Qualified Opportunity Zone or 1031 Exchange?

I spoke with a broker at length yesterday regarding the new Qualified Opportunity Zone ("QOZ"). He was frustrated because his client was looking for a QOZ project rather than a 1031 exchange. Surprisingly, the client was being advised by both his attorney and his accountant to deal with his tax issues this way. I wrote an e-mail highlighting what I saw as the flaws in this approach, which I have used as the basis for this article. I then invited this broker to schedule a call with the client and his advisors to discuss the situation in greater detail.

We have been on the cutting edge of the Qualified Opportunity Zone created recently. We think it is a wonderful vehicle for capital gains that previously could not be deferred, such as the sale of a business, stocks, etc. In the past, the only option I was familiar with was a Deferred Sales Trust, which could delay payment of taxes but offered no capital gains forgiveness.

By "we" I mean myself, the Capital Markets Group of Colliers in Boston that I work with closely, and Essex Realty Investments.

The Capital Markets Group at Colliers in Boston has been working to fund some QOZ projects. They have been at the cutting edge of this trend, and are working hard to be thought leaders in this arena. They work with a few Boston based law firms that have spent time getting to the real meat of how a QOZ works.

Essex is a Boston based group that works with real estate to address tax issues. They are former structured debt attorneys who spent over 20 years structuring cash-back 1031 exchanges for high net worth investors for exchanges over $60M. They have worked closely with the tax practice at Seyfarth Shaw. I consider myself pretty smart on real estate and tax issues, but these guys are way ahead of me. I have been doing a lot of work with these guys over the past year, and have been impressed with their knowledge and creativity.

I also want to say that I'm not a tax attorney, and this isn't tax advice. You should obviously run things by your attorney and/ or accountant. You should also make sure they really know what they are talking about, because I run into a lot of folks who don't let their ignorance on a subject stop them from voicing strong (and sometimes scary incorrect) opinions.

Unless an Investor missed their 45 day window for a 1031 exchange, or did not transfer proceeds from Escrow to a Qualified Intermediary (which would NOT allow a 1031 exchange), the consensus is that a 1031 exchange is much better for the investor if you can use a 1031 exchange. This is why specifically:

·        A 1031 exchange allows an investment ANYWHERE. QOZ by definition allows exchanges in economically challenged areas only.

·        A QOZ does not eliminate the need to pay the capital gains. The original capital gains can be reduced to 85% of original amount, and deferred. But you will pay them, where in a 1031 they may never need to be paid.

·        A QOZ does allow tax forgiveness on additional gains created by new QOZ investment over a time horizon. A 1031 allows the same through a future 1031 exchange. The QOZ timelines are rigid, and do not allow flexibility if the facts change over the investment period. Timelines for reinvestment in a 1031 are much more forgiving.

·        It does not appear that you can 1031 out of a QOZ (or use another QOZ). In other words, tax will get paid on at least 85% of the gain. You can defer through a 1031 (or series of 1031's) until a step-up in basis occurs as part of inheritance event. In other words, used correctly, capital gains NEVER needs to be paid if 1031's are used correctly. QOZ requires that the majority of taxes get paid eventually.

·        An investment in any transaction (1031 or QOZ) carries risks. There is a possibility that the QOZ will not be profitable. Not entirely sure how that addresses tax liability of original investment. 

·        If goal of using QOZ is to get access to cash tax free, there are 1031 exchange vehicles that do that rather well. The QOZ does allow an investor to ONLY invest the gains, and walk away with the original principal. Debt matching can be complicated.

These are just some points to consider. I hope this article is useful for you.