Opportunity Zones vs. Like-Kind Exchanges and How to Tell the Difference

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The Tax Cuts and Jobs Act (TCJA) made two changes to how taxpayers receive tax benefits when selling their assets. First, it created new Opportunity Zones (LMC TCJA Alert #8); second, it made major changes to the section 1031 like-kind exchange rules (LMC TCJA Alert #16). Each of these provisions defers tax on certain gains, yet they have very different rules and results. This alert highlights some of the distinctions.

 

Eligible Property: Following TCJA, only the transfer and reinvestment of real property used in a trade or business or held for investment qualifies as a tax-free like-kind exchange. This change to section 1031 excludes benefits formerly allowed for property other than actual real estate; for example, machinery, equipment, and intellectual property.

 

By contrast, under the Opportunity Zone incentives, any capital gain is eligible for the tax deferral. Gains stemming from the sale of a security, a family business, or real estate all qualify. Although reinvestment is limited to specific census tracts, any type of enterprise acquired within that area (such as a retail store, wholesale distributor, service business, or rental property) is eligible.

 

Amount to be reinvested: The entire proceeds of a like-kind exchange disposition (including any debt paid off at the closing) must be reinvested in replacement property in order to receive the full deferral under section 1031. Under the Opportunity Zone program, only the capital gain portion of the sale needs to be invested in an Opportunity Fund to defer the tax until 2026.

 

Timing: The like-kind exchange statute requires specific time frames before and after the date of the sale in which to identify and acquire the replacement property but has no formal holding period for the deferral to be eligible (we recommend at least two years). Investors often envision a three- or five-year horizon for certain types of deals.

 

Benefits under the Opportunity Zone program, on the other hand, are pegged to generally longer time frames. The original deferral becomes taxable on December 31, 2026 (or sooner, if the fund is sold). The gain to be deferred is reduced 10% for funds held for five years and 15% after seven, so investments after 2019 cannot qualify for the seven-year benefit. Appreciation on the sale of the fund itself is totally tax-free only if held for ten years.

 

Outside professional: Under section 1031, a qualified intermediary is usually required to complete a like-kind exchange. However, Opportunity Zone investors simply need to invest their gains in an Opportunity Fund to achieve the tax deferral. Entrepreneurs wishing to create an Opportunity Fund merely self-certify by including a form in their tax return.

 

State tax rules: Though states differ in their conformity to federal tax law, New York and New Jersey generally follow TCJA and respect the tax benefits of both Opportunity Zones and like-kind real estate rollovers. Owners who sell real estate in those states in a like-kind exchange but live elsewhere when the replacement property is later sold could avoid state tax. By contrast, the deferred gain on real estate reinvested in an Opportunity Fund remains sourced to the state where the original property was sold.

 

Your LM Cohen professional can help determine if one of these tax planning opportunities might fit your situation. All our prior Tax Cuts and Jobs Act Alerts are available on the Updates page of our website.

 

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