Market Commentary | November 25th, 2024

• A 45-day identification period for the new asset after the original asset’s sale
• A 180-day acquisition period for the replacement property
• Potential combination with other tax benefits, such as depreciation. When exchanging properties, the cost basis of the new property is reduced by previously claimed depreciation on the original property, allowing continued depreciation claims on the new property.
• Indefinite tax deferral through repeated exchanges, unless a 721-tax deferral option is used to UPREIT the DST interests into a REIT

IRC Section 1031 does not permit exchanges for primary residences. Instead, IRC Section 121 addresses the homebuyer exclusion limits.

Qualified Opportunity Zone Funds

Qualified Opportunity Zone (QOZ) Funds offer tax benefits for investors with capital gains, including:

• Capital gains tax deferral
• Potential reduction of the original deferred gain (if the investment is held for at least five years)
• Tax-free appreciation on the QOZ Fund investment if held for at least 10 years

Unlike 1031 exchanges, only the gain needs to be invested in a QOZ Fund within 180 days of sale to defer taxes, and the investment can be from any appreciated asset. QOZ Funds must adhere to specific guidelines, including:

• Investing only in QOZ-specific census tracts designated by the U.S. Treasury
• Holding at least 90% of assets in QOZ property
• Deriving at least 50% of gross income from active conduct of business in the QOZ
• Using a substantial portion of intangible property in active business conduct in the QOZ
• Having less than 5% of assets in nonqualified financial property

Deferred gains invested in QOZ Funds become taxable on December 31, 2026, or when the investment is sold, whichever comes first. Investors who hold their QOZ Fund investment for at least five years can permanently reduce their tax liability on the original deferred gain by 10%.

Comparing the Two

The key difference between 1031 exchange and QOZ programs lies in their tax deferral structures. Non-721 (pure) 1031 exchanges offer unlimited tax deferral, while QOZs have a limited deferral period but provide tax-free profits after a 10-year hold.

For those aiming to defer taxes indefinitely without accessing investment capital, non-721 1031 exchanges are preferable. They can be valuable estate planning tools, as heirs receive a stepped-up basis to the property’s fair market value at death, erasing previous appreciation.

QOZs are better for investors planning to realize profits within their lifetime. However, taxes on the original investment are due on December 31, 2026, regardless of circumstances.

Risks

Both 1031 exchanges and Qualified Opportunity Zones (QOZs) carry significant risks.

For 1031 exchanges, these include strict timelines, adherence to the ‘seven deadly sins,’ potential overpayment for replacement properties, and market volatility. QOZs face risks such as regulatory changes, economic uncertainties in designated zones, and the requirement to pay deferred taxes by December 31, 2026.

Both strategies involve illiquidity and the potential for investment losses that are inherent in any private real estate transaction, and sponsor/manager risk for syndicated private placement programs.

Optimal Choice

The optimal choice between these strategies hinges on each investor’s specific financial objectives and tax planning considerations. Depending on a client’s unique circumstances, both approaches can be effectively utilized, either independently or in combination, to maximize overall financial benefits.

IMPORTANT DISCLOSURE

This content is presented for informational purposes and is not an exhaustive list of all considerations related to 1031 exchange and qualified opportunity zone investments.  The information presented was not prepared in connection with any specific offering or based on the individual needs of any one investor but rather for general educational purposes. This communication shall not constitute an offer to sell or the solicitation of an offer to buy securities. 1031 Exchange and Qualified Opportunity Zone investments are intended only for persons who are accredited investors. We make no representation or warranty of any kind with respect to the acceptance by the IRS or any state taxing authority of your treatment of any item on your tax return or the tax consequences.

There is no guarantee that any real estate strategy, including those described herein, will be successful. An investment in a real estate investment offering is speculative and involves significant risks including but not limited to: no secondary market for the securities; limited liquidity for the securities, limitations on the transfer and redemption of shares; distributions made may not come from income, could be subject to Board discretion, not guaranteed and can be deemed a return of capital – there can be no limits on the amounts paid from these other sources;  the investment may lack property diversification;  the Sponsor and Trustee are generally dependent upon the advisor to select investments and conduct operations; and the advisor will face conflicts of interest. Investments are not bank guaranteed, not FDIC insured and may lose value.