1031 Exchanges & Qualified Opportunity Zones Drew Emmert - - PowerPoint PPT Presentation

1031 Exchanges & Qualified Opportunity Zones

Drew Emmert Ryan M. Whitaker Colleen R. Fausz

Part 1: 1031 Exchanges

Roadmap

• Overview of 1031 Exchanges
• History of 1031 Exchanges
• Benefits of 1031 Exchanges
• 1031 Exchange Requirements
• Types of Exchanges
• Common Issues
• Changes to 1031 Exchanges from Tax Cuts

and Jobs Act of 2017

Overview of 1031 Exchanges

• An exception to the recognition of taxable gain on sale of real

property, provided the seller reinvests in like kind property

• Any entity or individual that is subject to tax may exchange assets

they own

• This taxable gain is: (a) deferred until the property exchanged into is

later sold in a taxable transaction or (b) eliminated if the property exchanged, or a subsequent replacement property, owned until

• death. The assets pass to the heirs at the then fair market value on

the date of death. The deferred gain is eliminated.

• Can be partial 1031 exchange if unable to fully reinvest within the

exchange period

History of 1031 Exchanges

• 1918 – Income tax first imposed – general rule that all gain is taxable
• 1921 – Old Section 202(c) (predecessor to 1031)
• Simultaneous exchanges only
• Policy – (a) continuity of investment, and (b) administrative convenience
• “[I]f the taxpayer's money is still tied up in the same kind of property as

that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with the tax upon his theoretical profit. The calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value.” HR Rep No. 704, 73d Cong, 2d Session (1934).

• 1984 – “Deferred” exchanges allowed, time limits imposed
• 2017 – Tax Cuts and Jobs Act of 2017 – no more personal property exchanges

Benefits of 1031 Exchanges

• 1031 Exchanges allow taxpayers to:
• Not pay income taxes in the current year on the exchange
• Allows tax-deferred diversification – either in terms of

geographic scope, or type of property (e.g. residential to commercial, etc.)

• Increase cash flow available to the taxpayer to reinvest in their

business

• Reinvest in more productive property and to earn more

revenue from the property

1031 Exchange Requirements

• “Exchange” Requirement – sale of one property followed by purchase of another
• “Real Property” Requirement
• Fee Interest
• Leasehold Interest (30 years or more remaining)
• Tenancy in Common Interest
• “Like-Kind” requirement
• Very broad – almost all Real Property is “like-kind” to other real property; this rule

was primarily aimed at Personal Property exchanges which have been eliminated by the Tax Cuts and Jobs Act of 2017

• Old Property exchanged for Newer Property
• Commercial Property exchanged for Residential Property
• Improved Real Estate for Unimproved Real Estate

1031 Exchange Requirements continued…

• Qualified Use Requirement
• Both Relinquished Property and Replacement property have to be either

(a) held for investment; or (b) used in taxpayer’s trade or business

• NOT Personal Residence
• NOT Dealer Property/Inventory
• Same Taxpayer Requirement
• Individual sells Relinquished Property, same individual purchases

Replacement Property (matching of social security numbers)

• Entity sells, entity purchases (matching of EINs)
• Special Rules for Disregarded Entities, “Grantor (Revocable) Trusts”
• Timing
• Identify Replacement Property within 45 days
• Purchase Replacement Property within 180 days

1031 Exchange Requirements continued…

• No constructive receipt of funds from sale
• Deposit funds with a “Qualified Intermediary”
• No cash out
• Proceeds held in Escrow
• Must purchase Replacement Property with equal or greater value
• Must roll 100 percent of equity into Replacement Property
• If either of the above cannot happen, taxpayer receives “taxable boot” –

BUT can have partial-1031 exchanges.

• Documentation and Reporting
• Exchange Agreement and Escrow Agreement
• Addendum, Assignments, etc.

Mechanics of Standard “Forward” Exchange

• Prior to sale of Relinquished Property
• Taxpayer engages Qualified Intermediary and executes Escrow

Agreement and Exchange Agreement, among other legal documents; and

• Taxpayer assigns Purchase and Sale Agreement to QI so that QI can

receive funds from sale of Relinquished Property.

• Taxpayer sells Relinquished Property and funds are deposited in a

segregated “Qualified Escrow Account”

• Within 45 days from sale, Taxpayer “identifies” (in writing) Replacement

Property

• Within 180 days of sale, Taxpayer purchases Replacement Property
• After the exchange – QI or accountant reports 1031 exchange on IRS Form

8824

Types of Exchanges

• Simultaneous Exchanges
• Two parties swap their properties
• No longer common; more convenient for taxpayers to utilize “deferred

exchanges”

• Deferred Exchanges
• Forward Exchanges – Taxpayer sells, then purchases within 180 days
• Reverse Exchanges – Taxpayer purchases Replacement Property

First, Sells Relinquished Property within 180 days

• “Parking” Exchanges outside Regulatory Safe Harbor – risky, but if

structured properly, could allow taxpayer to effectuate 1031 exchange

• utside 180 day time period

Types of Exchanges continued…

• Improvement/Construction Exchanges
• When the value of Replacement Property is less than vale of

Relinquished Property, Taxpayer will generally owe tax on the difference (i.e. a “cash out”)

• “Improvement Exchange” solves this problem – Example:
• January 1 - Taxpayer sells Relinquished Property for $1MM
• February 1– Taxpayer purchases Replacement Property for $600,000
• February 1 through June 30 – Taxpayer makes improvements to

Replacement Property valued at $400,000

• Value of Replacement Property after improvements is $1MM, which is

equal to value of Relinquished Property – no tax owed! (assuming other 1031 requirements satisfied).

