PREDICTION:  Tax rates will rise, and property values will increase.

IRC Section 1031 allows sellers of qualifying real estate to exchange it for like-kind real estate and defer payment of taxes. . . possibly forever.

WHAT IS A TAX-DEFERRED EXCHANGE?

Section 1031 of the Internal Revenue Code allows any real estate in the USA held for investment or for use in the taxpayer’s trade or business to be exchanged for other like-kind property without payment of federal income taxes. Most states tax codes provide likewise. There are technical rules for completing the exchange, but it is a straightforward process with clear-cut rules expressly authorized by law.

Taxes that can be deferred include all capital gains taxes, all depreciation recapture taxes, all passive-investment taxes (so called “Obamacare taxes”), and, in most cases, state income taxes. In many circumstances, these taxes can add up to in excess of 30%. Instead of paying taxes, why not reinvest those funds as equity in another like-kind property instead, and continue to receive an investment return on those funds?

HOW IS LIKE-KIND PROPERTY DEFINED?

• A concept that is often misunderstood is “like-kind” property. The definition is much broader and simpler that some might expect. Basically, any real estate located in the USA and held for investment or for use in the taxpayer’s trade or business can be exchanged for any other USA real estate held for investment or for use in the taxpayer’s trade or business without paying taxes. That means, for example:

The physical use of the real estate is not what makes it like-kind; rather, all real estate located in the USA is like-kind to all other real estate located in the USA. Likewise, foreign real estate is like-kind to other foreign real estate, but it is not like-kind to USA real estate. The condition is that (i) the real estate being sold must have been held for investment or for use in the taxpayer’s trade or business, and not held primarily for resale, and (ii) the real estate being acquired must likewise be acquired for investment purposes or for use in the taxpayer’s trade or business and not primarily for resale.

ARE THERE TIME CONSTRAINTS?

At the time of closing, the taxpayer does not need to know exactly what property will replace the property being sold. The taxpayer has 45 days to identify potential replacement property, and up to 180 days after closing to acquire the replacement property. A key, however, is that the selling taxpayer cannot come into physical or constructive possession of the sale proceeds during the exchange period. To satisfy this condition, the seller will designate a qualified intermediary to hold the funds under an exchange trust agreement. This can be done quickly, often within a day or two before closing if necessary. Although the seller/taxpayer does not have the right to access the funds during the exchange period, the seller/taxpayer does have the right to direct the qualified intermediary to apply the funds toward the taxpayer’s purchase of any replacement property which is identified by the taxpayer during the 45-day identification period.

For all taxes to be deferred, the entire sale proceeds of the real estate being sold must be used to acquire the replacement property. For this purpose, “sale proceeds” includes all cash received at closing and any mortgage indebtedness that was paid off.

INCIDENTAL PERSONAL PROPERTY

Prior to January 1, 2018 tax-deferred exchanges of certain personal property were also permitted. The 2017 Tax Cuts and Jobs Act, effective January 1, 2018, ended this practice and limited tax-deferred like-kind exchanges to only real property. This raised concerns as to whether certain personal property commonly incidental to a sale of commercial property, such as appliances, carpeting, HVAC systems, security systems, Wi-Fi systems, trade fixtures, etc. would disqualify an exchange for tax deferral, or constitute taxable “boot”.

Under Final Regulations published by the Treasury Department effective December 2, 2020, personal property that is incidental to real property acquired in an exchange will be disregarded and may therefore be included as part of the tax-deferred exchange. Personal property is considered “incidental” in commercial transactions if (a) it is the type of personal property typically transferred together with real property, and (b) the aggregate fair market value of the personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement real property received in exchange.   

ADVANTAGES AND DISADVANTAGES

There are many advantages and not many disadvantages to structuring a sale as a tax-deferred exchange. The rules are technical but not very difficult to apply. It has virtually no impact on the buyer and provides extraordinary benefits to the seller.

For a real estate lawyer, besides providing a great service to your clients, an exchange provides a direct lead-in to the next transaction with an opportunity to handle the purchase of replacement property of equal or greater value that must close within 180 days.

Our tax code provides this benefit; it is up to real estate professionals to take advantage.

Thanks for listening . . .

