May 29, 2019 | Matt Baker
Real estate investors looking to defer capital gains taxes got a new tool recently in Opportunity Zones. But a tax deferral method already exists and has for years, the 1031 exchange. In many cases, it’s the superior method for tax savings.
The origins of this like-kind property exchange predate the Great Depression. Through all its years of utility, the 1031 exchange has remained a valuable tool for real estate investors even as new routes appear.
With the advent of the Opportunity Zone program—a more recent real estate investment/tax deferment vehicle—are the 1031 exchange’s days numbered? Daniel Waszak, senior vice president, Quantum Real Estate Advisors, doesn’t think so. While the new program may be worthwhile for some asset types, it’s not a panacea.
“There are only so many Opportunity Zones that I think make sense,” said Waszak. “In the world I play in, in the single-tenant, net-leased retail real estate market, it’s almost tying to shove a square peg into a round hole.”
The retail sector has been reeling for years because of the effects of e-commerce. Trying to develop a new retail venture in an Opportunity Zone—an area that by definition has poor demographics in terms of nearby consumers and labor base—would only compound the difficulties that the asset class faces.
Performing a 1031 exchange between one net-leased retail asset and another makes more sense as a way to defer capital gains taxes, so long as the replacement property is in a stable locale with good fundamentals.
“If you are doing an exchange and you find an asset you like, for whatever the reasoning is, then go buy that asset,” Waszak said. “If it happens to be in an Opportunity Zone, that’s just gravy on top. It should not be the deciding factor when you’re looking to do a 1031 exchange, in my opinion.”
As Waszak sees it, because Opportunity Zones are so new, they are still relatively untested. Tying one’s money up in a piece of legislation—one that has a ten-year lifespan built in—could be less lucrative than sticking with a 1031 exchange.
Also, Opportunity Zones require some level of property improvement. The core concept of the program is to infuse disadvantaged communities with capital gains funds, with the goal of uplifting the target area while simultaneously offering tax relief to the investors. But to get the full benefits, the investor must make improvements on the property.
Funding for Opportunities Zones can come from anywhere, not just the sale of an asset; but when a real estate sale is involved, an exchange is the more straight-forward approach. Though 1031 exchanges have been around for decades, investors can encounter trouble without proper guidance. The biggest issue that people run into is timing.
On a 1031 exchange, a 45-day window opens up on the day that the investor closes on the relinquished property. By the end of those 45 days, the investor must declare what the replacement property will be.
“It’s easy in the general course of life to say, ‘hey, 45 days is a month and a half. That’s a lot of time,’” Waszak said. “In the real estate investment world, 45 days goes by very quickly, because by the time you look at a deal, spend a couple of days thinking about it, looking at the market, drafting a letter of intent, negotiating that, putting a deal under contract, negotiating that out, your 45 days run out.”
Though the investor has another 135 days within which to perform due diligence and close on the replacement property, identification must occur in that first window. For those that delay, the preferred options on the market may be gone before they act, leading to settling for an asset with less-than-ideal fundamentals.
“I’m always advising clients looking to do an exchange to take a two-pronged approach. One is go get your asset sold. Obviously you want to get the highest price, the best possible terms and highest probability of a close,” said Waszak. “But you need to be looking at where you’re going with that money too, because those 45 days go quickly. Figuring out what kind of asset you want to buy within 45 days, that’s the blink of an eye in terms of transacting on net lease real estate or shopping centers.”
With the advent of Opportunity Zones, investors have a new outlet to defer capital gains taxes. In fact, some taxes can be eliminated with that program. Does this spell the end for the popularity of 1031 exchanges?
“Every year it seems like there are conversations about the elimination of exchanges or changing how it works to make it less favorable to these people associated with the transaction and help the government generate tax revenue, but I just don’t see how that can go away,” Waszak said. “I think they’re here to stay because it’s still a pretty robust environment.”