The short answer is, yes, you can rollover your 1031 into an OZ to reap the tax benefits.
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Can I combine a 1031 exchange with an Opportunity Zone investment?
I recently sold a commercial building in Los Angeles that resulted in $5.8 million net proceeds, which is currently being held by the 1031 exchange accommodator. My tax basis in this project is approximately $1.7 million. Resulting in a gain of $4.1 million. I’ve identified two potential projects to purchase (a) An apartment building in Santa Monica, which is not a QOZ. It has a purchase price of $2 million. (b) A commercial building in Los Angeles that is in an QOZ. I am trying to maximize the benefits of a 1031 exchange with an Opportunity Zone by potentially combining these two tools. I have the following questions: (1) If I purchase the Los Angeles commercial project that is in the Opportunity Zone and use all of the $5.8 million from the exchange, will I be required to pay any taxes on the $4.1 million gain assuming no sale or a roll over in another exchange? If taxes on the $4.1million gain are due, when is the latest that those taxes have to be paid in the absence of another sale leading to an exchange? Can this satisfy my exchange requirement and the 10-year hold for the benefits of the opportunity zone? (2) If I only invest $4.1 million in the QOZ Fund and pocket the $1.7 million base, when is the latest the capital gain on $4.1 million will be due? (3) If I purchase the Santa Monica not in a QOZ and use $2 million of the exchange, what will be the required amount of investment in the QOZ Fund that will not trigger tax payments at this time? Will I have to (a) $5.8 million - $2 million = $3.8 million or (b) Can I only invest $5.8 million - $2 milion - $1.7 million = $2.1 million?
Answers
A lot going on here, but due to the fact that CA has not and likely won't conform to the federal OZ provisions, I would recommend leaving your 1031 structure and defer both federal AND state tax. If you invest the full $4.1M gain into a Qualified Opportunity Fund and buy the Commercial property you will still need to double the tax basis in the building in order to meet the substantial improvement test. The full state tax will be due by April 15th, 2020 - or sooner and the federal tax will be due April 2027.
I'll put it this way: you generally can't complete a valid Section 1031 exchange and get credit for QOZ deferral at the same time. If you complete a valid Section 1031 exchange, you do not recognize capital gain at all, and you don't make an investment through a QOF. If you want to make an investment into a QOZ property and get the Section 1400Z-2 tax benefits, you need to invest through a QOF. If you complete a Section 1031 exchange, the deferral is valid, but the tax-free appreciation will not apply. There are some ways to thread the needle between Section 1031 and the QOZ program, but they are extraordinarily complicated, and it's impractical to explain the interplay in writing.
You can certainly combine a like kind exchange and a QOZ investment, but the interplay of the two sections is complicated, and anyone responding to your questions should be asking a lot of follow-up questions in order to make sure that they have the facts right, so that they can give proper advice. You have provided pretty specific numbers and locations and options, and, in the end, you are asking a professional to help you decide which way to go on a $4 to 5 million decision. I'd respectfully offer that this is the kind of question and serious detail that calls for an attorney-client relationship.
1) If you structure this investment through an opportunity zone fund you set up (I advise a two tier structure), no gain is initially recognized for federal purposes but the deferred gain is paid in 2026 (if QOF interest not earlier sold). California, as I recall, is non-conforming jurisdiction so you have a state tax cap gain pick up I believe in addition to your depreciation recapture (I heard legislation was introduced so that California might conform to the opportunity zone legislation but I'm not aware of its status currently or whether enacted). The remainder of the comments will focus on federal tax. You need to meet the substantial improvement requirement of the building and expend 100% of the basis of the tangible property within 30 months of construction. 2) deferral would end in 2026 and be due on the return for 2026 filed in 2027 (at the cap gain rate then in effect) 3) Here you are doing a partial 1031 exchange and the remainder is boot subject to tax and depreciation recapture. You'd have to pay the depreciation recapture which may be significant. Whatever cap gain is left after you run those computations (closer to $2.1MM) is what can go into an Opportunity zone fund and obtain deferral on (deferral ending in 2026). If you expect big appreciation at the back end, it may be worth it to go this route
For OZ purposes you only need to invest the gain, not the net proceeds. Also, I didn't think the qualified intermediary would release any money to you once you'd given it to them. Also, I think the 180 days are counted differently in the OZ program and the 1031 rules. For 1031 I think the 180 days starts on the day after the sale. On the OZ program it starts on the date of the sale. I think there is a lot of nuance here that would be better discussed in person or on the phone.
Thanks to my colleague Pat O'Bryan of our firm's tax practice Group for his work on this answer: 1) If you complete a 1031 exchange by fully investing all $5.8 million into the L.A. building, there would be no gain or loss recognized on the original sale by virtue of Section 1031, and there would be no gain until a subsequent taxable (non 1031 exchange) transaction. However, your ability to twin the Section 1031 exchange with Opportunity Zone benefits is somewhat limited. First, to complete a 1031 exchange the entity that sold the relinquished property must be the same entity (for Federal income tax purposes) that purchases the replacement property. Thus, in order to have the potential to get any opportunity zone benefits, the selling entity (which acquires the Los Angeles replacement property) itself must be able to qualify as either a Qualified Opportunity Fund (QOF) or as a Qualified Opportunity Zone Business (QOZB). While this is certainly possible, the ability can be limited where the existing entity owns other property or investments. Second, the portion of the QOF that would receive the OZ benefits will be limited. OZ benefits are limited to capital gain dollars invested through a QOF within 180 days of the capital gain event. The $5.8 million held by the qualified intermediary and invested into the replacement property was (presumably) not invested though a QOF when the property was originally acquired. Thus, the only portion of the new Los Angeles building that would be a good OZ investment would be any new dollars invested through a QOF into the property owning entity. Here, the money used to substantially improve the building could be invested through a QOF using other capital gain money, and the relative portion of that equity compared to the 1031 equity would determine the ratio of OZ benefit eligible investment to non-OZ eligible investment. 2) If there is no early disposition event and the $4.8 million is otherwise an eligible OZ investment through a QOF (and there is no 1031 transaction), then capital gains from the original sale would be recognized on Dec. 31, 2026 and would be due and payable on tax date 2027 (April 15, 2027). If the money is invested in a QOF in 2019, then only 85% of the $4.8 million of taxable income (or $4.08 million) would be recognized in 2026. 3) In order to get 1031 benefits, the full amount of the gain has to be invested, and any unvested amount is taxable (up to the original amount of the gain had there been no 1031 transaction). So you don't get proportionate 1031 benefits. Thus, purchasing the Santa Monica property through a 1031 transaction for $2 million would defer $300,000 of gain ($2 million minus $1.7 million = $0.3 million. That would leave you with $3.8 million to invest into an OZ in order to completely defer the taxes on the original sale.
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