Real estate investments are a big part of our practice, particularly for closings in Hilton Head Island. But not all purchasers are aware of their options to reduce, delay, or even eliminate capital gains taxes from their real estate holdings. One of the most popular options for years has been the 1031 Exchange. However, the federal government recently established the Opportunity Zone program and Opportunity Funds as a new investment vehicle giving an alternate option for any investor to reduce or eliminate their capital gains liabilities through real estate.
With this new option, the question has arisen: Is it better to invest capital gains into a 1031 Exchange or into an Opportunity Fund?
A brief overview of 1031 Exchanges and Opportunity Zones
1031 Exchanges - also known as like-kind exchanges - are established and regulated by the IRS and Internal Revenue Code Section 1031 (hence the name). These exchanges allow investors to defer paying capital gain taxes on the sale of real property by reinvesting sale proceeds into the purchase of a new property. This swap allows an investor to use the full gross proceeds to purchase a new investment, which also increases their total buying power.
Opportunity Zones are areas designated by the states wherein investors can invest capital gains and defer paying taxes on those gains for up to 10 years. The investments must be made through a Qualified Opportunity Fund. By doing so, investors may be able to not only defer taxes on capital gains, but depending on how long those investments are held in the Fund, the tax liabilities can be reduced or even eliminated in full. And any tax on gains from the Fund investment may even be avoided as well.
Differences Between 1031 and Opportunity Zones
1031 - All principal and gains from a sale must be reinvested within 180 days of sale of real property.
OZ - Any Gains from any sale must be reinvested within 180 days of sale. The investor can invest only some of the gains, but only that portion invested is eligible for tax advantages.
1031 - Proceeds must be passed through a qualified intermediary.
OZ - Proceeds must be invested into a Qualified Fund, but may be invested directly.
1031 - Only proceeds from sale of real estate can be used and must be rolled into real estate being purchased for investment or for productive use in a trade or business.
OZ - Capital gains from any investment can be rolled over into a Qualified Fund. The Qualified Fund must be used to invest in designated Opportunity Zones.
1031 - Generally used for single asset swaps (sale of single property for purchase of single property).
OZ - Opportunity Fund can be a pooled fund from multiple investments - and multiple investors - and used to invest in multiple properties.
Capital Gains Tax Deferral:
1031 - Indefinite deferral on the capital gains, can continue to be rolled over into subsequent sales and purchases.
OZ - Capital gains taxes may be deferred on the initial investment until April, 2027.
Capital Gains Tax Reduction:
1031 - No tax reduction is available.
OZ - Capital gains tax on the initial investment is reduced to 90% for investments held at least 5 years (10% basis increase) and 85% for investments held at least 7 years (15% basis increase).
Capital Gains Tax on Final Divestment:
1031 - Investor will owe taxes on gains from the final sale.
OZ - If the investment is held for at least 10 years, the appreciation on that investment will not be subject to capital gain taxes.
Evaluating Your Options
So which option is right for you? It will really depend on your circumstances and needs, in light of the conditions above.
1031 Exchanges are great for active real estate investors with resources needed for ongoing management and who do not need to access their gains. These are only available for gains arising from sale of real estate, so other investors and gains won't be eligible. These exchanges are also great for older investors who intend to hold investments or continue to make like-kind exchanges and bequeath the assets upon their death, thereby taking advantage of basis step ups on inheritances (and estate tax thresholds).
Opportunity Zones and Funds, meanwhile, are beneficial to passive investors looking to diversity their portfolios through professionally managed pooled funds. These benefits are available to investors with gains arising from any sale of an appreciated asset as well, so its not limited to real estate swaps. It is also beneficial to investors who want access to their invested funds or who have a varying time frame and looking to reduce their ultimate tax obligations.
If you are interested in rolling your investments over through either a 1031 exchange or in a Qualified Opportunity Fund, Dills Law Firm can assist you in coordinating these exchanges. If you would like to learn more, please contact Rob Dills by email or phone at (843) 868-8210.
DISCLAIMER: This post, and all posts on DillsLawFirm.com, are meant to provide basic education on a range of legal issues. Nothing written here should be construed as legal advice regarding any particular situation. No attorney-client relationship is created by this post or the information contained herein, and this post may constitute attorney advertising. To get specific legal advice, you should seek out the services of an attorney.