Now that we are four years into the Opportunity Zone program, QOF and QOZB investments are starting to experience the same twists and turns as vanilla deals, including early exits. In the real estate context, OZ players are faced with the options when they are considering a very generous and unexpected offer to purchase their OZ project despite falling well short of the 10-year holding period required to get the OZ program's signature tax benefit. This presents the sponsor with a serious dilemma: they might want to accept the prospective buyer's overwhelming offer, but they don't want to let their investors down by sacrificing the plum tax advantage an OZ investment can secure after a 10-year hold.
If the sponsor is comfortable investing in a new OZ project, the solution to the sponsor's issue might be a Section 1031 exchange, a tax deferral technique popular since at least the Ninth Circuit's Starker decision in 1979. That ruling allowed taxpayers to enact delayed exchanges instead of simultaneous ones, giving taxpayers more flexibility to accept cash proceeds from real estate sales and use the funds to purchase replacement property without paying income taxes immediately. A subsequent revenue procedure set forth a safe harbor for parking exchanges, which allowed taxpayers the freedom to purchase replacement property first and sell relinquished property later (thereby completing the 1031 process in "reverse").
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 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 so-called "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 partners, the idea of contributing further capital as development equity is more realistic, opening up yet another avenue for an OZ entity to comply with both statutes at once.
Using Section 1031 for initial acquisitions
Upon the OZ program's release, many practitioners correctly concluded that the same dollars could not be used for Section 1031 and an Opportunity Zone investment because some of the requirements of each program diametrically opposed each other. For instance, Section 1031 requires direct investment in real estate, but the OZ rules require investment only through a QOF. This may lead taxpayers to think that a Section 1031 exchange and a QOF investment present an "either/or" choice, but this is not necessarily the case.
A taxpayer could complete a Section 1031 exchange into real estate located in an OZ and use QOF money to construct improvements from scratch or perform enough renovation to meet the substantial improvement requirement. Legally, the taxpayer could elect QOF treatment for the exchanging entity (which might require adding a member to an LLC treated as a disregarded entity) and use one of the three methods described in the previous section to secure OZ capital.
Alternatively, the taxpayer could enact a ground lease between the exchanging entity and a QOZB, then begin construction through the QOZB.
A taxpayer could also combine a Section 1031 exchange with a QOF investment by taking boot from the exchange and using it as Opportunity Zone capital. This may pose some technical ambiguities, however. For instance, if the exchanger is an individual, the exchanger can only receive boot at two points during the process: the exchanger can take boot directly from the buyer of relinquished property at closing, or the exchanger must wait until the end of the 180-day exchange period. Since the exchanger will be identifying replacement property, the exchanger cannot accept boot from the QI after the 45-day identification period has elapsed.
This raises an important question: if a taxpayer accepts boot after the 180-day exchange period has elapsed, does the taxpayer have any chance to defer capital gain into a QOF? In other words, does the 180-day deferral period for QOF investing begin the day the taxpayer receives boot, or does the period begin the day the taxpayer sold the relinquished property? If the answer is the latter, the QOF's deferral period will end by the time the taxpayer receives the boot from the QI. The IRS has never directly answered this question, but the Section 1031 regulations are instructive for some situations. If the exchange straddles tax years -- meaning the relinquished property is sold in Taxable Year 1 and the exchange period ends in Taxable Year 2 -- then the regulations dictate that the installment sale rules apply to the receipt of boot in Year 2. When this rule is synthesized with the OZ regulations' commentary on installment sales, the guidance clearly provides the receipt of boot in Year 2 starts a new 180-day deferral period. But we still do not have an answer if the entire 180-day exchange period elapses during the same taxable year, so in these situations, proceed with caution.
Although most taxpayers and advisors view Section 1031 exchanges and Opportunity Zone investing as rivals rather than companions, a deeper analysis of each compliance regime shows that the two techniques are actually compatible with each other in many ways. QOFs and QOZBs can themselves perform Section 1031 exchanges, or taxpayers can combine QOF investing with Section 1031 to achieve better tax results. For real estate projects taking place in Opportunity Zones, synthesizing Section 1031 exchanges with OZ structuring could make a significant difference in tax outcomes, so both taxpayers and professionals should be aware of the ways the two programs can fruitfully interact with each other.
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