By Mai Nguyen
Hall & Company Tax Manager
Two very beneficial tax deferral mechanisms continuously circulating in mainstream media currently are (1) real estate’s best friend, the Internal Revenue Code Section 1031 Like-Kind Exchange and (2) a rising star that was born from the 2017 Tax Cuts and Jobs Act, Qualified Opportunity Zones. These are both great tax-saving strategies, but what are they and how will they save your tax dollars?
Let’s first start off with the old-fashioned IRS Code Section 1031 Like-Kind Exchange. When you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or like-kind, you are not required to recognize gain or loss. By doing so, you are deferring not only capital gains tax, but also deferral on 1250 unrecaptured gains and any net investment income tax that may apply. At the time of your death, your estate will receive a step-up in basis, and depending on the gift and estate exemption at that time, you may or may not be subject to estate taxes. Essentially, you are deferring your rollover gains into your estate and with the step-up in basis, you may wind up not having to pay income or estate taxes on these real estate investments. Again, the keyword here is “like-kind”, any property that you receive that is not like-kind (i.e. cash) will have to be recognized (basically no deferral on properties that are not like-kind in nature or character). Prior to the 2017 Tax Cuts and Jobs Act, the exchange of personal or intangible property also qualified for nonrecognition of gain or loss. Effective January 1, 2018, only real property would qualify under this Code Section.
The Qualified Opportunity Zone, on the other hand, does not require like-kind investments. It allows for the gain on sale of any appreciated assets, such as stocks to be reinvested into a Qualified Opportunity Fund. A Qualified Opportunity Fund (eligible investments include exclusively capital/1231 gains) is an investment vehicle organized for the purpose of investing in a Qualified Opportunity Zone (economically distressed communities in dire need of redevelopment assistance). In essence, an investor will receive preferential tax treatment by investing in a qualified opportunity zone.
The Qualified Opportunity Zone effectively offers three great tax benefits (1) deferral of tax on rollover gain (2) partial exclusion of rollover gain and (3) permanent exclusion of post-acquisition gain. The deferral of tax on rollover gain is recognized the earlier of (1) date in which Qualified Opportunity Fund interest is sold or exchanged or (2) the taxable year that includes December 31, 2026. The partial exclusion of rollover gain is a tax cut of either 10% or 15 % depending on the length of investment period. Qualified Opportunity Fund held longer than 5 years will receive a 10% exclusion of the deferred gain, while investments held longer than 7 years will receive a 15% exclusion. The permanent exclusion of post-acquisition gain is an exclusion of 100% of appreciation accumulated after December 31, 2026 for investments held longer than 10 years. An election is made at the time of sale or exchange to increase basis of investment to fair market value, therefore $0 gain, $0 tax on appreciation after December 31, 2026.
The discussion above is just a brief overview and does not elaborate on the technicalities of events that may disqualify a 1031 Exchange or Opportunity Fund. There are strict timelines that must be adhered to for both strategies to qualify. Here at Hall & Company CPAs, we have a team of very knowledgeable and trusted advisors that are standing by to assist with any scenarios that you may have. We are here to help maximize your gains and minimize your taxes, give us a call @ 949-910-4255.