Written in partnership with RCX Capital Group, and Ensenia Wealth.
When investors sell appreciated assets, particularly real estate, they face a choice: pay capital gains tax, or implement a tax mitigation strategy. Depending upon the state and the investor’s income level, including depreciation recapture and medicare tax, the tax liability can be as high as 30-40%. Two highly effective tax management tools available to investors are 1031-exchanges and Opportunity Zones.
While Opportunity Zones and 1031s both offer the ability to invest on a tax-deferred basis, each of these vehicles has unique benefits and drawbacks, and one may align better than another depending upon the type of gain and investors’ objectives. For instance, some offer income immediately, while others do not.
An investor’s objectives often dictate which vehicle is appropriate to employ. Often, investors’ objectives include tax deferral and obtaining stable, current income. Ownership of quality real estate assets is also desirable. However, many investors want to reduce the burden of managing those assets. Another common objective is estate planning. Investors don’t want to leave their heirs with a large tax liability when they pass on their assets and often don’t want to leave significant administrative or management obligation either. Diversification of real estate holdings is also a common goal. Investors seek to achieve a diverse portfolio of different sponsors, geographic regions, asset types and tenants. Each tax-advantaged vehicle has different strengths, so alignment with investor objectives is paramount.
A 1031 exchange can be employed when an investment property is sold. The name comes from section 1031 of the IRS code, which allows the investor to make a “like-kind” exchange of real estate and defer the payment of capital gains taxes. 1031 exchanges allow investors only 45 days from the closing of their “relinquished property” (the property being sold) to identify a “like-kind” replacement. Investors have a total of 180 days following the closing of their relinquished property to close on the acquisition of one or more replacement properties. These time constraints, along with the rules around identification and what qualifies as “like-kind,” are complicated and can be difficult to implement correctly. Investors can satisfy a 1031 exchange by following these requirements and acquiring one or more real estate assets (fee simple) or Delaware Statutory Trusts.
Delaware Statutory Trust
Many investors are familiar with acquiring a replacement property to satisfy a 1031 exchange. However, Delaware Statutory Trusts (DST) also qualify for a 1031 exchange and have slightly different features. DST rules were laid out in The Delaware Statutory Trust Act (DSTA). Rather than having to find a “like-kind” property, an investor with a taxable event such as the sale of appreciated property, can invest proceeds in a “beneficial interest” of a DST. For tax purposes, the holder of this “beneficial interest” is treated as owning an undivided fractional interest in the property held by the DST. The DST is managed by a sponsor real estate firm and the investors aren’t burdened by management requirements.
Opportunity Zone Funds
This new tax deferral vehicle was established by the Tax Cuts and Jobs Act in 2017. Opportunity Zone Funds have become a fascination in the commercial real estate industry. The goal of the law was to foster development and investment in economically distressed areas. Approximately 8,700 zones have been designated across the country. Investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date which the QOF is sold or exchanged or December 31, 2026. If the QOF investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain. If it is held for more than 7 years, the exclusion becomes 15%. If the investment in the Opportunity Fund is held for more than 10 years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged. Some of the rules around Opportunity Zones still need to be clarified by the IRS. For an investor to take advantage of the full reduction benefit, the investment must be made by December 31, 2019, so investors are flocking to QOFs quickly to get the maximum benefit.
Technology and Experience
Understanding these tax-advantaged vehicles requires expertise and experience. While there is no replacement for an expert advisor, technology can make that expertise more accessible. Technology makes it easier to find a suitable “like-kind” replacement property for a 1031 exchange. Compliance and due diligence on DSTs can be streamlined through technology. Similarly, opportunity zone funds may need additional due diligence processes as an understanding of the new rules evolves. Having a combination of experience and technology can make for better implementation and execution of tax-advantaged vehicles.