Common Issues

• Personal Property included in purchase price – separately allocate

in Purchase Agreement and on Closing Statement

• Found replacement property before finding purchase of relinquished

property – Reverse Exchange

• Issues with documentation and reporting – consult with Tax Attorney
• r CPA who is experienced in 1031 exchanges
• The value of my replacement property is not sufficient to fully defer

gain – do “Improvement Exchange”

• “One of my partners does not wish to effectuate a 1031 exchange” –

do equity restructuring in advance of exchange, or cash the partner

• ut at closing with corresponding gain allocation

Changes to 1031 Exchanges from Tax Cuts and Jobs Act of 2017

• No more personal property exchanges – only real property
• 100 percent expensing on certain Qualified Improvements

– may mean less 1031 exchanges

• Alternative to 1031 Exchanges – Qualified Opportunity

Zones

• Only required to rollover “gain” into QOZ, whereas 1031

required to (a) roll over equity position, and (b) purchase property with a value equal to or greater than Relinquished Property.

Part 2: Understanding Qualified Opportunity Zones

What is a Qualified Opportunity Zone?

• Provides significant tax incentives for taxpayers to

reinvest unrecognized capital gains in certain property and businesses located or operating in QOZs.

• Enacted as part of the Tax Cuts and Jobs Act of 2017.
• Encourages economic development in low-income areas

by providing various tax incentives for private investments in QOZs.

Where are the Opportunity Zones?

• Treasury has designated QOZs in all 50 states, the

District of Columbia, and five U.S. possessions - Map is FINAL

• KY - 144 low-income census tracts in 84 counties
• 7 designated in Kenton (5), Campbell (1), and Boone (1)

counties.

• Hamilton Co., OH – 30 QOZs, including CBD, OTR,

Avondale, Queensgate and Camp Washington.

Qualified Opportunity Zones in Ohio

https://development.ohio.gov/bs/bs_censustracts.htm

Qualified Opportunity Zones in Hamilton County

https://development.ohio.gov/bs/bs_censustracts.htm

Qualified Opportunity Zones in Kentucky

Source: http:/ /www.thinkkentucky.com/OZ/

Qualified Opportunity Zones in N. Kentucky

Source: https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml

Qualified Opportunity Zones in N. Kentucky

Source: https://www.cims.cdfifund.gov/pre paration/?config=config_ n mtc.xm1

QOZ Tax Incentives

• 1. Temporary deferral of capital gain.
• 2. Step-up in basis.
• 3. Permanent exclusion of gain on appreciation.

Temporary Deferral Incentive

• Taxpayer can elect to temporarily defer capital gain from the sale or transfer to an

unrelated party of any property that the taxpayer owns as long as the taxpayer reinvests the deferred amount in a QOZ.

• GAINS DEFERRED - Proposed regulations make it clear that deferral is only

available for gain that is treated as capital gain for federal tax purposes.

• ANY PROPERTY - There does not appear to be any restrictions on the types of

property that can be sold to generate the gain - not limited to real property or business property.

• Taxpayer must reinvest the deferred amount within the 180-day period beginning on

the date of the sale or transfer of the property generating the gain - proposed regulations address deferral of gain from partnership.

Basis Step-Up Incentive

• Provides a tiered "step-up" in the taxpayer's basis in the gain it reinvests in

the QO Fund depending on how long the taxpayer holds the investment.

• Absent this statutory "step-up," the taxpayer's initial basis in the reinvested

gain is zero.

• "Step-Up" Holding Period. If the taxpayer holds the investment for at least

five years, the taxpayer's basis in the investment is increased by an amount that is equal to ten percent (10%) of the amount of capital gain that the taxpayer elected to defer.

• If the taxpayer holds the investment for seven years, the taxpayer's basis is

increased by an additional five percent (5%) of the deferred gain.

Basis Step-Up Incentive

• Because the temporary gain deferral period ends no later than the tax year

including December 31, 2026, the taxpayer will need to reinvest capital gain in a QO Fund and elect deferral treatment by December 31, 2019 to permit the taxpayer to hold the investment for seven years and receive the full benefit of the basis step-up provision.

Permanent Exclusion Incentive

• Taxpayer can permanently exclude capital gain
• n the sale or transfer of an investment that the

taxpayer holds for at least ten years.

• Taxpayer would IRS Form 8949 to elect

permanent gain exclusion.

QO Zone Incentives - Example

Before July 30, 2019 July 30, 2026 July 31, 2029 Jan 31, 2019 July 30, 2024

QO Zone Incentives - Example

* Assume OZ Investment is sold for $3 million at the end of each holding period.

