For real estate investors, owners and sellers, the 1031 Exchange program has become a critical tool to defer taxes on real estate transactions. But the 1031 exchange program has limitations, not least of which the artificial timeline it creates for those within the transaction.
So what do you do if you’re sold a property and missed the 45 day identification window? You may think your only choice is to pay the associated capital gains taxes. But you’d be wrong. There is a new solution, one that provides all the same tax advantages without the strict timeline.
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
Ok great – how does that work in practice? Once you’ve sold an investment property, you have a 45 day window during which you must identify the property into which you’ll be exchanging. There is some fine print and quite a few limitations to consider but the identification period is the most important thing to know about the 1031 exchange.
You cannot complete a 1031 exchange. Period. The tax code is very specific. If you go even a day over 45, you cannot utilize the program. This presents quite the challenge for real estate investors. It’s not always easy to have a property lined up to purchase within that 45 day identification window.
Luckily, yes! While you can’t make use of the 1031 program, you can still defer, reduce and even eliminate your capital gains taxes by investing the proceeds from your real estate transaction in a qualified opportunity zone fund (QOF) or qualified opportunity zone business (QOZB).
These investment vehicles provide real estate investors with significantly more timeline flexibility than can be achieved through a 1031. If you’ve had trouble finding the right property for a 1031 exchange, investing in an opportunity zone fund is your next best bet.
There are lots of ways to incur a significant capital gains liability. Maybe you’ve sold some real estate, unloaded some cryptocurrency or even benefited from some stock market speculation. But in the case of real estate, OZ Funds give you a lot more time to make decisions than you have in a 1031 situation. The opportunity zone code says that an investor has 180 days to re-invest their capital gains in a qualified opportunity zone fund (QOF). That’s 4x longer than in a 1031.
Further, if your fund invests in a qualified opportunity zone business (QOZB) – you can make use of the working capital provision of the code which gives a QOZB over 30 months to plan and execute a real estate transaction in an opportunity zone. All the while, you get massive tax deferrals.
Investing your capital gains in a QOF or QOZB provides greater flexibility than a 1031 exchange. In a 1031, you forced to “swap till you drop” – effectively cxchanging between properties forever. But by investing your capital gains in a QOF or QOZB, you have multiple exit opportunities depending on the tax advantages you’re looking for.
Yes that’s right. ELIMINATED! Unlike a 1031, where you have to hold on to some piece of real estate forever, investing in a QOF allows you to eliminate your capital gains tax burden in just 10 years.