Opportunity Zones may be a Swiss Army Knife for Investors.

There are a few sit­u­a­tions where the Oppor­tu­ni­ty Zones may be con­sid­ered a Swiss army known for solv­ing investor prob­lems.  Some real estate investors may be feel­ing the end of the year §1031 pan­ic.

Novem­ber 18, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

Oth­er investors may be har­vest­ing gains from a vari­ety of invest­ments oth­er than real estate and seek­ing tax defer­ral. There are a few dif­fer­ent vari­eties of OZs. 

For exam­ple, there may be a sin­gle prop­er­ty locat­ed with an oppor­tu­ni­ty zone and ref­er­enced as a QOZ; there may be mul­ti­ple prop­er­ties acquired as a Qual­i­fied Oppor­tu­ni­ty Zone Fund (QOF); there may also be a qual­i­fy­ing busi­ness devel­op­ment with an oppor­tu­ni­ty zone known as an Oppor­tu­ni­ty Zone Busi­ness Prop­er­ty (QOZBP).  OZ are designed to incen­tivize invest­ment as well as devel­op­ment with­in the des­ig­nat­ed zones.  All improve­ments need to occur with­in 30 months of invest­ment acqui­si­tion. All OZs  have require­ments on defer­ral of tax­es as well as a step up in basis to mar­ket val­ue if the invest­ments are held for ten (10) years for fed­er­al cap­i­tal gains. Mean­ing gains are not taxed on a fed­er­al basis.  We have oth­er arti­cles on the full details of the OZ invest­ment strat­e­gy.

Over the past year the real estate mar­ket has slowed in some areas.  Investors who antic­i­pat­ed suc­cess­ful­ly iden­ti­fy­ing and clos­ing on replace­ment prop­er­ties may not be enter­ing pan­ic mode. For accred­it­ed investors still with­in the 45-day iden­ti­fi­ca­tion peri­od may find a suit­able replace­ment alter­na­tive with the prepack­aged Delaware Statu­to­ry Trust (DST) options. For investors expe­ri­enc­ing a bro­ken exchange, there may be a poten­tial solu­tion for investor by switch­ing to an alter­na­tive exit strat­e­gy. This strat­e­gy uses a dif­fer­ent sec­tion of the Inter­nal Rev­enue Code (IRC).

Qual­i­fied Oppor­tu­ni­ty Funds Can Ben­e­fit 1031 Exchange Investors. Investors and 1031 exchange prac­ti­tion­ers may have unique options to enhance tax-effi­cient port­fo­lio con­struc­tion.

Here are the vari­ety of ways QOFs may be uti­lized:

