We explored Qualified Opportunity Zones with experts Chris Catarino and Steven Rossman, both CPAs at Drucker & Scaccetti in Philadelphia, in July 2019.
We have returned to them to discuss the Section 1031 exchange and how it compares with Qualified Opportunity Zones. Catarino and Rossman explain the differences between the two and when to use them.
By: Jim DeLuccia, Manager, Learning Content
In 2019, I met with Chris Catarino and Steven Rossman, both CPAs and PICPA members, to discuss Qualified Opportunities Zones and how CPAs can advise clients on these investment incentives. I'm happy to be catching up with them again, this time to discuss the relationship between these opportunity zones and 1031 exchanges. I'm also back at the offices of Drucker and Scaccetti, where Chris and Steve work, to speak with these two tax experts. Chris is a principal with Drucker & Scaccetti, while Steve is a shareholder.
Chris and Steve, thanks again for allowing me to be a guest in your offices as you guys are guests on CPA Conversations.
[Rossman] It's our pleasure. Thanks for taking a walk over from down the street. As always, it's our pleasure to host you and talk about the topics at hand.
Great. And I know this is another one with a lot of content to get to here. Without further ado, Steve, I guess I'll start with you. We discussed, as I mentioned, qualified opportunities zones in a previous podcast, but not as they relate to Section 1031, so can you briefly define the 1031 exchange?
[Rossman] Be happy to do that, Jim. 1031 exchange is a similar deferral treatment, similar to qualified opportunity zones, but there's a lot of differences. So a 1031 is also called a like-kind exchange. It's a situation where the taxpayer swaps one asset for another asset. So when you do a 1031 exchange at the time of the exchange, you don't recognize any gain that was built in to the asset that you're giving up.
So that gain is deferred until you ultimately sell the new property that you acquired or the new asset that you required in exchange for your old asset. Your basis in the new property is carried over from your basis in the old property. Before the TCJA, the Tax Cuts and Jobs Act, 1031 exchanges could include real estate, aircrafts, livestock, autos, and professional sports contracts.
But after the TCJA, it's limited only to swapping real estate for real estate. One other item to highlight, relative to 1031 exchanges, is that if you don't use all of the proceeds from the sale of your old property, there's a concept called boot, which is basically cash that you keep. And in a 1031 where there's boot, you still recognize the gain that, that boot is not deferred. You have to pay the tax on that gain at that point.
Now that Steve has laid that out for our listeners here, Chris, how can 1031 exchanges and qualified opportunity zones work together?
[Catarino] Yeah, that's a great question. And it's a question that we've fielded a lot from our clients. And the answer is that we see 1031s and opportunity zones as almost being mutually exclusive. Most of the times, we have a client coming to us saying that they're selling a piece of real estate and they're considering whether they should do a 1031 or an opportunity zone and really that's the choice. It's one or the other. There's really no opportunity to do a 1031 and an opportunity zone at the same time.
Steve had mentioned boot. In a case where you're showing property and taking boot, in a 1031 that would be taxable. You may have an opportunity to use an opportunity zone to defer that boot, where you 1031 and do an opportunity zone for that boot piece. Also the place we see some 1031 interest within the opportunity zone context is if there's an opportunity fund that has purchased and developed a property and there may be in year three, four, five of their holding period and they need to get to year 10, in order to get the opportunities on benefits.
That fund may decide to sell that property in year four and do a 1031 into a new property that they can then hold through the 10th year. So that's the limited overlap that we see. But, generally, the conversation is more whether it's a 1031 or an opportunity zone, not both.
How do the 1031 exchange requirements and opportunity zone rules differ? I think we're heading in that direction here based upon Chris's last answer there.
[Rossman] Jim, there's about a dozen differences between the two programs and we'll go back and forth. Chris and I will tag team to give you what we see as the major differences between the two programs. In a Qualified Opportunity Zone investment, the Qualified Opportunity Zone, you must put your gains into Qualified Opportunity Zones, whereas in a 1031 exchange, you can buy property that's in a zone or you can buy it anywhere. So that's geographically the 1031 exchange can be anywhere, versus the opportunities on investment, which clearly your funds have to go into an opportunity zone project.
[Catarino] I think one of the other similarities between them is that there is a time period. With a 1031 you sell the property, you have 45 days to identify potential replacements, and then you have 180 days to close on the replacement property. For an opportunity fund, when you sell the property, similarly, you also have 180 days where you can wait, to identify an opportunity zone project to invest in. There are some similarities in the timeline. The opportunities zone doesn't have an identification period the way that a 1031 exchange does.
