USING SECTION 1031 EXCHANGES INSIDE OPPORTUNITY ZONE ENTITIES
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Many taxpayers are unaware that the OZ program and Section 1031 are compatible in certain ways , and the IRS explicitly blessed the use of Section 1031 exchanges by OZ entities in the Preamble to the final regulations under Section 1400Z-2 . If used correctly , the sponsor of an OZ vehicle could accept an attractive offer to sell , use the proceeds to invest in different Opportunity Zone real estate , and notch two important tax benefits . First , the beneficial owners of the OZ entity need not pay any interim income taxes , which would normally be required for a cash sale prior to the 10-year holding period elapsing -- even if the proceeds are reinvested into other OZ property . Second , the holding period of any prior investments by the exchanging OZ entity is tacked onto the holding period of the replacement property , so sponsors need not " restart the clock " when enacting a Section 1031 exchange .
MECHANICS AND KEY ISSUES
The Opportunity Zone rules do not prohibit taxpayers from taking advantage of any other tax techniques or incentives allowed under federal , state or local rules . The only catch is
The Opportunity Zone rules do not prohibit taxpayers from taking advantage of any other tax techniques or incentives allowed under federal , state or local rules .
that the taxpayer must comply with the OZ program and the other desired programs simultaneously . This holds true for Section 1031 exchanges as well , meaning that taxpayers must navigate the requirements of both statutes at the same time , raising interesting structuring and compliance issues .
If a QOF or QOZB acquires replacement property in a Section 1031 exchange , the replacement property must be QOZBP for the entity to continue eligibility for OZ tax benefits . QOZBP requires tangible property to be either originally used or substantially improved . Unless the taxpayer is acquiring a socalled " pre-CO " property to achieve original use treatment , rendering property as QOZBP means either renovating it or developing it . Section 1031 is significantly less friendly to development than Section 1400Z-2 , meaning taxpayers need to find a way to finance the renovation or development that will achieve compliance with the OZ rules .
An exchanging OZ entity has three choices to get the necessary capital :
• First , the entity could approach a lender for construction financing , which might not be possible if acquisition financing already exists or if the leverage ratio is too high to begin with .
• Second , the entity could make a capital call and fund construction through contributions from its investors , which could be unpalatable to certain partners . For many QOFs , the expectation is that capital calls will not occur to avoid mixed investment treatment .
• Third , the entity could use Section 1031for eligible dollars in a so-called " build-to-suit " exchange . The build-to-suit exchange has two varieties : the safe harbor version and the non-safe harbor version .
° The safe harbor version is described in Revenue Procedure 2000-37 , under which an Exchange Accommodation Titleholder ( EAT ) owned by the qualified intermediary ( QI ) may only hold the replacement property for 180 days , and all construction using Section 1031 capital must occur within that timeframe .
° The non-safe harbor version is described in the 2016 U . S . Tax Court decision in Estate of Bartell , where the EAT held the replacement property during a construction period lasting almost two years . While the tax court upheld the structure in Estate of Bartell and decided for the taxpayer , the IRS did not acquiesce to the decision and plans on challenging non-safe harbor structures in the future .
This optionality is a plus for any sponsor considering the strategy . For those who do not have to answer to limited
OPPORTUNITYZONE . COM