In an interview with ADISA board member Greg Mausz, Jay Frank, the president of Cantor Fitzgerald Asset Management, explains the key differences between opportunity zones and 1031s.
According to Frank, opportunity zones, on the surface were created around five years ago under the 2017 Tax Cuts and Jobs Act under the Trump administration. The program is trying to encourage investment that creates economic development in lower income areas. You can take capital gain dollars on the sale of any asset, short term or long term, and invest them in lower income areas.
In contrast, regarding 1031’s, if one sells an investment property, they have to take their entire, proceeds of the sale, basis and gain, to be exchanged into replacement property to defer 100% of the tax liability.
However, for opportunity zone only, the gain needs to be, or is eligible, for investment.
“1031 exchange tends to be preferred for someone that’s looking for current income right away,” said Frank. “Where an opportunity zone might generate income, but it might take a few years to get there because you’re building buildings. You know, until those buildings are built and stabilized in generating cash flow, an OZ’s not going to generate income.”
Greg Mausz 00:10
Welcome to another edition of Focus on Alternatives, brought to you by ADISA, the Alternative and Direct Investment Securities Association. For more educational content like this, please visit adisa.org and check out the resource library. My name is Greg Mausz, I’m your host. Today I’m joined by Jay Frank, and he is the president of Cantor Fitzgerald Asset Management. Thank you for joining us here today.
Jay Frank 00:34
Greg Mausz 00:35
So, we’re going to be covering opportunity zones versus 1031, but let’s lay the groundwork first. Most of the audience understands opportunity zones, but could you give a few basics for those that may not?
Jay Frank 00:47
It’s a zone where there is an opportunity. Now on, on the surface they were created just about five years ago under the 2017 Tax Cuts and Jobs Act under the Trump administration. And essentially the program is trying to encourage investment that creates economic development in lower income areas. So you can take capital gain dollars on the sale of any asset, short term or long term, invest them in lower income areas. And as long as those dollars are invested the right way in building buildings substantially improving buildings or starting businesses, you can qualify to a host of lucrative tax benefits.
Greg Mausz 01:25
So, speaking of tax benefits, there’s a lot of them. Walk us through those.
Jay Frank 01:29
Sure, I’ll try and keep it simple and hit the highlights. First off, if you have a capital gain, say you have owned Amazon stock that you had bought for a million dollars and you sell it for 2 million. If you just want to invest the capital gain portion, so just the million dollars of gain. If you do so, you defer the recognition of that tax until 2026. So instead of owing tax next year, you’d owe it in 2027. So you have all that additional, what would be tax revenue to the IRS working for you in your investment for an extra however many number of years, depending on the date you invest.
The second and most material tax benefit is as long as you hold your investment for the minimum 10 year required hold period upon exit from the oz, your basis steps up to fair market value. That does two interesting things. One, any new gain that was created by your OZ investment over that decade long hold period. It’s all tax free. The second one that’s not intuitive is any depreciation that was recognized from owning real estate for 10 plus years. Which is, should be substantial. All of that depreciation recapture tax is also eliminated through the step up. So, when you take these benefits and there’s more ancillary benefits, but those are the main ones, when you add them all up, it can be a 50 to 75% all in tax benefit. Versus someone that didn’t do an OZ investment. Depends on your state, depends on your tax bracket, depends on the return of the fund, but think 50 to 80 is how I quantify these, these tax benefits.
Greg Mausz 02:59
Fantastic benefits. How effective do you think the program has been in attracting capital and making those developments?
Jay Frank 03:06
Yeah, you know there’s two ends to every, any trade, right? That’s what makes a market. So that’s one that you read about in the news. Personally, over a hundred billion is what I keep hearing, has been invested in OZ’s. You know that’s a lot of numbers, that’s a lot of money. And so when I look at the programs we’ve done or other peers in the space and how many buildings are going up in lower income communities, I know that most of those buildings would not have been built had it not been for the OZ program. So, I actually know it could be two or three or four X as large as it is, but this is a hundred billion dollars. I would say 85, 5 billion of the a hundred wouldn’t have got done had the tax benefits not been there. So I, I’m, I’m a big fan.
Greg Mausz 03:48
So, you just said it could be more. Why hasn’t it been more?
Jay Frank 03:51
Great question. And you know, when you think about the role of the financial advisor as the trusted advisor with the client an advisor doesn’t talk to clients about something, they’re not a hundred percent knowledgeable about. Human beings don’t talk about things they’re not a 100% knowledgeable about. And so, the, if there’s a problem with OZ program, it’s the complexity of the program, and so people just aren’t that comfortable talking about it. But that’s why we do things like this, you know, educational series. As people spend the time to become experts, they realize that there’s a larger and wider application, and I’m happy to help support that.
Greg Mausz 04:25
So where have we seen most of the flows coming into QOZ forum?
Jay Frank 04:29
Yeah, you know, I hear from across the industry, I think it’s pretty consistent. Number one, the sale of business interest. You get, you know, a savvy individual selling a business typically. Usually it’s a big concentrated gain. They’re looking for something to do something about a very, maybe a multimillion-dollar tax liability, whether it’s their estate planning attorney or their CPA, hopefully they’re a financial advisor or one of the three at least is bringing this idea. So we see big chunky transactions from business sales. So dollar amounts probably from that. Second and third, it’s between stock sales and real estate sales. So, on the stock side, maybe someone’s rebalancing their portfolio, maybe they owned a company that went public, you know, right. And they have a gain. That gain can go into the OZ, but the most underutilized is the use of the OZ for someone selling investment real estate.
