Second Chances: Opportunity Zones as an Alternative for Failed 1031 by Partnerships, S Corporations, and Nongrantor Trusts
By: David S. Hansen
Most real estate investments help through some form of entity for liability protection purposes. These entities are often a partnership or an S Corporation. Such investors may make the decision that it would be prudent to terminate a particular investment in real property from time to time. Perhaps they believe the market is at a high point. Perhaps they wish to diversify to other investments.
Often, when they meet with their accountant or tax attorney, they realize that such a transaction may result in a significant tax bill at the end of the day. One way of deferring that tax liability is to enter into a “1031 Exchange.”
A 1031 Exchange is named after Internal Revenue Code (“IRC”) § 1031, which provides that no gain or loss is recognized if a would-be taxpayer (the “exchanger”) exchanges real property for other real property of equal value. Variants on the 1031 Exchange include the use of third-party intermediaries who sell the original “relinquished property” and use the proceeds to purchase “replacement property.” The use of intermediaries eliminates the necessity of finding a particular property owner with both the land the exchanger wants and who happens to want the land the exchanger has to exchange. The idea behind IRC § 1031 is that if an exchanger merely exchanges one piece of land for another of equal value, they have not had an increase in wealth and so should not be taxed.
IRC § 1031 comes with a number of technical requirements to prevent people from abusing the system by “cashing out” and then holding the cash for later investment. Notably, an exchanger has to identify replacement property within 45 days of giving up their replacement property and close the transaction within 180 days of giving up the replacement property. Failing to meet those deadlines will make the entire transaction taxable in full, even if not the exchanger’s fault (for example, if the owner of the replacement property backs out of the deal).
Additionally, other circumstances could result in partial or complete taxation of the exchange. If the replacement property is worth less than the relinquished property, there is often a cash payment to make up the balance. That cash payment will generally be taxable as “boot.” Finally, some exchangers are under the misconception that they only need to exchange their equity. If they have a million-dollar home with $300k of equity and a $700k loan, an exchange for a mere $300k home will result in $700k of debt relief boot. Perhaps in a partnership, some partners want to do a 1031 exchange, but another wants to cash out.
There are numerous other technicalities that may result in an inadvertent tax bill at the end of the day.
Fortunately, there is a potential second chance in the form of opportunity zones IF the exchanger is a partnership, an S corporation, or a nongrantor trust that distributes gain to the beneficiaries (grantor trusts have to use the 180 day period starting on the disposition of the relinquished property). Treas. Reg. 1.1400Z(a)-1(c)(9).
The 2017 tax law created so-called “opportunity zones.” Opportunity zones are certain economically depressed areas specifically identified by the federal government, and they exist in every state. IRC § 1400Z-1. If you make an investment of otherwise taxable gain in an active business in an opportunity zone, all gain is deferred until December 31, 2026. IRC § 1400Z-2. If the investment is held for at least five years prior to December 31, 2026, 10% of the invested gain is forgiven completely. Id. If the investment is held for at least ten years, all further appreciation in the investment is tax-free. Id. Notably, the investment must be in an active business, so the opportunity zone investment can’t just be in raw land.
Treas. Reg. 1.1400Z2(a)-1(c)(8) provides considerable flexibility in the timing of an investment in an opportunity zone by partners of a partnership. If the partnership engages in a taxable transaction and does NOT invest in an opportunity zone within 180 days, a partner of that partnership who is allocated a portion of that gain may themselves invest the gain in an opportunity zone within (1) 180 days from the date the partnership could have; (2) 180 days from the end of the partnership tax year; or (3) 180 days of the non-extended due date of the partnership tax return. Pursuant to Treas. Reg. 1.1400Z(a)-1(c)(9), the same rules apply to S corporation shareholders or beneficiaries of a nongrantor trust which distributes gain to beneficiaries.
Thus, for example, if a calendar-year partnership sells land through an intermediary on January 1, 2020, but fails to receive the replacement property by June 29, 2020, ordinarily the transaction would be completely taxable, and the partners would recognize and pay tax on their share of the gain from the sale. However, under Treas. Reg. 1.1400Z2(a)-1(c)(8), they could instead invest their gains (potentially pocketing the basis tax-free) in an opportunity zone at any time between January 1, 2021 and September 11, 2021 (180 days after the partnership tax return is due) and owe no tax for 2020 and only 90% of the tax due if the investment is held through December 31, 2026.
Opportunity zones are thus an extremely useful second chance for partners, shareholders, and nongrantor trust beneficiaries to avoid suffering the negative tax consequences from a failed 1031 exchange by the partnership.
It is worth highlighting that there are some pros and cons of opportunity zones compared to a traditional 1031 exchange, so the investment in an opportunity zone might not be for everyone:
The ability to shift from a 1031 into an opportunity zone investment on the failure of the first option is a valuable tool to remember when making your end of the year planning for 2020. Note, this is the last year you will be able to rely on the delayed investment horizon and still gain the benefits of the 10% gain forgiveness for holding the property five years before December 31, 2026.
Given the complexities involved in an opportunity zone transaction, you should reach out to a qualified tax advisor if you are considering taking advantage of the option to invest in an opportunity zone.
©ScottHulse, P.C. This material is provided for informational purposes only. It is not intended to constitute legal advice nor does it create a client-lawyer relationship between ScottHulse and any recipient. Recipients should consult with counsel before taking any actions based on the information contained within this material.