Earlier this year, we sold an investment property in the San Francisco Bay Area that my wife and I had owned since 2006. Needless to say, the market was very good to us over the past 13 years—we walked away with a substantial capital gain.
The obvious next move would be to roll the gain into a new investment property via a 1031 exchange. Indeed, had we sold this asset back in 2016, a 1031 exchange would have been the only tax-deferred strategy available.
That said, we’re well into 2019 now, and the 2017 Tax Cuts & Jobs Act included provisions for Opportunity Funds, a new tax-deferred investment mechanism available to anyone with a capital gain and a desire to roll it into a new project.
As I started researching both options in more detail, I found myself becoming more confused and uncertain about which path to pursue. So, I slowed down and did a deep dive on both options before coming up for air with renewed clarity.
My decision? I remain convinced that 1031 exchanges are still the obvious choice for real estate investors committed to building a portfolio for the long haul. Here’s why.
A Quick Primer on 1031 Exchanges
While there are specific steps and timelines that must be adhered to per IRS guidelines, 1031 exchanges essentially allow you to roll the upside from the sale of one real estate asset into a new “like-kind” investment without paying any capital gains taxes. Your taxable basis from the disposed property rolls directly over into the new asset, and voilà, you’re now enjoying rental income from a larger property, plus new depreciation and all the other tax goodies we’ve come to expect from owning real estate.
If the market is going up and you’re generally selling assets for more than you paid, then your portfolio is growing at a clip that’s up to 30 percent faster than it otherwise would have been if you were paying federal and state capital gains taxes along the way.
We all know that size matters in real estate because it’s an asset class that kicks out cash flow. If your portfolio is now 30 percent larger because of your 1031 exchange strategy, then it’s likely you’re enjoying current rental income that’s 30 percent higher. Cue the new pool, some jet skis, or that metallic green 1965 Mustang you’ve been dreaming of since high school!
It’s worth noting that I’ve heard a few investors talk of 1031 exchanges as a “kick the can down the road” strategy that eventually catches up with you. But this is only true if you decide to exit the real estate game and cash out before you “cash it all in.” Then yes, you will indeed be faced with a monster depreciation recapture and capital gains tax bill.
It’s worth noting, that this eventual tax bill is no higher than the sum of what your past tax bills would have been without employing 1031 exchanges. Also, remember that you enjoyed higher income along the way.
That said, even this final tax bill isn’t inevitable. If you’re nimble enough to kick the can all the way over the cliff at the end of the road, your heirs will inherit your real estate portfolio along with a one-time step-up in basis to current market value. With 1031 exchanges, it’s death or taxes—but never both.
A Quick Primer on Opportunity Funds
The 2017 Tax Cuts & Jobs Act introduced a new tax-deferred investment option, whereby investors with capital gains from the sale of virtually any asset class (stocks, bonds, gold, fake Rembrandts, genuine Picassos, etc.) can be rolled into qualifying investments in any of the 8,700 designated Opportunity Zones around the country.
Qualified Opportunity Zones are specific geographic areas that state governments have decided are economically challenged and in need of special investment incentives. In return for funneling investment dollars into these areas, the tax code was amended to allow for partial deferment of capital gains taxes from the disposed investment and tax-free gains on the new investment if it appreciates in value.
At first glance, Opportunity Zone investing seems like a good deal, but as I learned more about the details, a very different story began to emerge.
Qualified Opportunity Zone investments offer two clear tax benefits:
- Capital gains taxes due on the original asset sale are reduced by 10 percent after five years and by another 5 percent after seven years.
- Capital gains on the new Opportunity Zone investment are completely tax free once you’ve held the investment for 10 years.
While the benefits are relatively easy to understand, the risks and downsides are both subtle and significant.
Key Differences: Opportunity Funds vs. 1031 Exchanges
Real estate investors would do well to appreciate some important material differences between the new Opportunity Funds and traditional 1031 exchanges. Below are several to consider.
1.) Opportunity Fund investing is open to all types of investors, not just real estate folks.
Before the TCJA, someone selling stocks for a big gain had no other option than to pay the capital gains taxes. There has historically been no “like-kind” exchange option for traditional investments and so the Opportunity Zone benefits are mostly designed to compete with the prior status quo for most investors. This was basically pay your taxes and move on.