Kymn

Opportunity Zones are among the hottest of Hot Topics in real estate investment today.  With the December 22, 2017 enactment of the Tax Cuts and Jobs Act that added Section 1400Z to the Internal Revenue Code, Opportunity Zones were authorized as a potentially powerful tax deferral and tax exclusion incentive to develop predominantly low-income communities. The tax issues related to Opportunity Zone investment are multilayered and complex, but the essential tax benefits are reasonably straightforward and easy to understand. The potential tax benefits of investment in Opportunity Zones are serving as an exciting foundation for investment in community redevelopment. Opportunity Zones are not, however, the tax and investment panacea some imagine.

STATUTORY AUTHORIZATION

Authorization to create Qualified Opportunity Zones was set forth in new IRC Section 1400Z-1. Special rules for treatment of capital gains invested in Qualified Opportunity Zones are set forth in Section 1400Z-2.

DESIGNATION OF OPPORTUNITY ZONES

As of December 2018, all Qualified Opportunity Zones have been designated. Each Opportunity Zone corresponds to a Census Tract meeting certain low-income guidelines. There is currently no mechanism to create any additional Qualified Opportunity Zones or to expand or modify any existing Qualified Opportunity Zone.  Various mapping tools are available online to enable you to locate Qualified Opportunity Zones and to determine whether any specific property is located within a Qualified Opportunity Zone and therefore eligible for the special tax treatment authorized by IRC 1400Z-2. 

THREE KEY TAX BENEFITS OF OPPORTUNITY ZONE INVESTMENT

The three principal tax benefits of investment in a Qualified Opportunity Zone, assuming the technical rules required by IRC 1400Z-2 and the implementing regulations are satisfied, are as follows:

1. Tax Deferral. Tax on capital gain reinvested in a Qualified Opportunity Zone is deferred until December 31, 2026 (unless the investment is sold or exchanged prior to that time).  See: IRC §1400Z-2 (B). The capital gain subject to deferral is not limited to just capital gains from the sale of real estate, but also includes other capital gains, including those derived from the sale of stock and partnership interests as well.
2. Partial Exclusion of Deferred Gain; 5 Year and 7 Year Holding Periods. A portion of the deferred gain reinvested in a Qualified Opportunity Zone for five years or seven years is excluded from taxation by increasing the tax basis of the investment by a percentage of the reinvested gain. In the case of an investment held for at least five (5) years, the tax basis of the investment is increased by an amount equal to ten percent (10%) of the amount of the deferred gain. In the case of an investment held for at least seven (7) years, the tax basis of the investment is increased by an amount equal to an additional five percent (5%) of the amount of the deferred gain, with the result that after seven (7) years of gain deferral the basis of the property will have increased by an aggregate of fifteen percent (15%) of the deferred gain. Since the recognition date for deferred gain is December 31, 2026 pursuant to IRC §1400Z-2(B), as referred to above, in order to receive the maximum tax benefit the gain must be reinvested in a Qualified Opportunity Zone on or before December 31, 2019 (seven years before December 31, 2026). But still, the tax benefits for the five (5) year holding period remains available for investments made through December 31, 2021. See: IRC §1400Z-2(B).
3. Stepped-Up Basis For Post-Investment Gain; 10 Year Holding Period. Perhaps the most powerful incentive is the special rule for investments held for at least ten (10) years. Pursuant to IRC §1400Z-2(C), in the case of a qualifying investment in a Qualified Opportunity Zone held by the taxpayer for at least 10 years, upon election by the taxpayer the basis of the investment will be stepped-up to its fair market value as of the date the investment is sold or exchanged. The effect of this provision is to exclude all appreciation in the investment from taxation (although it should be noted that the taxpayer would have been obligated to recognize and pay tax on 85% of the initially deferred gain (7-year holding period) or 90% of the initially deferred gain (5-year holding period) as of December 31, 2026).  If there has been substantial appreciation during the holding period of ten or more years, no tax on that gain will be owed if the taxpayer elects to have the tax basis stepped-up to the fair market value of the investment as of the date it is sold or exchanged. See:  IRC §1400Z-2(C).

