Opportunity Zones may be the biggest news in the world of economic development since the establishment of the 1031 Exchange. The Tax Cuts and Jobs Act of 2017 introduced the Opportunity Zones program which offers generous tax advantages, delivers enormous benefits to private-sector investors, and promises economic growth for low-income communities. Although this program is new, Opportunity Zones have made a significant splash in the economic development world, and they’re worthy of every investors’ attention.
The Scenario – 1031 Exchange vs. Opportunity Zone
Assume you own a business and you are ready to sell. Selling the business means you are going to incur significant capital gains tax.
You have a choice:
- i) Use a 1031 Exchange and defer your capital gains tax
- ii) Reinvest in a property or business that offers both capital gain deferral and capital gain exclusion in exchange for investing in low-income communities termed Opportunity Zones
Below, we explain the differences between 1031 Exchanges and Opportunity Zones.
1031 Exchange Components
The traditional concept of the 1031 Exchange has been around a long time. Here’s the breakdown:
- You must have a Qualified Intermediary handle the transaction to preserve the deferral.
- Qualified Use – you must have the intent to hold the property or properties for investment.
- “Like-Kind” Property – the replacement property must be “like-kind” to the property that is sold. Real property must be exchanged for real property, as long as it is for rental, investment or used in business.
- The exchange must be equal to or greater than net sales price of the property sold.
- 45 days to identify like-kind replacement properties and 180 days to complete the exchange.
A 1031 Exchange has nuances that limit investors. One of the largest restrictions is that 1031 Exchanges only apply to real property – you cannot use a 1031 Exchange if you sell stock. You also cannot take any cash out of the transaction if you intend on using the deferral.
Opportunity Zones – the Trifecta Tax Incentive
Now in comparison, let’s take a look at Opportunity Zones:
- Capital Gains earned from the sale of any asset (stocks, property, etc.), not just real property, can be used in Opportunity Zones. This quickly eliminates the need for like-kind exchange under 1031 Exchanges.
- In addition, there is no requirement that all of the capital gains must be applied to the investment in Opportunity Zones. In fact, you can split it up however you prefer, which provides investors great flexibility.
- The taxpayer has 180 days from the day capital gains are recognized to reinvest into a qualified opportunity zone property or fund. If invested into a qualified fund, the fund can have additional time to reinvest the funds.
- Three Tax Incentives offered under Opportunity Zones:
- Temporary Deferral – A temporary deferral if inclusion in taxable income for capital gains is invested into an asset with an Opportunity Zone. The deferred gain will be recognized on the earlier of the date on which the asset is disposed of or December 31, 2026.
- Step-Up in Basis – A basis is increased by 10% if the investment in the asset is held by the taxpayer for at least 5 years and by an additional 5% if held for at least 7 years, thereby excluding up to 15% of the original gain from taxation.
- Permanent Exclusion – Consider this tax incentive the kicker. If the asset within the Opportunity Zone is held for at least 10 years, a permanent exclusion from capital gains tax is applied to that asset once is sells or transacts after 10 years.
The 1031 Exchange program does not limit you geographically like Opportunity Zones since you are not obligated to invest in a low-income community designated under the Opportunity Zone regulations. However, Opportunity Zones allow taxpayers to use proceeds allocated to basis without any restrictions – hence you can keep part of the proceeds from a sale if you desire. In addition, the ability to permanently eliminate up to 15% of initial capital gain and then exclude all gains from the sale of a Qualified Opportunity asset held past 10 years really sets Opportunity Zones apart from 1031 Exchanges.
If you are in the market to sell an asset that might have a capital gains associated with it, be sure to take some time and understand your options. The savings could be tremendous. If you are interested in selling your asset or investing within an Opportunity Zone please consider contacting Suraj Bhakta at NewGen Advisory. We will be happy to assist you in the process.