By now it’s no secret that the Biden administration has released its “Green Book” outlining the administration’s tax plan. Perhaps unsurprisingly, but nevertheless worrisome to real estate investors, is the administration’s proposal to significantly limit gain deferral on Section 1031 exchanges. Historically, real estate investors have been able to rely on Section 1031 to trade properties and defer gain recognition on the exchange. If structured properly, this deferral benefit has been available regardless of the amount of gain inherent in the exchanged property. While the Biden administration’s proposal still would allow for Section 1031 exchanges of real property, the deferral benefit would be limited to $500,000 per year (or $1 million for married individuals filing a joint return).
Section 1031, in its original form, has been around since the Revenue Act of 1921. The policy and rationale behind Section 1031 seemingly make sense. Suppose an investor sells property and directs all proceeds from the sale into a new like kind property. In that case, the investor should not be taxed on their theoretical gain so long as the investor continues the investment in the like-kind property. The taxable event should be deferred until the investor ultimately cashes in on the investment.
So why attempt to repeal or limit a tax statute that makes sense? Well, Section 1031 applies only to exchanges of real property. Outside of the real estate space, an investor who sells or exchanges an appreciated investment typically recognizes a taxable gain immediately, even if that investor chooses to reinvest all sales proceeds into an asset of a similar nature. Why should this investor be required to recognize a taxable gain immediately while the real estate investor is able to defer gain recognition for an indefinite period? This seems to be the Biden administration’s rationale behind its proposal, as the Green Book refers to Section 1031 exchanges as a “loophole” and the “like kind real estate preference.”
Policy arguments aside, let’s cut to the chase: Will the Biden administration succeed in limiting the Section 1031 deferral benefit? Your guess is as good as mine. While Congress has amended Section 1031 on several occasions, it has withstood the test of time in one form or another for the past 100 years. That said, if the administration’s proposal makes its way through Congress and is signed into law, real estate investors may want to explore alternatives. Here, we focus on two: qualified opportunity funds and umbrella partnership real estate investment trusts.
Qualified opportunity funds.
The Tax Cuts and Jobs Act of 2017 created the federal qualified opportunity zone program, which is designed to unlock access to private capital to facilitate economic growth in distressed communities designated as opportunity zones. The opportunity zone program works like this:
- An investor generates a capital gain (or another eligible gain) by selling an asset. Within 180 days, the investor reinvests the sales proceeds into an investment vehicle called a qualified opportunity fund.
- The QOF funnels the new capital into a subsidiary company called a qualified opportunity zone business, which is the operating company.
- The opportunity zone business acquires eligible property located in an opportunity zone and operates the underlying business.
The opportunity zone program is suitable for certain real estate investments. If structured properly, investors are rewarded with three tax incentives. First, investors can defer recognition on the initial capital gain transaction to the extent that proceeds are reinvested into the QOF. While this initial gain deferral is certainly a pro for the investor, two interrelated cons await. Unlike Section 1031 exchanges, which allow for an indefinite deferral period, the opportunity zone program requires the investor to recognize and pay tax on the deferred gain on Dec. 31, 2026 (or, if earlier, when the investor sells its investment in the QOF). This potentially creates a liquidity issue for an investor, as the individual will be required to pay tax on the deferred gain on Dec. 31, 2026, at the latest, even if the investment is still tied up in the QOF.
Second, the investor can exclude 10% of the initial deferred gain from the taxable income if the investor has held the QOF investment for at least five years as of Dec. 31, 2026. Investors hoping to take advantage of this second benefit need to make the initial investment in the QOF before the end of 2021 to achieve the five-year holding period by Dec. 31, 2026.
The third incentive is the real cherry on top for investors. Investors who have held their QOF investment for at least 10 years are able to permanently exclude from their taxable income any appreciation on their QOF investment when it is sold. For example, if an investor initially invests $1 million of eligible gain into the QOF and sells the investment for $2 million after 10 years, the investor is able to permanently exclude the $1 million of gain attributable to the appreciation on the investment. Note that this benefit applies only to the appreciation of the investment; tax still will become due on the initial deferred gain.
The opportunity zone program offers a somewhat unique Section 1031 alternative to real estate investors. Investors interested in investing in a QOF would be wise to seek competent counsel to thoroughly vet the structure, as the tax incentives are contingent on the QOF and opportunity zone business satisfying various compliance requirements.
Umbrella partnership real estate investment trusts.
Another potential Section 1031 alternative for real estate investors is the UPREIT. UPREIT transactions are nothing new. Unlike the opportunity zone program, which is newer and comes with more uncertainty on various structuring and compliance points, UPREITs have been around since the early 1990s.
An UPREIT allows owners of appreciated real estate to contribute the property to a partnership subsidiary of a real estate investment trust in exchange for partnership units. The partnership units received in exchange for the contribution of property can be converted into REIT shares. The investor’s initial contribution of the property to the partnership is a tax-free transaction under Section 721 of the code. The gain inherent in the contributed property is deferred until the investor sells his or her partnership interest or converts it into REIT shares, or the REIT owner sells the contributed property.
As with Section 1031 exchanges, the primary benefit of an UPREIT transaction is the investor’s ability to defer gain recognition on appreciated real property. The investor typically can choose when to trigger gain recognition by selling the partnership units or converting the partnership units to REIT shares or cash. This provides investors with much more flexibility as compared to a QOF investment. Of course, there are disadvantages with the UPREIT structure, namely limited voting rights and lack of control over the underlying property once it is contributed to the partnership.
Time will tell what will happen, if anything, to Section 1031. In the meantime, real estate investors may wish to become knowledgeable about the various alternatives to Section 1031 and the pros and cons associated with such alternatives.
This article was originally published in the October 6 edition of the Colorado Real Estate Journal.