Commercial Investment Real Estate March/April 2019 | Page 37

Weighing the Options by Daniel Pessar Should long-term real estate investors consider qualified opportunity zone investments for gains deferral instead of more traditional 1031 exchanges? IRC Section 1031 and the newly enacted Section 1400Z-2 both allow for deferral of capital gains, but they are very different in their benefits and costs. The best approach for investors depends on factors such as their liquidity, the types of real estate they want to own, and their broader portfolio goals. Depending on an investor’s goals and profile, just one benefit or cost may lead it to choose a certain approach. Qualified Opportunity Fund Investment 1031 Exchange ▲ May defer capital gains from many assets (even stocks) sold ▼ Disposition of “like kind” (real) property. by an investor. ▲ Can use any funds. ▼ Using disposition proceeds, must track funds to purchase replacement property. ▲ Only required to reinvest gain amount. ▲ Can invest in any valid QOF. ▼ Must reinvest total value and equity amount. ▼ Strict rules and time limits for property identification, such as ▲ Allow capital gain reduction of up to 15 percent after 5- or 7-year ▼ No capital gain reduction. 200-percent rule, three-property rule, and 95-percent rule. hold and 100% after 10-year hold. ▲ A partner in a partnership that elects not to make a QOZ investment to defer partnership-level gains can make its own deferral election for its distributive share of the gain. ▲ 180 days may be just the beginning of time for investment since the ▼ When a partnership elects not to do a 1031 exchange, partners cannot simply elect to do their own exchange with their distributive share of property disposition proceeds. Options to circumvent this issue, such as the drop-and-swap strategy, by which partners obtain tenancy- in-common interests in exchange for their partnership interests in advance of a planned property sale, may involve too much risk and complexity for some investors. ▼ Only 180 days to close and must close on replacement properties. QOF still has time to invest the funds and even longer for electing partners in a partnership that did not make an election. ▲ No advance identification of properties required. ▼ Deferral only up until 2026. In that year, investors will have tax with ▼ Advance identification of replacement properties. ▲ Can defer capital gains on disposition property indefinitely. no corresponding income. ▼ May only benefit from purchases of qualifying property (several rules to comply with at acquisition and throughout hold term). ▼ QOZ real estate investments require substantial improvement ▲ May benefit by purchasing any like-kind property (almost no rules in terms of replacement property). ▲ No additional investment required. of the property. ▼ Potential to lose benefits if not held for 10 years. ▲ Great flexibility to finance, sell, or exchange the replacement ▼ New law, complex structuring in certain cases, room for costly admin- ▲ Simple process, mature industry, less room for costly property after purchase. istrative errors in making election and keeping QOF in compliance. administrative errors. ▼ Statute starts the 180-day clock when capital gains would otherwise ▲ Reverse 1031 exchanges allow investors to close immediately on be recognized and there is no indication that an investment entered into before that time would benefit from election. opportunities and to sell the disposition property afterwards, while still enjoying deferral. ▼ May lose certain benefits if selling QOF investment and making another election to invest gains in (another) QOF because proposed regulations do not mention an allowance for continuity in terms of the 5-, 7-, or 10-year period. ▲ Investments can be exchanged for other investments while maintaining the same deferral benefits. Daniel Pessar worked in real estate private equity for six years. He is a student at Harvard Law School and author of “Help! 108 Ways to Boost Your Investment Property Profit.” Contact him at [email protected]. CIREMAGAZINE.COM March | April 2019 35