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Robert Bloink and William H. Byrnes

Financial Planning > Tax Planning

Opportunity Zone Investments or a 1031 Rollover?

By Robert Bloink By William H. Byrnes

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What You Need to Know

  • It might not always be possible to comply with the rules required for a 1031 rollover to work.
  • Opportunity zone investments can provide an alternate tax deferral strategy.
  • Congress might expand the benefits of the opportunity zone program, so interested clients should pay close attention.

The rules governing like-kind exchanges of real estate under IRC Section 1031 have been around for decades. They provide a powerful tool to allow taxpayers to continue investing in real estate without the need to immediately recognize gain that is simply rolled over into another real estate investment.

Still, taxpayers must comply with detailed rules for the 1031 rollover strategy to work, and it’s not always possible to comply with the strict time limits that apply under the code.

Opportunity zone investments, while relatively new, can provide an alternative tax deferral strategy in situations where the 1031 exchange can’t play out as expected. These investments, however, come with their own detailed regulations that must be understood for clients to successfully defer recognition of gain under the law.

Opportunity Zones: The Basics

The rules governing qualified opportunity zone investments were developed within the 2017 tax reform package.

Opportunity zones allow taxpayers who invest in certain designated projects to defer recognizing capital gains from previous investments. These investments are similar to 1031 rollovers — taxpayers roll gain from a previous asset sale into the opportunity zone investment.

They’re then permitted to defer the tax liability associated with that gain until Dec. 31, 2026. (Legislative proposals would extend the gain deferral period that exists under current law).

If the taxpayer holds the opportunity zone investment for at least five years, their capital gain will be further reduced because the cost basis in the OZ investment will increase by 10%.

That said, under current law, investments made after Dec. 31, 2021, are not eligible for the 10% basis increase unless Congress acts to change the law.

Taxpayers who hold the investment for at least 10 years can eliminate taxation on the original gain entirely.

What Is a 1031 Exchange?

A Section 1031 exchange is a non-taxable like-kind exchange of one real estate investment for another real estate investment. By exchanging one real estate investment for another, the taxpayer can defer the capital gains taxes that would be due if the taxpayer had a gain on the sale.

The gain is deferred until the replacement property is sold. Often, taxpayers who engage in 1031 exchanges continue to defer gain under the rules again and again — for example, by purchasing a second replacement real estate property with the proceeds from the first replacement property.

Balancing the Issues for Clients

While 1031 rollovers have significant tax benefits, they can also be difficult to execute. Often, taxpayers don’t have replacement real estate investments identified when it becomes advantageous to sell an original real estate investment.

Under the 1031 rules, replacement real property must be identified within 45 days after the original property is sold, and that replacement property must be purchased within 180 days of the original sale. Strict tracing rules apply, so that the proceeds of the first sale must be used to execute the second sale.

Opportunity zone investments must also be made within 180 days after the sale of the original property, but there are no tracing rules. Taxpayers can use any funds to purchase the OZ investment (and the investor only must invest as much as the amount of gain they wish to defer).

Further, with opportunity zone investments, the cost basis and capital gains on the investment are separated. Investors can choose to only invest the capital gains — retaining their cost basis for different investment opportunities. In a 1031 exchange, the taxpayer must roll all of the proceeds from the original real estate sale into the replacement investment.

Under 1031, additionally, taxpayers can only continue to defer gain as long as they remain in the real estate investment business. It’s possible to avoid recognizing any gain at all if an opportunity zone investment is held for a 10-year period.

Note also that in the context of 1031 exchanges, sale proceeds are held by a qualified intermediary during the time between sale of the original property and purchase of the replacement property.

In the opportunity zone context, investors can maintain control of their funds (and use them for other purposes) during the 180-day window.

Conclusion

Opportunity zones present a relatively new opportunity — currently, only for a limited amount of time. However, it is entirely possible that Congress will act to extend and expand the benefits of the opportunity zone program, so interested clients should pay close attention to developments in the law.

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Robert Bloink

William H. Byrnes

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