EXAMPLE:   Suppose QOZ investor sells an asset and realizes a capital gain of $500,000 on October 1, 2019, and then decides to invest that $500,000 in gain in a Qualified Opportunity Zone investment on or before November 1, 2019.   The tax on that gain is deferred until December 31, 2026 or until the investment is sold, whichever first occurs.  If the investment is held at least five years, as of November 1, 2024, the basis in the investment will be increased by 10%, meaning $50,000 of the originally invested $500,000 gain is excluded from taxation. If the investment is held at least another two years (for a total of seven years), as of November 1, 2026 the basis in the investment will be increased by another 5%, meaning an additional $25,000 of the originally invested $500,000 is excluded from taxation.  As of December 31, 2026, the remaining deferred gain of $425,000 ($500,000 minus $50,000 (the 5-year exclusion) and minus $25,000 (the 7-year exclusion) will be realized, with the result that taxes shall be due on $425,000 of the originally deferred gain as of the investor’s tax filing date in 2027.  

Suppose also that in the ten or more years following the initial investment of gain on October 1, 2019 the Qualified Opportunity Zone property in which the investment was made appreciated substantially, with the result that the post-investment gain attributable to the initial $500,000 investment (i.e. the gain after October 1, 2019) is $2,000,000.  Under IRC §1400Z-2(C), at the election of the taxpayer to step-up the basis of the property to fair market value, the $2,000,000 post-investment gain is excluded from taxation.

OPPORTUNITY ZONES AS SOCIAL-IMPACT LEGISLATION

The challenge for Opportunity Zone investing is that it is not enough to simply “invest” and hold in an Opportunity Zone. Instead, either (i) the original use of qualified opportunity zone business property must commence with the investment of qualified opportunity funds, or (ii) if the property is already in use, it must be substantially improved within thirty (30) months.  Generally speaking, “substantial improvement” means improving the property by an amount equal to the cost basis of the property upon acquisition by purchase after December 31, 2017, less any amounts reasonably allocated to land. See: IRC §1400Z-2(d)(2)(D).

Opportunity Zones were designed to inspire social-impact projects. Investment projects in Opportunity Zones are supposed to make a positive difference for the low-income community in which it is situated. The investor seeking the tax advantages of investing in a Qualified Opportunity Zone must put its funds to work to create economic opportunity in the community. Merely investing in an existing property or business is not enough.

SECTION 1031 TAX BENEFIT vs. OPPORTUNITY ZONE TAX BENEFIT

A question I am often asked is whether an Opportunity Zone Investment is better than a tax-deferred exchange pursuant to IRC Section 1031? The short answer is that one is not inherently better than the other, they are just different. It’s like asking whether penicillin is better than a sandwich. Clearly, if you are merely starving a sandwich is better. If you have a bacterial infection, you might be better off using penicillin.  The tax benefits of investing in a Qualified Opportunity Zone are different from the tax benefits offered by a tax deferred exchange of like-kind property pursuant to IRC Section 1031, and the circumstances under which each may be beneficial are different. Each has its place. I will be posting an updated article on IRC Section 1031 tax-deferred exchanges shortly.

OPPORTUNITY ZONES AS ECONOMIC DEVELOPMENT INCENTIVE

Qualified Opportunity Zone investments in real property require significant capital improvements and the acceptance of a substantial degree of investment risk. The investment risk is that the property must yield acceptable investor returns to sustain the project over a holding period of at least 5 years, but ideally 10 years, and that during the 10-year holding period the property will substantially appreciate in value, making the promised exclusion of gain taxation meaningful.  Because of the substantial investment required to substantially improve property (i.e. double the basis of the existing improvements) and the uncertainty that the primary tax benefit to be derived from appreciation in value over 10 or more years will be achieved, today’s value of property is not automatically enhanced merely because it is located within an Opportunity Zone as some existing owners seem to believe. The project itself must make substantial economic sense on its own – just as if it were not in an Opportunity Zone. The tax benefits available through a Qualified Opportunity Zone investment will not make a poor investment or a marginal investment good. They will only make a good investment better. 

What makes a Qualified Opportunity Zone investment similar to a IRC Section 1031 Exchange is that they both provide for tax deferral. Tax deferral for a Section 1031 investment is potentially without end. Tax deferral for a Qualified Opportunity Zone investment is temporary, but carries with it the additional benefit of potential exclusion of gain from taxation.  Section 1031 exchanges have been part of the Internal Revenue Code for nearly 100 years and are well understood as a tax deferral tool. Qualified Opportunity Zone investments are a brand-new tax mitigation tool authorized in December 2017, with the rules for their use still being written.