[Rossman] Let me jump right in there on that same point, in a 1031 exchange, you need to use a qualified intermediary, which is a third party to hold your funds, while you're taking your old property and looking for a replacement and holding that gain so that it can't be used anywhere else.
Otherwise, you can't have a 1031 exchange. Versus on the opportunity zone investment, you don't need a third party to hold your money. You just put it into your opportunity fund, so that that is another major difference.
[Catarino] Yeah, that's a big one because sometimes we'll have a client that sells a property and then asks us, "Can I do a 1031?" And we'll be like, "Well, if you sold it already and you didn't park the proceeds with an intermediary, you can't anymore."
Whereas if somebody says, I sold a property, can I do an opportunity fund? The answer to that is yes. Even though they may have taken the cash from the sale and used it in different places, for an opportunity fund, they don't trace the cash. Also, when you do a 1031, you have to roll over all of your sale proceeds.
Like Steve mentioned, any cash you take off the table is taxable boot. For an opportunity fund, the only thing you need to invest is the gain portion. So you can take that return of basis in cash and keep that and just reinvest the gain and get the full benefits of the opportunity fund so you're able to take cash off the table and still maximize the benefits in an opportunity fund.
Yeah, I have to ask, does boot stand for something?
[Rossman] It's a real word. It's not an acronym.
But yeah, it's the word that they use to identify the actual cash that you received as part of a 1031 exchange and that you kept and that's taxable as gain. One other item that we should address is that in a 1031 exchange, all of your gains can get rolled over and deferred. But in a Qualified Opportunity Zone investment, you can only use capital gains, so if you have ordinary gains that are part of the 1031 exchange, they can be deferred, but that's not part of the qualified opportunities own program.
[Catarino] The 1031 rules also require that “same tax payer rule,” which gets complicated when you have a partnership that sold property and maybe one of the partners wants to do a 1031 when the others don't. In an opportunity zone context, a partnership or an entity can sell the property and then each individual partner can decide whether they want to do an opportunity fund or not. So there's a little bit more flexibility there.
[Rossman] In the 1031 exchange, most of the rules apply to the actual, all the rules that you have to be within the 180 days and the 45 days of identifying a new replacement property, that all happens at the upfront for a 1031 exchange. And there's very little rules that are applicable to after you've acquired the replacement property. It's kind of set it and forget it.
But in the Qualified Opportunity Zone investing, you've got rules up front where you've got to take your capital gain and invest it in a qualified opportunity fund within 180 days and then after the transaction happens, there's a lot of rules that happen afterwards as well.
You've got to do your asset testing, you've got to make sure that 90% of your dollars are invested in Qualified Opportunity Zone business property. In the 1031, a lot of the rules apply during the transaction and before the transaction. Whereas in the qualified opportunity fund investment, there's rules before and there's rules after.
[Catarino] One of the other contrasts is that the 1031s now under the Tax Cuts and Jobs Act, it's only applicable to real estate, selling real estate and buying real estate. For an opportunity fund, there's more flexibility, so you can sell anything that results in a capital gain. That could be stocks in your portfolio, it could be the sale of a business. And then you don't necessarily need to invest in real estate. You can invest in an operating business in an opportunity zone. There's more flexibility on the types of assets. It doesn't need to be just real estate for real estate.
Now that both of you gentlemen have laid that out, I guess the next question I had is, is there an advantage to taking one tax planning strategy over another here? 1031 versus opportunity zones?
[Catarino] We just talked about a little bit more on the what are the requirements for each and how do you execute a 1031 versus an opportunity fund transaction. But when we talk to our clients about choosing one or the other, the real driver is the differences in the tax benefits themselves. A 1031 is a pure deferral of gains. It's, you're just kicking the can down the road, right.
And that deferral is essentially indefinite because you can hold that replacement property for as long as you want. You can sell that replacement property and do another 1031 and just continue to defer. In an opportunity fund there's a deferral component. You're able to defer your gain going in.
There's also that gain. There's a timeline, though. That gain gets recognized in 2026. So you will be paying tax on that original gain, granted with an opportunity fund, there is a little bit of a haircut so that gain amount, your taxed on comes down a little bit, either 10% or 15% based on how long you own it.
And the real benefit for an opportunity fund is on the back end. After holding the opportunity fund investment for 10 years, any gain on the sale of that investment after 10 years is entirely excluded from tax. So that's the major difference between the opportunity fund and the 1031. The 1031 is deferral. The opportunity fund has a deferral portion. It gets recognized in 2026, but then there's this exclusion piece after 10 years that can be very powerful.
