Most investors with realized capital gains seek strategies to minimize the taxes on those gains and redeploy their assets in a tax-advantaged way. Historically, many real estate investors would pursue a 1031 exchange and reinvest their sale proceeds in other real estate properties to defer tax payments. Over the last few years, however, investing in QOZs have become a less restrictive and potentially more advantageous option for investors seeking to defer and even eliminate capital gains tax.
What are Qualified Opportunity Zones?
Passed as part of the Tax Cuts and Jobs Act of 2017, QOZs are land tracts designated by the U.S. Treasury Department and Internal Revenue Service to be economically depressed or underserved. To incentivize private investment in these communities, the QOZ legislation created tax breaks to investors who make qualified long-term investments that have the potential to promote economic growth in these zones.
By investing in QOZs, investors can 1) defer the payment of capital gains tax for several years and 2) completely avoid capital gains tax on the appreciation of a QOZ investment itself.
Below are the specifics of how QOZs work:
- Tax deferral: Normally, investors are required to pay capital gains taxes in the year the gains are realized. But if capital gains are deployed into a QOZ Fund within 180 days of their realization, tax payment on those gains can be deferred until December 31, 2026.
- Tax elimination: Provided an investor holds his or her interest in a QOZ fund for at least 10 years, appreciation realized from the sale of either the QOZ investment or the investor’s interest in the QOZ fund are not subject to tax.
How do QOZ investments compare to 1031 exchanges?
The federal government already allows for the deferral of capital gains on the sale of certain assets in special situations. Investment property owners, for example, currently have the ability to postpone paying capital gains on the sale of their holdings provided they reinvest that capital into a similar property in what is a 1031, or “like-kind,” exchange.
QOZ investments, however, are not subject to the same like-kind requirements. Moreover, while the Tax Cuts and Jobs Act of 2017 limited 1031 exchanges to real estate — private property exchanges for assets such as automobiles and heavy equipment are no longer allowed — there are no such restrictions on deferrals through a QOZ investment.
In a traditional 1031 exchange, investors are required to reinvest the entire value of the original property sold into a similar investment to qualify for the tax deferral. For example, say you sold a property for $25 million, with a cost basis of $15 million, realizing $10 million in capital gains. If you sought to defer paying taxes on that $10 million through a 1031 exchange, you would have to reinvest all $25 million — the entire value of the investment — into a similar property to qualify for the tax break. Furthermore, you’re also required to have the same size mortgage on the property in order to avoid taxable gains.
In a QOZ fund, however, you only have to invest the amount of the capital gain — in this case $10 million — within 180 days of the sale to take advantage of the tax deferral.
Another nice advantage of a QOZ fund is that an investor is able to reset the depreciable tax basis and receive depreciation expense within a QOZ investment. Often, this is not the case with 1031 exchanges.
Lastly, investment diversification and execution simplicity are also key advantages of QOZ investments compared to 1031 exchanges.
Provided that the capital gain in question stems from the sale of an asset to an unrelated person, the investment upon which the gain was realized could be almost anything — from stocks to real estate to a private business to fine art. In addition, gains generated within partnership investments, capital gain dividend distributions, and gains recognized by the markup of regulated futures contracts, foreign currency contracts, and certain options under IRC Section 1256 can also qualify for the QOZ program.
Perhaps the most attractive component of the QOZ program relates to the gains generated from the actual investment in the QOZ. If you hold your QOZ investment for 10 years, you would owe no capital gains taxes on the QOZ investment itself upon sale. The only way to receive a comparable tax treatment in a 1031 exchange is a step-up in tax basis upon the taxpayer’s death1. Short of employing a “death strategy” to avoid taxes, in a 1031 exchange your original capital gains are deferred until you sell your replacement property, at which point you can realize the gain and pay taxes — or attempt to defer the taxes again through another exchange.