The rules governing like-kind exchanges of real estate under IRC Section 1031 have been around for decades. They provide a powerful tool to allow taxpayers to continue investing in real estate without the need to immediately recognize gain that is simply rolled over into another real estate investment.
Still, taxpayers must comply with detailed rules for the 1031 rollover strategy to work, and it's not always possible to comply with the strict time limits that apply under the code.
Opportunity zone investments, while relatively new, can provide an alternative tax deferral strategy in situations where the 1031 exchange can't play out as expected. These investments, however, come with their own detailed regulations that must be understood for clients to successfully defer recognition of gain under the law.
Opportunity Zones: The Basics
The rules governing qualified opportunity zone investments were developed within the 2017 tax reform package.
Opportunity zones allow taxpayers who invest in certain designated projects to defer recognizing capital gains from previous investments. These investments are similar to 1031 rollovers — taxpayers roll gain from a previous asset sale into the opportunity zone investment.
They're then permitted to defer the tax liability associated with that gain until Dec. 31, 2026. (Legislative proposals would extend the gain deferral period that exists under current law).
If the taxpayer holds the opportunity zone investment for at least five years, their capital gain will be further reduced because the cost basis in the OZ investment will increase by 10%.
That said, under current law, investments made after Dec. 31, 2021, are not eligible for the 10% basis increase unless Congress acts to change the law.
Taxpayers who hold the investment for at least 10 years can eliminate taxation on the original gain entirely.
What Is a 1031 Exchange?
A Section 1031 exchange is a non-taxable like-kind exchange of one real estate investment for another real estate investment. By exchanging one real estate investment for another, the taxpayer can defer the capital gains taxes that would be due if the taxpayer had a gain on the sale.