Greg Mausz 05:21
So that makes sense because a lot of real estate actually gets 1031 exchanged. We’ve seen a lot of growth in the 1031 exchange market. Can you compare and contrast, you know, from the real estate side, should a person do a 1031 exchange or an OZ?
Jay Frank 05:37
Great question. I mean, section 1031 is often complicated, but we just celebrated it’s hundredth anniversary a couple years ago, so it’s been around for many generations, and it seems very simple, but I bet you a hundred years ago, everyone was like, what’s this 1031 thing? So let me give you some of the material differences on the surface. Number one, if you’re selling an investment property, Greg, you have to take your entire, in proceeds of the sale, your basis plus your gain, all of it needs to be exchanged into replacement property to defer a hundred percent of the tax liability. In an opportunity zone only, the gain needs to be or is eligible for investment. And that’s, that’s a material difference. You imagine having a 2 million property million gain million basis in an opportunity zone, that million dollars of basis could come off the table tax free. In a 1031 all 2 million have to go.
Number two, I would say that a, a 1031 exchange tends to be preferred for someone that’s looking for current income right away. Where an opportunity zone might generate income, but it might take a few years to get there because you’re building buildings. You know, until those buildings are built and stabilized in generating cash flow, an OZ’s not going to generate income. So that’s the second big consideration. The third, and this is a nod in the, in the benefit of the oz with, with a, with a 1031 exchange, you can only swap and defer taxes indefinitely. You never get a step up from section 1031. You know how to get a step up, you must pass away. Not the, not always the preferred method of exit in an opportunity zone. Once you’ve held for 10 years and exit the fund, you’re getting a full step up as if you passed away. So, people that have a longer life expectancy, you know, say you’re 40 years old, you expect to live to 90 or 100 years old. You’re talking about having to defer for 50 or 60 years. And if you happen to own the asset, like a lot of wealthy families do in an irrevocable trust, irrevocable trusts never die, there’s never a step up. So, an OZ where you’re getting this 10 year step up, you’re getting out of the, the rat race, if you will, and taking, getting your chips out to go home and you know, live to fight another day. I think that’s a, that’s a big benefit of oz’s over 1031 exchange.
Greg Mausz 07:47
Great outline for that comparison. So let’s get granular. Let’s say, in what scenario would a QOZ be better and then vice versa. What’s, a good scenario when 1031 would be better?
Jay Frank 07:58
I’ll give you the book ends, and then you can fill in the in between. Let’s say you bought some land in Las Vegas for $3 million few years ago. Good timing, assets went up in price. Your land’s now worth 4 million. You lose land. You bought it with no debt’s, right? You just have, so you have a 3 million basis, you sell it for 4 million. If you want to do a 1031, all 4 million of those proceeds need to go in the replacement property. All four, you get no liquidity. If you want to do an OZ, you get to take that initial 3 million of basis and put it in your pocket tax free out of the game. The million goes into the OZ and enjoys the benefits of the OZ investment. If you ask me that, I don’t think that should anyone, should ever consider a 1031 in that example. But again, that’s a bookend, right?
The other bookend that the 1031 bookend gets a little more complicated. Let’s say you bought an investment property for a million dollars a long time ago, 20, 25 years ago. You’ve depreciated it to zero your million-dollar property, you’re selling it. It’s now worth $2 million. In addition, somewhere along the way you put a million dollars of debt. So, $2 million sale price million dollars of debt no basis. Okay. If you want to do a 1031, all 2 million need to go on that replacement property. You defer all of your taxes. If you want to do an OZ, you get that $2 million sale proceeds. The first million goes to pay off the bank, that million dollar mortgage that you have. So you’ve got a million dollars of, you know, cash in your in your pocket. Right? You have a $2 million tax liability, though. You have a million-dollar gain, and a million dollars of depreciation recapture. So, if you want to defer all of your taxes with an OZ, $2 million needs to be invested in the OZ. You only have a million dollars on the table. So you would either have a taxable event for a million, or you’d have to come out of pocket and put a new million dollars. Do OZ’s get done in that situation? Probably, but very, very rare. That’s probably where a 1031 is superior. Every case, almost every other case is somewhere in between those two. And I think what individuals and professionals will find, when you run the analysis, 1031 versus 721 versus not paying taxes versus doing an OZ, you’ll see that an OZ is viable and probably in the client’s best interest a lot more often than people, people think.
Greg Mausz 10:14
Well, and that’s the core of this message here, is to kind of open the horizon, open people’s eyes to that concept. So, any key takeaways as we wrap up?
Jay Frank 10:22
Yeah, I think the key takeaways is when, how I approach this fiduciary responsibility. First of all, it’s the right thing for the client. Second of all what we find with financial advisors and CPAs that really become fluent in opportunity zones and 1031 s and everything else, the value proposition that they’re bringing to the table, they’re able to do a better job for clients, but they’re able to win more business and really grow their practice now. Ultimately everybody, everybody wins.
Greg Mausz 10:47
Jay, thank you so much for sharing, and thank you for watching. For more information about alternative investments, please visit adisa.org. Thank you.