The potentially powerful tax incentives offered by Qualified Opportunity Zone investment, coupled with their focus on revitalizing economically distressed communities, is what has made investing in Opportunity Zones one of the hottest topics in real estate.

END*

*NOTE: The foregoing article is for educational purposes and is not intended as tax advice. Taxation of Opportunity Zone investments is highly technical and fact sensitive. Consult with your own tax advisor when applying the subject matter of this article to any specific tax scenario.

This is the second installment of a three-part series on Section 1031 like-kind exchanges. Part 1 explained WHY you should consider use of a Section 1031 like-kind exchange when selling commercial or investment real property. Part 2 covers the key rules for HOW to implement a Section 1031 like-kind exchange. Part 3 will cover special issues applicable to a Section 1031 like-kind exchange when a Tenant-In-Common [TIC] interest is being acquired.

KEY RULES FOR SECTION 1031 EXCHANGES

The following is an outline of key rules applicable to Section 1031 exchanges. Become familiar with these rules. Unless you intend to completely cash out of real estate investing, a Section 1031 exchange may work to your benefit. If you intend to keep investing in real estate or using real estate in your trade or business, a Section 1031 exchange will maximize the capital you have available to reinvest.

Key Elements of a Section 1031 Exchange*

What is Section 1031?

Section 1031 refers to Section 1031 of the Internal Revenue Code of 1986, as amended.

What does it do?

Section 1031 permits a taxpayer (the Exchangor) to dispose of certain real estate and personal property and replace it with like-kind property without being required to pay taxes on the transaction.

What property qualifies?

To qualify for a Section 1031 exchange, the property being disposed of (the Relinquished Property) must have been used in the Exchangor’s trade or business and/or must have been held for investment purposes. The property being acquired (the Replacement Property) must likewise be acquired for use in the Exchangor’s trade or business or for investment.

What property is considered like-kind?

For real estate, to be like-kind means simply that real estate must be exchanged for real estate. The rules related to personal property are significantly more complex. Personal property is any property that is not real estate.

Real estate exchanges are fairly straightforward. A warehouse may be exchanged for another warehouse or for any other qualifying real estate including, for instance, a factory building, office building, shopping center, single-tenant store, parking garage, or even a parcel of vacant ground so long as it qualifies as being acquired for use in the Exchangor’s trade or business or is to be held for investment. This is not a difficult test to pass. Similarly, a qualifying parcel of vacant ground or a shopping center or office building or factory or other parcels of investment real estate may be exchanged for any other qualifying real estate investment.

Personal property exchanges are not so straightforward. For personal property, the property must be substantially similar and of the same type or class. For example: a car can be exchanged for another car; and a bull can be exchanged for another bull; and a cow can be exchanged for another cow; but, a bull may not be exchanged for either a cow or a car.

Although personal property exchange rules are substantially more technical and complicated than real property exchange rules, generally speaking, depreciable tangible personal property held for productive use in a trade or business can be exchanged for other depreciable tangible personal property held for productive use in a trade or business so long as they fall within the same NAICS classification code.

For instance, Limited Service Restaurants such as fast food restaurants, pizza delivery, sandwich shops, etc. fall within 2012 NAICS Code 722513. Accordingly, the assets of one can be exchanged for the assets of the other under Section 1031. But, note that the NAICS Code for a bar, tavern or nightclub is 722410, and the NAICS Code for a full service restaurant is 722511, so an exchange of assets of either of these for the assets of the other, or the assets of a Limited Service Restaurant (even though otherwise physically identical), may not likely be considered “like kind”.

The point, for purposes of this post, is that exchange rules for personal property are substantially more complex than exchange rules for real property. Accordingly, if you are exchanging personal property – either in conjunction with an exchange of real property or purely as a personal property exchange – great care must be taken to comply with the personal property exchange rules to receive the benefits of a tax deferred exchange under Section 1031.

What property is excluded?

Some types of property are expressly excluded from tax deferred exchange treatment by statute, rule or regulation The following types of property do not qualify for aSection 1031 exchange: stocks, bonds, partnership interests, limited liability company interests, personal residences, stocks in trade or inventory, and certain other intangible property.

