The 1031 Exchange has been one of the most tax efficient investment vehicles available to real estate investors for many years. The history of this incentive dates back almost 100 years, when it applied primarily to individual farmers engaged in the trade of livestock and property.
The federal subsidy in the form of a tax break was also promulgated in tune with the era’s public policy of facilitating growth of families and businesses.
Today’s real estate market and probably the country’s developed landscape would look very different without this ubiquitous and powerful reinvestment incentive for the individual and institutional investor alike.
The Problem with 1031
Perhaps through its historical origins in farming and facilitating the American progress through upgrades in land, livestock and equipment,
modern critics contend that the 1031 is unduly advantageous to real estate investors, offering more benefit to real estate investors than say, venture capitalists or stock market investors.
Yet another criticism is the federal incentive provided by 1031, which sought to sate developer’s appetites by encouraging farmers and other landowners sell high-priced land close to town in exchange for land in more remote areas (on a tax-free basis), irrespective – and perhaps in spite of – urban density consequences.
But these consequences are hard to measure. As The New York Times’ David Kocieniewski explained, “With hundreds of thousands of transactions a year, it is hard to gauge the true cost of the tax break for so-called like-kind exchanges, like those used by Cendant, General Electric and Wells Fargo.”
And according to George K. Yin, a University of Virginia School of Law professor and former chief of staff of the Congressional Joint Committee on Taxation, they may be hard to end, too.
“Tax expenditures are very similar to an entitlement program, so they’re easy to start but once a tax break gets started, people think they’re entitled to it, so they are very difficult to end,” he told the Times in 2013.
Advancing Tax Breaks Through Opportunity Zones
Now, with the promulgation of the Opportunity Funds Program, these same 1031 Exchange investors are being afforded even greater potential tax-saving tools.
A significant advantage of an OZ is that assets need not be “like-kind” as otherwise required by a 1031. By the same token, the Opportunity Zone Program requires a 10-year hold to achieve the maximum benefits, although the investment basis tends to step up at years 3 and 7 and the economic value of the overall deferral commences day 1.
The 1031 investor can and might reinvest numerous times during the 10-year period required by the Opportunity Zone Program. Moreover, a 1031 is not geographically limited – any market anywhere in the U.S. qualifies.
Opportunity Funds not only offer investors the ability to defer and reduce their initial capital gains tax bill, they also offer a way to eliminate any capital gains taxes earned from their Opportunity Fund investments under certain conditions.
Perhaps most importantly, the legislation as currently written suggests that any appreciation on the OZ investment after the year 10 hold period expires will also continue without any tax liability whatsoever. The Opportunity Zone Program permits the investor under the right conditions to abate any and all capital gains taxes – all in addition to the initial deferral and gradual reduction of those taxes.
Comparing Both Options: Rollover
1031: Unlike 1031 Exchanges, the OZ investor can reinvest only the previous capital gain portion of the previous investment and is not required to invest the principal of that original investment.
OZ: The OZ investment also requires no investment intermediary as long as the investment is made into an Opportunity Zone Fund, reducing transaction friction.
Requisite Asset Type and Location
1031: Be it real estate, equipment, art or livestock, the 1031 investor is limited to “like-kind” and generally single asset purchases.
OZ: The OZ investment can consist of re-deployment of capital into any one or more of a number of types of assets or businesses. This attribute can potentially bring diversification to a portfolio and mitigate investment risk. However, these OZ investment assets must be located within one of the 8,700 federally-designated Opportunity Zones.
Deferral of Capital Gains Tax Liability
1030: The 1031 permits deferral of capital gains tax indefinitely and there is no time minimums or maximums with respect to investment rollovers.
OZ: The OZ Fund, on the other hand, will be taxed at a finite date – the first of either December 31, 2016 or when the investment asset is otherwise sold.
A Gradual Capital Gains Tax Reduction:
- Day 1: Capital gain on original investment is deferred (for free) and invested until earlier of December 31, 2026 or the investment exit.
- Year 7: 15% Step-up basis.
- Year 10: All post-investment appreciation is considered by the IRS to be tax-free and investor receives a step-up in basis to Fair Market Value (FMV) of investment asset.
Determining the Short- and Long-term Returns
The best comparison can be seen by looking at a new investment asset that is both “like-kind” to the original and happens to be in a designated Opportunity Zone:
Short Term (< 10 Years):
Capital gain tax exposure on original investment is deferred (for free) at least until investment exit.
The OZ investor is locked into holding the investment asset for relevant hold periods at least as far as capital gains tax deferral is concerned.
The 1031 investor deferring an otherwise taxable gain further into the future never mitigates the capital gains taxes eventually due – the tax liability is merely deferred.
Long Term (> 10 Years):
After 10 years, the OZ investor receives a full abatement on capital gains taxes.
Surprisingly, the legislation currently has no limitation as to when – or if – the OZ investor is ever taxed on the OZ investment appreciation – so this 10-year hold could foreseeably continue to 15 years or 30 years without incurring any tax liability on that gain.
The 1031 investor (if still alive) sits on a potentially large capital gains tax bill on the appreciation of the investment asset if and when sold.