• • Absent QO Zone, this would likely be the tax result to Taxpayer for the same course of action - initial sale of asset,

reinvestment in new project, and eventual sale

• $1 million of gain recognized at time of asset sale and $2 million of gain recognized when new project is sold.

NON – OZ Investment

Qualified Opportunity Fund

• An investment vehicle organized as either a partnership (including an LLC

treated as a partnership for tax purposes) or corporation that was formed for the purpose of investing in a qualified opportunity zone property.

• At least 90% of the Fund's assets must consist of QOZ Property.
• A taxpayer can self-certify to become a QO Fund -Taxpayers are not

required to seek pre-approval or related action to establish a QO Fund.

• To self-certify, the taxpayer will complete a form and attach it to a timely filed

federal income tax return for the relevant taxable year. IRS Form 8996 is used for self-certification - form is also used for annual 90% compliance.

Investment Types in Opportunity Zones

Qualified Opportunity Property

• 3 categories permitted
• Directly invest in real-estate within the zone
• Investment in entities that invest within the zone
• Investment in active QOZ businesses
• Cannot include an interest in another QO Fund.

QOZ Partnership Interest + Stock

• Any capital or profit’s interest in a domestic partnership (including an LLC

treated as a partnership for federal tax purposes) or any stock in a domestic corporation if:

• a. the QO Fund acquired the interest after December 31, 2017 in

exchange for cash;

• b. at the time the QO Fund acquired the interest, the entity was a

QOZ Business or was organized to be a QOZ Business; and

• c. during substantially all of the time the QO Fund held the interest,

the entity qualified as a QOZ Business.

• “Substantially all” as it relates to time of holding period means 90 percent.

QOZ Business Property

• Tangible property that a QO Fund or QOZ Business purchased after

December 31, 2017 and that is used by the QO Fund/QOZ Business in a trade or business operating in a QO Zone for substantially all of the time that the QO Fund/QOZ Business owns the property.

• The original use of the property in the QO Zone must begin with the QO

Fund or QOZ Business, or the QO Fund/QOZ Business must substantially improve the property.

• “Original Use” - First use to which the property is put, whether or not

such use corresponds to the use of such property by the taxpayer.

QOZ Business Property

• Property treated as "substantially improved" if the basis of the QO Fund or

QOZ Business in the property increases over a 30-month period beginning at acquisition by an amount that exceeds its initial basis (i.e., the purchase price) in the property.

• Improvement expenditures of the QO Fund or QOZ Business in the property
• ver the 30-month period must exceed the original acquisition price.
• Permits parties to purchase and develop property without having to meet

the 'original use" requirement. Does not permit parties to purchase developed property with little or no additional improvement.

• Regulations provide substantial improvement measured by addition to

adjusted basis of the building, not the underlying land.

QOZ Business Requirements

• The activity must be a trade or business in which substantially all (70%) of the tangible

property owned or leased by the taxpayer is QOZ Business Property.

• At least 50% of the total gross income of the taxpayer must be from the active conduct of

such trade or business WITHIN THE ZONE, and the taxpayer must use a substantial portion of its intangible property in the active conduct of such trade or business. New Regulations provide three safe-harbors:

• Hours worked by Employees/Contractors within Zone.
• Amounts paid to Employees/Contractors for work performed within Zone.
• Facts and Circumstances test based on (1) tangible property within zone, and (2)
• perations and management functions within Zone.
• "Sin Business" Restriction. The business activity must not constitute a private or

commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.

Other Guidance from Proposed Regulations

• Leased Property.
• Leased Property can be Qualified Property
• Value of Leased Property included in both the numerator (assuming it is

qualified) and the denominator of 90 % test.

• Valuation of Leased Property either the value reported on the QOF’s financial

statement, or unadjusted cost basis of the property (NPV of total lease payments at the beginning of lease, remains the same throughout holding period)

• Must be market-rate, arms-length leases, no intent to purchase for less than

FMV

• For purposes of a QOF who is in the business of leasing property to third parties,

merely “triple net” leases may not qualify as “active conduct of a trade or business.”

Other Guidance from Proposed Regulations

• Inclusion Events.
• Sale of QOF Interest – all gain included on date of sale
• QOF’s sale of QOZP – all gain included
• Transfer of QOF interest by gift
• Distributions of cash/property in excess of basis
• Change in form of QOF investors (Grantor Trust, Partnership and S-Corp

changes of ownership

• NON-INCLUSION Events: transfers by reason of death, contribution to

Grantor Trust or Partnership, certain other changes in ownership of QOF)

• Reinvestment Rule. If QOF sells property, has 12 months to reinvest into other

QOZ property without penalty; remains in compliance with 90% test so long as proceeds held in cash/cash equivalents or debt instruments with less than 18 months maturity

Basic Model for Real Estate Development Project

• New construction
• Substantial improvement

Real Estate Development

Basic Model for Real Estate Development

Questions?

Drew Emmert 513.357.5289 aemmert@dbllaw.com Ryan M. Whitaker 513.357.5291 rwhitaker@dbllaw.com Colleen R. Fausz 859-426-2169 cfausz@dbllaw.com