods is the requirement of a closing within 180 days of selling the particular property.
Comparing the Two Scenarios:
1031 exchange: You purchase property for $1,000,000, and sell it 10 years later for $2,000,000. It doesn’t matter what your initial purchase price was for the property. You would then re-invest the full $2,000,000 into a 1031 qualified property. By investing the full $2,000,000, you will avoid paying capital gains tax on the “boot,” which is any capital that is not re-invested from the sale of the previous property.
(If you sold the property for $2,000,000, but only purchased a replacement property for $1,500,000, you would pay capital gains tax on the remaining $500,000.)
Qualified Opportunity Zones: You purchase a property for $1,000,000, which you later sell for $2,000,000. With the QOZ, only the $1,000,000 gained will be eligible for investment. You now invest the $1,000,000 in a QOZ. After five years of investing you will receive a “tax break” on 10% of the capital gains. This means, if you now sell the property at the five-year mark, you will only pay capital gains tax on $900,000 of the initial investment.
Now, let’s say you keep the $1,000,000 in the QOZ for an additional two years (total of 7 years). You will receive an additional 5% tax break on the capital gains, for a total of 15%. Therefore, if you sell the property at this point, you will only pay capital gains tax on $850,000 of the initial investment. The most beneficial investment term in the QOZ is ten years though. After ten years, the entire investment becomes tax exempt.
Now you may be wondering what the benefit of a 1031 exchange would be in comparison to the QOZ. Regardless of when you invest in the QOZ, you will have to pay the deferred amount of the original capital gains tax by December 31, 2026. Now, if you remain invested for the 5-year or 7-year term, your investment in the QOZ will be subject to the tax incentives stated above. If you remain in the fund for the full 10-year term, then your capital gains from the appreciation of the fund will be tax exempt.
Investors must consider these factors when deciding which investment strategy to take advantage of. Investing in a 1031 exchange could be considered more secure because it was established in 1921 and the rules have been solidified. On the other hand, the QOZ is recently amended and could potentially be modified based on the circumstances that occur with new investors.