[Rossman] Another advantage for the 1031 exchange that there's not a similar advantage in the qualified opportunity fund investment is that at the death of the owner in the 1031 exchange, the basis of the replacement property is stepped up to fair market value. The heirs of the 1031 people, their basis in the property has stepped up the fair market value. So if they sell it, even though there was that deferred gain from the 1031 that it's muted, it goes away because the fair basis of the market value has been stepped up at the date of death to the fair market value.
[Catarino] The only time in a 1031 that that deferral becomes an exclusion is if the owner of the property dies. It's great tax planning, it's maybe not great life planning. And what's interesting is in an opportunity fund context, to draw that comparison, if an investor makes an opportunity fund investment and defers gain in and then passes away before 2026, that gain that they deferred is considered income in respect of a decedent or IRD and that gain is still taxable to the beneficiaries or to the estate. That gain does not get eliminated. So the exclusion, the heirs can still qualify for that exclusion after 10 years, but that original differing gain cannot be eliminated in an opportunity fund.
[Rossman] We'd be remiss if we didn't talk about another planning technique that's not 1031 and that's not Qualified Opportunity Zone investment. A lot of our clients are coming to us and they're saying, okay, these are the two choices, but there's another code section: code Section 1202 stock, which is small business stock, that if it doesn't have the restrictions of holding it for 10 years for elimination of the appreciation. There's a five-year hold, but if it's an operating business where the taxpayer is thinking about getting into a new venture, a 1202 stock might be another alternative to doing that.
[Catarino] Yeah, we have clients that have started businesses in opportunity zones and they're set up in opportunity funds and we've structured it so that the 1202 can apply if they decide to get out of the business after five years, but before 10.
[Rossman] And also the 1202 could be a better play if the person doesn't have capital gains to invest in the opportunity zone because you don't need capital. 1202 there is no restriction on the dollars that going in as the investment. It's just, as long as you buy the small business stock and hold it for five years, there's an exclusion on the gain that you have for the 1202 stock.
[Catarino] I think the last thing as an adviser having these conversations with your client, is not to forget that really the most important piece is the economics of the deal, not necessarily the tax benefits. So if you have a client that's interested in 1031, maybe opportunity zones and they say, “hey, I really like this property but it's not in an opportunity zone, I think it's going to perform better.” Don't even worry about the tax benefits, right?
Go for the investment that's going to economically yield the best results. Don't tie yourself to thinking I have to maximize the tax benefits and leave financial dollars on the table. We use the analogy: we don't let the tax tail wag the dog.
No, I appreciate you making that clarification. Finally, these two strategies were created at the federal level, but are there any Pennsylvania rules that must be considered? If so, what are they?
[Rossman] Pennsylvania does not recognize 1031 exchanges. If a gain is deferred through a 1031 exchange, it won't be taxable for federal purposes, but it will be taxable for Pennsylvania purposes. The one thing that you have to keep in mind though, is that for Pennsylvania, the basis of the new asset will be higher because it's what you paid for the new asset versus the lower basis that would get carried over for federal purposes.
[Catarino] Right, and on the opportunity zone side, beginning in 2020, Pennsylvania is following the federal rules for opportunity zones, so they conform to them beginning 2020. So while Pennsylvania doesn't have the 1031 benefits, they will have the benefits for opportunity zones.
It's a little curious that there were some investments made, I think it was even the end of ‘17, ‘18 and ‘19 that for Pa. will not qualify, but going forward it looks like those opportunity zone benefits will apply for PA tax purposes.
[Rossman] And in that same vein, Chris, for the tax free appreciation, that'll be Pennsylvania will follow the rules for that. Circling back to the 1031 analogy where for federal purposes you've got a lower basis. Same thing's going to happen if you did do your opportunity zone investment in 2018, 2017, or 2019, before Pennsylvania conformed to the federal rules.
[Catarino] One thing before we close, I just wanted to share with our listeners that in 1031 exchanges are reported on Form 8824 for federal purposes. And the qualified opportunity fund investments are reported on Form 8996. And just to tell everybody, I think it was just this week, the IRS came out with a new draft Form 8996, which requires additional information about the qualified opportunity fund investments.
So the prior form, which was used for the 2018 and 2017 reporting, it was only two pages and it was really just demographic information about the fund itself and also about the assets that were held, the amount of assets that were held. But this new form, the new draft form has a whole lot more information about what assets that the fund are actually invested in.