Get Ready To Weigh The Pros And Cons
Earlier this year we discussed Qualified Opportunity Zones and their respective funds. The Tax Cuts and Jobs Act (TCJA), which was signed into law late December 2017, presented us with an opportunity to defer the taxation of capital gains by investing the gains in government designated economically distressed areas. But that wasn’t the only opportunity that was revealed. The TCJA also modified the like-kind exchange rules under Section 1031.
Read Also: Investing In A Qualified Opportunity Fund
Like-kind exchanges enable taxpayers to defer taxation on the gain when the property sold is exchanged for another property or multiple properties that are similar in use and all proceeds resulting from this sale must be reinvested for complete deferral. Under the new rule, property exchanged under Section 1031 is limited to real estate only. The exchange of personal property is no longer allowed.
The details to accomplish a 1031 exchange is beyond the scope of this post. Just know that a 1031 transaction must be properly structured and strict guidelines must be followed to accomplish the tax deferral. At the very least, you are advised to seek professional guidance to fully understand 1031 exchanges and whether or not it can apply to your situation.
Qualified Opportunity Zones and Section 1031s both provide tax benefits. But before moving forward in either direction, it is very important that you evaluate each option closely and how it might reflect your specific situation to identify any and all pros and cons.
Start Keeping Score
The following points can help you build a scorecard that will help guide you in your decision-making process.
Here are the reasons a Qualified Opportunity Zone might win over a Section 1031 Exchange:
- A Qualified Opportunity Zone is a perfect opportunity if a Section 1031 Exchange fails.
- The character and use of the property can be real or personal property.
- Only the amount of capital gain needs to be invested, not your basis.
- There is no like-kind requirement.
- A qualified intermediary is not needed.
- The basis step up (10 percent to 15 percent) reduces a portion of the deferred gain.
- An entire partnership or any of an entity’s partners may opt for deferral.
- Stock in corporations qualify.
Since both options need to be compared, here are the reasons a Section 1031 Exchange might win over a Qualified Opportunity Zone:
- A Section 1031 Exchange can potentially provide a permanent deferral.
- There are no time restrictions for a Section 1031 Exchange holding period. The only restriction is that property be held for investment.
- The location of property can be anywhere in the United States, not just in Qualified Opportunity Zones.
- There are no additional capital requirements.
- A related party purchase is permissible under some circumstances.
- The investor has more control.
- There is a full step up in the basis of the property at death.
- There is no need to sell assets to pay tax on the gain at any given point.
- Refinancing is allowed without restrictions.
- Real estate related deductions are directly deductible by the owner.
The Winner Is?
So, in simple terms, why would one invest in a Qualified Opportunity Zone over a Section 1031 Exchange or vice versa? There really is no simple analysis. All investments must be reviewed and analyzed. We are here to walk you through the process.
Email Rea & Associates to speak with a professional tax advisor to learn more.
By Cindy Kula, CPA/PFS, CFP (Cleveland office)