1. How to Defer §1031 Boot. Not all exchanges may bal­ance out com­plete­ly and there may be cash remain­ing. Find­ing §1031 eli­gi­ble invest­ments with small­er remain­der amounts can be dif­fi­cult.  When a prop­er­ty is exchanged into a low­er priced prop­er­ty the dif­fer­ence is tax­able and referred to by §1031 prac­ti­tion­ers as “boot.”.  For investors hop­ing to defer tax lia­bil­i­ties on boot the DST may be one solu­tion. How­ev­er, QOFs can also defer boot aris­ing from the sale of non like kind assets that may be part of a real estate trans­ac­tion.
2. As a Back Up Plan When a 1031 Does Not Work Out. The rules for exe­cut­ing a suc­cess­ful 1031 exchange are com­plex. The Qual­i­fied Inter­me­di­ary (QI) will need to hold the sales pro­ceeds on the relin­quished prop­er­ty. The replace­ment prop­er­ty (or mul­ti­ple prop­er­ties) being acquired need to be iden­ti­fied with­in 45 days, and the pur­chase must be com­plet­ed with­in 180 days. Under­stand­ing how the 45-day iden­ti­fi­ca­tion list works to an investor’s favor is anoth­er strat­e­gy. There are rules Qis must fol­low on being able to release the investor pro­ceeds they are hold­ing. Cer­tain rules per­mit the release of funds on day 46 and oth­er sit­u­a­tion pro­ceeds may be released on day 181. If the exchange is not care­ful­ly planned in advance, a planned exchange can become inel­i­gi­ble for §1031 tax defer­ral ben­e­fits. Luck­i­ly, none of these restric­tions apply to QOF invest­ments. This means QOFs are fre­quent­ly called upon as a back­up plan when a §1031 exchange can­not be used to defer a cap­i­tal gain lia­bil­i­ty.
3. Using a Qual­i­fied Inter­me­di­ary May Result in Very Gen­er­ous QOF Ben­e­fit Eli­gi­bil­i­ty  A unique sit­u­a­tion aris­es when an investor intend­ing to exe­cute a §1031 hires a qual­i­fied inter­me­di­ary (QI) to hold the sale pro­ceeds but the exchange is not com­plet­ed. If the QI holds the funds into a new tax year the investor can claim install­ment sale treat­ment by fil­ing IRS form 6252. This install­ment sale treat­ment may be avail­able for funds held by a QI with­in the same tax year, but the issue is rel­a­tive­ly new and untest­ed. Under install­ment sale rules the day the QI releas­es the sales pro­ceeds will be the investor’s new cap­i­tal gain real­iza­tion date. The final oppor­tu­ni­ty zone reg­u­la­tions allow tax­pay­ers to begin their 180-day invest­ment peri­od on the date of receipt of install­ment sale pro­ceeds or at their tax­able year end. This allows tax­pay­ers a sec­ond chance at defer­ring their tax lia­bil­i­ty when a §1031 exchange does not go as planned.
4. Sale Defer­ring a Cap­i­tal Gain on the Sale of a Part­ner­ship or S‑Corp inter­est. The sale of the inter­est in an enti­ty, even if the under­ly­ing asset of the enti­ty is real estate, is con­sid­ered per­son­al prop­er­ty, so not “like kind” to real estate. This makes the sale of inter­ests in a part­ner­ship or S‑Corp inel­i­gi­ble for a 1031 exchange. How­ev­er, an invest­ment in a QOF can defer tax on the sale of a part­ner­ship or S‑Corp inter­est.
5. An Alter­na­tive if a Tax Return is Filed Before the 1031 Exchange is Com­plete. When a tax­pay­er ini­ti­ates a §1031 exchange late in their tax year they might inad­ver­tent­ly end their 180-day exchange win­dow ear­ly by fil­ing a tax return. For exam­ple, a 1031 is begun in Decem­ber with plans to com­plete the exchange by May. In this cir­cum­stance, if the tax­pay­er files their tax­es on April 15th under §1031 rules, fil­ing the tax return ends the 180-day exchange peri­od mak­ing them inel­i­gi­ble to com­plete the exchange. How­ev­er, under oppor­tu­ni­ty zone rules fil­ing a tax return does not end the 180-day invest­ment win­dow. QOF investors are allowed to amend their tax returns. This allows a tax­pay­er in this cir­cum­stance to piv­ot to a QOF invest­ment and defer their cap­i­tal gain lia­bil­i­ty.
6. Cap­i­tal Gains on Col­lectibles. For years, investors in col­lectibles such as art, wine, pre­cious met­als and more, were able to use §1031 exchanges to defer their tax lia­bil­i­ties. Unfor­tu­nate­ly, the Tax Cuts and Jobs Act of 2017 dis­al­lowed the use of 1031 exchange for col­lectibles. (No more exchang­ing boats and planes). To make mat­ters worse, cap­i­tal gains on col­lectibles are taxed at a high­er mar­gin­al rate of 28% ver­sus 20% for most assets. (There may also be state tax­es due as well). For­tu­nate­ly, a QOF invest­ment can defer almost any type of cap­i­tal gain includ­ing col­lectibles.
7. Liq­uid­i­ty for High Tax Basis §1031 investors. QOFs can be an excel­lent option for investors sell­ing a high-cost basis prop­er­ty. For exam­ple, if the investor sells a prop­er­ty for $6 mil­lion and their tax basis is $4 mil­lion, to defer the $6 mil­lion cap­i­tal gain a §1031 exchange would require the entire $6 mil­lion in pro­ceeds to be rein­vest­ed. A QOF invest­ment only requires the $2 mil­lion cap­i­tal gain be rein­vest­ed to defer the entire cap­i­tal gain lia­bil­i­ty. Investors using the QOF would be free to use the $4 mil­lion in prin­ci­pal as they wish. We recent­ly had an investor with the sit­u­a­tion and decid­ed to move from a DST into a OZ.
8. Estate Tax Plan­ning. §1031 exchanges offer investors a 100% basis step up on death, elim­i­nat­ing all cap­i­tal gain tax­es due for the estate’s ben­e­fi­cia­ries. This is a very tax-effi­cient strat­e­gy for most investors (or actu­al­ly the heirs). How­ev­er, if the investor’s estate is large enough to trig­ger estate tax­es, then you do not want the step up in basis because it will be tax­able at the 40% estate tax rate (actu­al­ly 18%- 40%). It is bet­ter to defer the tax with a QOF which does not trig­ger a basis step up on death and pay the cap­i­tal gain rate of 20% at the end of the defer­ral peri­od. 
9.  Poten­tial liq­uid­i­ty event. Not all OZ are struc­tured the same.  OZ invest­ment may be offered in a few dif­fer­ent struc­tures.  OZ may be a sin­gle prop­er­ty, mul­ti­ple prop­er­ties, a fund, and even as a poten­tial stock offer­ing.  How­ev­er, all OZ have require­ments to invest in the zones match­ing the cap­i­tal to either devel­op the prop­er­ty or busi­ness.  In some sit­u­a­tions, if the con­struc­tion on the build­ing is com­plet­ed there may be a cash out refi­nanc­ing pri­or to the time the deferred tax­es need to be paid by the investor. This is cur­rent­ly April 2027 (tax year 2026) under the cur­rent rules.  Each offer­ings have advan­tages and offer dif­fer­ent alter­na­tives for invest­ment.  To take advan­tage of the full ben­e­fit from elim­i­nat­ing cap­i­tal gains on any prof­its from the invest­ment (aka step up in basis) the hold­ing peri­od needs to exceed 10 years.  How­ev­er, there is a com­pound return the longer the invest­ment stays in the invest­ment

Investor Dis­clo­sure:

DST’s (Delaware Statu­to­ry Trusts) are for accred­it­ed investors only.  Please us for addi­tion­al details on how a DST may be a solu­tion to your §1031 and §1033 Exchange and com­pli­ment your finan­cial objec­tives. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

DST News would like to acknowl­edge the con­tri­bu­tion of con­tent by Four Springs Cap­i­tal, Madi­son Cap­i­tal Group and Cap­i­tal Square to the arti­cle.  These com­pa­nies are Delaware Statu­to­ry Trust (DSTs) spon­sors that pro­vide replace­ment solu­tions for finan­cial advi­sors to con­sid­er for §1031 and §1033 exchanges.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, in any form, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.