By Austin Bowlin, CPA
In last month’s article, we presented an overview of a newly established designation created through the Tax Cuts and Jobs Act of 2017 called Economic Opportunity Zones (EOZs) and discussed the preferential tax treatment for investment in the zones. The preferential tax treatment rests in the treatment of capital gains liabilities.
Over the past few months, many clients have asked whether Opportunity Zone investments present a better tax mitigation and reduction strategy than 1031 Exchanges. The answer to that question depends on many factors unique to the individual and their own situation, however there are some key differences between EOZ investments and 1031 Exchanges worth considering:
EOZ investments do not defer tax indefinitely – a 1031 Exchange enables an individual to continue to exchange until they (or their spouse) pass away and a “step up in basis” is received, which completely eliminates the depreciation recapture (25%), capital gains (15-20%) and Net Investment Income Tax (3.8%). EOZs, on the other hand, will receive a reduction of the capital gains taxable amount of 10% after being held for 5 years and an additional 5% after 7 years. However, as the legislation is currently written, the tax liability would become due in 2026.
1031 Exchanges require all sales proceeds to be exchanged – whereas EOZs require only the gain resulting from the asset sale to be exchanged and the original cost basis can be received as cash resulting from the sale. Note that only the tax associated with the gain and depreciation of real property can be deferred in an EOZ; any tax resulting from depreciation of personal property recapture must be paid. This structure presents a situation in which an EOZ investment holds more merit for an asset sale with a reasonable amount of remaining tax-basis than that of a long-held depreciated asset sale with little to no remaining basis.
Additional gains associated with the EOZ investment are non-taxable – technically this attribute of the EOZ investment is not that dissimilar to that of a 1031 Exchange, provided the investor continues to exchange for the rest of their life.
Opportunity Zone investments are required to “substantially improve” their investment – the IRS released guidance in late October that defines “substantial improvement” as investing at least the same amount of money used to acquire any structures on a property, to enhance and improve the structures within 30 months of acquisition. Because of this mandate, the focus of EOZ Funds investing in real estate must be either ground up development or heavy value-add. Either investment strategy could make it difficult for investors to receive cash flow from their investments in early years. 1031 Exchanges can be executed on any type of investment property, including stabilized cash flow producing assets. Investor’s objectives will determine whether this proves to be a problem with EOZ investments or not.
There is no one-size fits all response for the question of whether EOZ investments are a better tax deferral strategy than 1031 Exchanges. The reality is they have very different structures and treat tax-deferral very differently as well. It is our hypothesis that Economic Opportunity Zone funds will see greater investment from gains resulting from stocks liquidations and other asset sales that do not have 1031 Exchanges as an option. We look forward to continuing to monitor the legislation, fund opportunities, and case law associated with EOZs. If you would like to discuss your specific situation and whether EOZ Funds are an option worth considering, do not hesitate to reach out or visit our booth at this year’s upcoming TRENDS 2018 Rental Housing Management Conference & Trade Show on December 14th at the Washington Convention Center.