Are there timing issues?

Section 1031 exchanges can be simultaneous, but they are not required to be. In fact, most exchanges made pursuant to Section 1031 are not simultaneous. There are, however, strict timing rules that apply tonon-simultaneous exchanges and strict rules prohibiting access to funds.

What are the time limits?

The Replacement Property or properties must be identified, in writing, not later than forty-five days after the Relinquished Property is transferred (the Identification Period). The Replacement Property or properties must be acquired not later than the earlier of (i) 180 days after the Relinquished Property was transferred, or (ii) the due date for the Exchangor’s tax return, including any extensions (the Acquisition Period). The Identification Period is included within the Acquisition Period.

How many Replacement Properties may be identified?

There is no fixed limit to the number of Replacement Properties that may be identified, but there are two primary rules that apply: (1) the Three-Property Rule, and (2) the 200% Rule.

1. The Three-Property Rule allows you to identify up to three (3) properties as potential Replacement Properties, regardless of value. You need not acquire all three properties, but as of the end of the Identification Period, not more than three properties may be identified. This is the most commonly used identification rule.

2. The 200% Rule allows you to identify any number of potential Replacement Properties so long as the aggregate value of all identified properties does not exceed 200% of the value of the Relinquished Property. You need not acquire all identified properties.

Generally, if you identify more properties than permitted, you are treated as if you have not identified any properties. However, there is one more rule that might save the day. The 95% Rule allows you to identify any number of potential Replacement Properties, regardless of value, so long as you actually acquire within the Acquisition Period at least 95% of the value of all properties identified. Use of the 95% Rule is rare, and is generally considered more a safety valve rule than an intentionally used exchange rule

Must all exchange proceeds be used?

There is no requirement that all proceeds received upon sale of the Relinquished Property be used to acquire the Replacement Property. Any exchange proceeds not used, however, are taxable.

What constitutes exchange proceeds?

Exchange proceeds means the net sale price of the Relinquished Property, including all net equity and the amount of any mortgage encumbering the Relinquished Property, whether paid off at closing or assumed by the purchaser. It is not sufficient to merely reinvest the net equity received upon sale. The purchase price of the Replacement Property must equal or exceed the aggregate of the net equity received upon sale of the RelinquishedProperty plus any mortgage encumbering the Relinquished Property at the time of the sale closing.

Example: If the Relinquished Property is encumbered by a $700,000 mortgage and is sold for $1 million as part of a Section 1031 exchange transaction, to defer all taxes, the purchase price of the Replacement Property must be at least $1 million, not merely $300,000.

When can the Exchangor obtain access to unused proceeds?

Proceeds from sale of the Relinquished Property may be accessed only when the exchange is completed, fails, or expires. If no potential Replacement Properties are identified within the Identification Period, the exchange fails, and the Exchangor may receive the funds. Those funds will, however, be taxed in the year received. But note: If a mortgage was paid off at the Closing of the Relinquished Property, and the amount of the mortgage was greater than the tax basis of the Relinquished Property, the amount paid to satisfy the mortgage in excess of the tax basis of the Relinquished Property is taxable in the year of Closing of the Relinquished Property.

If all properties identified within the Identification Period are acquired within the Acquisition Period, the exchange is completed, and any remaining funds may be received by the Exchangor. Those remaining funds are taxable. If less than all identified properties are acquired, but the Acquisition Period expires, all remaining funds may be received by the Exchangor, but are taxable.

Conclusion:

These are the basics. As tax rates rise, Section 1031 exchanges become increasingly valuable.

A Section 1031 exchange is not a new and exotic tax shelter scheme. Tax deferred exchanges of like-kind property have been recognized by the Internal Revenue Service as a valid tax deferral strategy since the early 1920s. The structure and effect of a Section 1031 exchange were specifically authorized by Congress by enacting Section 1031 of the Internal Revenue Code of 1986, as amended, and the Internal Revenue Service has promulgated extensive regulations for its implementation.

Use Section 1031 to your advantage, but be sure to strictly comply with the Section 1031 rules.

* Special Thanks to my tax partner, James M. Mainzer, for consulting on this post.

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As required by the Internal Revenue Service under Circular 230, you are advised that any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this article.