Home News Guest Content: Opportunity Zones vs 1031 Exchanges

Guest Content: Opportunity Zones vs 1031 Exchanges

With the release of the second round of proposed opportunity zone (OZ) regulations by Treasury and the IRS, we expect an increasing number of OZ product offerings on the horizon.

By: Timothy Witt, Director of Research and Due Diligence Officer at Concorde

With the release of the second round of proposed opportunity zone (OZ) regulations by Treasury and the IRS, we expect an increasing number of OZ product offerings on the horizon. Many sponsors have been holding off due to regulatory uncertainty, and this latest round is receiving a positive reception in the sponsor community.

Ultimately, we believe the dollars going into OZ projects will be dominated by gains from the sale of stock and private businesses. In the near term, a fair amount of the equity being raised through independent broker-dealers may result from the sale of investment real estate.

Many securities representatives have successfully built practices around serving these types of investors. With approximately $2.5 billion invested industry-wide in DSTs by 1031 exchange investors in 2018 (source: Mountain Dell Consulting), we expect that a subset of these investors may be attracted to OZ offerings instead of DSTs. Also, real estate investors who previously would not consider a DST may find OZ investments attractive.

Representatives and their clients should consider several issues when deciding between these two options. While tax savings creates motivated investors, a third option – paying the taxes – may superior to a poor investment which could result in significant capital loss. Despite the direction an investor pursues, he or she must intently focus on the underlying fundamentals of the investment.

In the case of an OZ project, the investors should pay attention to the track record of the developer, the sponsor’s relationship with and due diligence on the developer, the demographics and growth trends of the submarket (do they support the rents required by new construction), and the completeness of the project (entitlements, permits, construction financing, GC contract).

Beyond the investment merits of the projects, highlighted below are ten factors representatives should consider when advising a client on the suitability of a 1031/DST versus an OZ project.

  1. Under 1031, the investor must reinvest all the proceeds from the sale of a property to defer all taxes. OZ rules only require the gain to be reinvested. If the investor has a meaningful basis, the OZ option enables the investor to take money off the table and put it into his or her pocket today rather than having the entire investment locked up in a DST for 5 to 10 years.
  2. There are no limits on the number of times an investor can engage in a 1031 exchange. An investor can continue to exchange until death when his or her heirs will be eligible for a stepped-up basis. An OZ investor only receives a temporary deferral and will recognize a capital gain on December 31, 2026 (net of up to a 15 percent step-up in basis).
  3. DSTs strive to produce immediate cash flow. OZ investments are typically real estate development projects, which will not generate potential investor cash flow until they are built and stabilized over a two- to four-year period.
  4. Real estate in a DST wrapper is stabilized with at least some level of operating history (rents, occupancy, expenses). OZ projects carry numerous development risks, including construction delays, disputes with neighbors/municipalities, cost overruns, missed lease-up projections, etc.
  5. DSTs provide fully identified assets which can be investigated by a broker-dealer, representative and client. While some OZ funds are fully identified, others are full or partial blind pools where not all assets can be researched, and the sponsor may stretch on the quality of future fund assets.
  6. Most DSTs are single-property offerings with little diversification. While certain OZ offerings have a single asset, we are seeing some larger multi-asset funds that could provide a greater level of diversification (as well as more opportunities for something to go wrong).
  7. DSTs, in my view, are likely to provide modest returns starting at current valuations coupled with a historically long economic recovery. And, DSTs aren’t designed to be home runs; rather they are created with the intent of providing potential stable cash flows coupled with asset preservation. Development projects can potentially generate higher IRRs as the current environment offers the potential to develop at higher cap rates than those of stabilized assets. With that said, IRRs on OZ funds will be moderated by a long holding period.
  8. The rules and regulations surrounding 1031 exchanges and DSTs are well-established. DST sponsors are accustomed to structuring their offerings to comply with the seven deadly sins of Revenue Ruling 2004-86. DST-focused representatives typically understand the IRS’s 1031 exchange safe harbor requirements. OZ funds also require a high level of compliance but within a new, very complex and developing regulatory framework Non-compliance with the law or final regulations could result in investors being hit with back taxes and penalties.
  9. Both product types should be considered long-term investments. The gain generated by an OZ investment is not taxable should the investment be held for at least 10 years, creating a minimum holding period of 10 years. The holding period of a DST may be less than 10 years.
  10. Finally, an investor seeking to do a 1031 exchange has only 45 days to identity replacement property and must use a qualified intermediary (QI) to hold the funds throughout the exchange. On the other hand, OZ investments do not require a QI, and the investor has up to 180 days to reinvest the gain. As a result, if suitable, an OZ fund can be a backup for an investor who was unaware of or unable to meet the 1031 requirements.

Many real estate investors are hearing about opportunity zones through the media but are likely unaware of the nuances and risks of OZ investing. As broker-dealers and their representatives consider the issues discussed herein, they will be better positioned to guide clients looking to reinvest proceeds from the sale of investment real estate in a tax-efficient manner.

Tim Witt serves as director of research and due diligence officer for Livonia, Michigan-based Concorde, a national securities broker-dealer registered with FINRA. For more information, visit https://concordeis.com/.

This is for informational purposes only and does not constitute an offer to buy or sell securitized real estate investments. There are risks associated with investing in real estate properties including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies and illiquidity. Diversification does not guarantee profits or guarantee protection against losses. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation.

The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.

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