Why Invest in an Opportunity Zone?
biggest draw of an Opportunity Zone investment is that it can be made using capital gains that are not exclusively from real property held for investment. The sale of a business, personal property or stocks can’t be used for a 1031 Exchange, but are eligible to be put into a Qualified Opportunity Fund that invests in an Opportunity Zone.
However, the primary intent of the Opportunity Zone incentive is to have the capital infused into economically depressed areas long enough to make a difference in the community. Therefore, incentives for excluding, rather than just deferring, tax liability only take effect after a property is held for at least 5 years, at which time 10% of the tax liability will be excluded. After 7 years, that number jumps to 15%. If it’s held for 10 years, all of the
gains can be permanently excluded. For example, if you invested in a property worth $1M and its value increases to $2.5M within the 10 years it’s held, you will get a permanent tax exclusion on the $1.5M profit.
The Opportunity Zone incentive will run out at the end of 2026, so you do have a limited time in which you can defer your tax gains. The upside is that until then you get full access to the capital you would otherwise have to pay in taxes to invest and grow your money. The downside is that the deferred portion of the original tax will be due by April 15, 2027, even if the new gain is excluded.
If you can hold on to an Opportunity Zone investment for 10 years, another huge benefit comes when the property eventually is sold. At that time you will be eligible for an increase in basis (the amount of the original investment) of the investment equal to its fair market value. Since taxpayers are taxed on the difference between their basis and the sale price, this effectively means the transaction will be tax free.
According to a Zillow study reported in the World Property Journal, sale prices on properties in Opportunity Zones have risen by 20% just since last spring, indicating a strong interest in these types of properties. To get the full benefit of the tax deferral, you have about 2.5 years left to decide whether to make an investment in an Opportunity Zone.
Why Invest in a 1031 Exchange?
Unlike investing in an Opportunity Zone, a 1031 Exchange can be used as a tax incentive only if you have capital gains resulting from the sale of real property held for investment. However, since becoming part of the tax code in 1921, 1031 Exchanges have long been a great tool to foster economic growth and development. A 1031 Exchange has no time restrictions on how long it needs to be held, so a 1031 exchanger has the option to reinvest more times within a same 10-year period as someone investing in Opportunity Zones, potentially getting a better overall return on investment. In fact, the 1031 Exchange incentive can be a permanent tax deferral vehicle, as long as the investor continues to meet the reinvestment requirements. Some additional advantages could be:
- Flexibility – you can choose to not take full tax deferral if you want to reduce your debt, mortgage, etc. Opportunity Zones rules don’t allow for this.
- Step-up in Basis – if you continue to do 1031 exchanges throughout your lifetime, the full tax deferral can be passed on to your heirs - and the value will be stepped up to the full present day fair market value.
- Real Estate Tax Deductions - 1031 Exchange investors benefit from deductions such as mortgage interest, depreciation benefits, etc. Since an Opportunity Zone investor invests into a fund rather than real property, they don’t get those benefits.
- Opportunity to Refinance – 1031 investors can refinance to pull money out of their new investment after the exchange is complete. The IRS hasn’t addressed Opportunity Zone refinancing options yet.
- Timing/Payment of Taxes – If an Opportunity Zone investor doesn’t have the cash to pay the deferred taxes due by the end of 2016, they may need to sell other assets to pay them. 1031 investors potentially have more control over the timing of the taxes they owe.
So What’s Best for Me?
Depending on an investor’s particular financial situation, 1031 Exchanges and investments in Opportunity Zones are both exciting opportunities to maximize their return on investment and save on capital gains. However, they are both complicated strategies with different sets of investment rules that must be followed. You should consult with your tax professional to review your options carefully and discuss how you could potentially combine both strategies before deciding what is best for you.