As a result, the Opportunity Zone benefits passed into law are clearly better than nothing but are not specifically tailored to compete with 1031 exchanges.
2.) Opportunity Zones have strict hold period requirements that are notably absent from 1031 exchanges.
To enjoy the full 15 percent basis step-up, you must stay in the Opportunity Zone deal for the full seven years. If you sell because you suddenly need more income or need to rebalance your risk profile, then your original capital gains tax bill will come due. You may not have the option to roll into another Opportunity Fund investment or jump back into a 1031 exchange strategy.
With traditional 1031 exchanges, you have the option to sell an asset whenever it suits you for whatever reason, and then roll into another like-kind investment without triggering capital gains taxes. The absence of a required hold period for 1031 exchanges gives you option value that simply does not exist with Opportunity Fund investments.
3.) It’s not exactly clear which real estate investments are “qualifying” under the Opportunity Zone provisions.
The IRS has recently issued guidance and stabilized income property will not qualify. Some development projects and major renovations may meet the tests to qualify, but these are projects in which significant additional dollars must be invested beyond the original property purchase. 1031 exchanges have no such limitations. You’re free to sell a 100 percent occupied duplex and purchase raw land if you like, so long as the new asset is also held for “investment” purposes.
In my mind, this flexibility is a major win for 1031 exchanges over Opportunity Fund investing.
4.) Perhaps most importantly, the potential downside of moving wealth from a 1031 strategy to Opportunity Funds increases in relation to the size of your existing portfolio.
If you’ve been amassing assets for years and have a tax basis that’s dwarfed by the current market value, then the capital gains taxes you’re going to incur on the difference is going to be plenty painful.
Remember you can only reduce the capital gains taxes due on the original Opportunity Fund investment by a maximum of 15 percent. That leaves 85 percent of the original gain exposed upon exiting the Opportunity Fund investment.
With a long-term 1031 strategy, you can effectively avoid all capital gains and depreciation recapture tax liabilities if you see it through to the bitter end.
5.) Finally, the simple fact that we’re still awaiting final IRS guidance regarding Opportunity Fund investing is a red flag that highlights the extent to which this new area of tax law remains unsettled.
While new and emerging ideas often carry the lure of opportunity, they also carry more risk. They have neither proven themselves in the market nor created a politically potent class of winners who will fight to protect their gains.
1031 exchanges, on the other hand, have been used by real estate investors since at least 1935 and have not been substantially revised for 35 years. The bottom line here is that the rules governing 1031 exchanges are far less likely to morph in the coming years than the much newer regulations around Opportunity Funds.
While I’ve become accustomed to managing risks associated with market rents and cap rates, I’m not particularly interested in adding regulatory and political wildcards into the mix.
Why You Might Still Prefer Opportunity Funds
I can really only think of three reasons real estate investors might want to jump ship and try an Opportunity Fund investment strategy despite the shortcomings discussed above.
- If you want to get out of the real estate business entirely, now is a good time to do it. You can exit into a regular operating business in an Opportunity Zone instead and pay no capital gains taxes for up to 10 years. Your days of chasing down late rent checks and no-show plumbers will be in the rearview mirror forever!
- You have 180 days to find and commit to a new Opportunity Fund investment vehicle, which gives you considerably more breathing room than the 45-day window to identify suitable replacement properties with a 1031 exchange. If you miss the 1031 exchange window or don’t like your real estate investment options, Opportunity Funds might be a good backup plan.
- Finally, if you happen to find a very compelling Qualified Opportunity Zone investment, then it could conceivably be preferable to continuing your 1031 strategy. If you can find an operating business or real estate development deal that you’re convinced will deliver higher than typical capital appreciation over 10 years, the math might work out in favor of the Opportunity Zone investment option. You’ll pay no capital gains tax on the increase in value attributable to the new investment—but only if you hold it for the required 10-year minimum. We all know a lot can change in a decade, so choose wisely!
It may come as no surprise that I’m sticking with the tried-and-true path. I’m currently pursuing a 1031 exchange and will give Opportunity Fund investments a second look only as a backup plan.
Have you sold any properties for a sizable gain recently? How are you weighing your options?