Qualified Opportunity Fund Gains and Like-Kind Exchanges

Qualified Opportunity Fund Gains and Like-Kind Exchanges

Posted by on Feb 20, 2021

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The Opportunity Zone program burst on the scene in late 2017 as a way in which trillions of dollars of capital gains could benefit lower-income communities. If you participate in the program, you could defer taxes on capital gains by rolling them into a Qualified Opportunity Fund (QOF).

However, the deferral clock strikes midnight on Dec. 31, 2026. At this time, you’ll owe taxes on those original capital gains. If your next question is: “Can I do a like-kind exchange on the taxable gains from an Opportunity Fund?” in an effort to avoid paying those taxes, the answer is no. As we mentioned in a previous blog, there are many differences between the like-kind exchange and Qualified Opportunity Zone (QOZ) programs.

On the other hand, the IRS built gains exclusions into the QOZ program, under certain circumstances. While these exclusions won’t eliminate that capital gains tax, they can reduce what you owe.

Revisiting the like-kind exchange

The like-kind exchange, interchangeable with the term “1031 exchange,” refers to Internal Revenue Code §1031. This IRS mandate allows you, the investor, to defer capital gains taxes on the sale of real estate property by “exchanging” that original property into a replacement real estate asset of equal or greater value. 

Perhaps you’ve already used the 1031 exchange to exchange from direct property ownership into passive investments, such as Delaware Statutory Trusts (DSTs). You can do this, as the IRS identifies DSTs as real estate properties. However, you can’t exchange proceeds, or gains, from a Qualified Opportunity Fund, because this original investment is not real estate. It is a fund. 

The term “like-kind” refers to real estate assets of a similar nature, regardless of grade or quality, which can be exchanged. Under this definition, a fund and real estate are not similar. This means you can’t defer capital gains taxes by exchanging proceeds or profits from your QOF into real property.

The QOF gain exclusion

QOFs and 1031 exchanges are incompatible. You could, however, reduce the tax amount on the original amount you invested in the QOF, as long as the investment took place before Dec. 31, 2019. In this case, as long as you hold that investment for a minimum of seven years, you could benefit from a 15% exclusion gain. For example, if you invest $100,000 into a Qualified Opportunity Fund before the end of 2019, when that December, 2026 date rolls around, the original gain is reduced by $15,000. This means you would owe taxes on $85,000, as opposed to the original $100,000.

Even if you haven’t met that particular deadline, all isn’t lost. You could permanently exclude taxable gains from a qualifying Opportunity Zone investment, as long as you:

  • Hold that QOF investment for at least 10 years
  • Elect to increase the basis of your QOF investment to its fair market value, on the sale or exchange date

The takeaway

Given the structure of Qualified Opportunity Funds, you can’t exchange your way out of capital gains taxes. The Opportunity Zone program goal focuses on tax deferral, not tax elimination. 

However, depending on when you invest in a QOF, and how long your monies remain in that fund, you could owe less on capital gains. As such, the complexities and deadlines of this program require an understanding of a Qualified Opportunity Fund’s purposes and goals, as well as your own investment objectives. 

There are material risks associated with investing in QOZ properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.

 


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