Why self-directed investors have the best of both worlds.
Whether you have been in real estate for one day or more than a decade, you can’t miss the current buzz about opportunity zones. Did you know the deadline for investing in a qualified opportunity zone (QOZ) is almost here?
As that deadline approaches, investors and fund managers are becoming increasingly fevered in their efforts to attract as much capital as possible to their target QOZs. However, a lot of self-directed investors, individuals using self-directed IRAs and 401(k)s to invest in real estate and other alternative assets, are starting to wonder:
“Do opportunity zones really offer anything that I’m not getting within my self-directed account already?”
Naturally, you cannot get a simple “yes” or “no” answer to this question. To further complicate matters, many organizations that have spent years targeting real estate investors seeking tax advantages for their investments are muddying the waters. They make the argument that, in truth, a 1031 exchange is a better vehicle when it comes to tax benefits than a QOZ anyway.
Going It Alone
Self-directed investors often find themselves on their own when it comes to putting the pieces of the puzzle together. Many try wading through the massive piles of IRS minutia regarding the opportunity zone program and rules and regulations for 1031 exchanges in an attempt to do their homework before placing their capital. Others opt blindly for one option or the other, trusting project managers with whom they have previous relationships not to lead them astray.
Both options are better than doing no research at all, but neither is truly the best way to make a decision about where to put your hard-earned capital. As a self-directed investor, you are in possession of one of the most powerful investing tools in existence, your self-directed retirement account or accounts. Make sure your decision to invest in an opportunity zone or to leverage a 1031 exchange strategy does not inadvertently hobble your ability to gain tax advantages or restrict your capital’s future flexibility.
Know Before You Invest: Opportunity Zone Basics
If you are like a lot of investors, self-directed and otherwise, you probably have an idea of what opportunity zones are but may not really have the whole picture in place. Here is a quick summary from the IRS:
“[An opportunity zone is] an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as opportunity zones if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the U.S. Treasury via his delegation of authority to the Internal Revenue Service.”
The bold print is important; even if you believe an area should be an opportunity zone, unless it has been certified as a QOZ, then any opportunity funds operating in the area will not be able to offer you the incredible tax advantages associated with qualified opportunity funds (QOFs).
Speaking of tax advantages, here are three basic facts about QOFs and QOZs you must know before you invest:
1. According to current legislation, you must invest in a QOF by the end of 2019 to qualify for the greatest possible financial benefit. Although you can invest in a QOF after December 31, 2019, doing so may not allow sufficient time for you to defer, reduce, or eliminate the maximum amount of capital gains taxes permitted under the opportunity zone program. QOZ investments made by the end of this year could, if properly managed, bring:
a. Deferment of capital gains on the initial investment
b. Step-up in basis on the original gains after five- and seven-year holding periods
c. Zero capital gains on appreciation of the asset after holding in the fund for a period of 10 years
2. QOFs allow you to move capital gains from one investment class to another. This is important because 1031 exchanges only permit “like-to-like” investments, meaning that to defer capital gains using a 1031 exchange, you must take the gains from the sale of real estate and invest those gains in another piece of real property. With opportunity zones, however, you can put capital gains from any asset class into the fund and derive the associated tax advantages.
3. QOFs must invest more than 90 percent of their assets in properties located within an opportunity zone. Those investments must result in “significant improvement” as defined by the Treasury and the IRS. Failure to keep the appropriate volume of funds from a QOF invested in a QOZ or failure to meet the “significant improvement” guidelines could result in decertification of a QOF and, subsequently, a loss for investors of the benefits associated with their opportunity zone investments.
Opportunity Zones vs. 1031 Exchanges
There are four main aspects of 1031 exchanges and QOF investments that are quite similar:
- They enable investors to defer capital gains on the sale of an investment.
- They encourage investors to reinvest gains rather than liquidate them by offering tax incentives and advantages.
- Investments tend to be based in or revolve around real estate.
- You have 180 days after the sale of an asset to reinvest gains in a QOF or do a 1031 exchange.
While these similarities may help investors feel as if they can really “go either way” when it comes to investing in one vehicle or the other, there are some big differences between the two as well. For example, 1031 exchanges can conceivably delay payments on capital gains indefinitely, while QOFs defer only until the fund closes, the property in the fund is sold, or December 31, 2026. That date is a hard deadline for capital gains deferral in QOFs.
Furthermore, both vehicles place stringent guidelines over your capital once it has been invested. It is not a simple matter to enter and exit investments made using a 1031 exchange or into a QOF regardless of what the fund manager may tell you. Exit the vehicle incorrectly, and you will pay through the nose as your capital gains lose their deferred or reduced status. Things can get complicated and expensive quickly.
The Best of Both Worlds
Self-directed investors have the best of both worlds when it comes to these exciting options for tax strategy and investment strategy. Self-directed investors use a tool for their investments, their self-directed retirement account, with far fewer restrictions on it and many of the same (if not better) tax advantages than an opportunity fund or a simple 1031 exchange. Furthermore, by leveraging the right combination of strategies, you can access tax advantages far more, well, advantageous than either vehicle offers with far more flexibility when it comes to accessing your investment capital.
So, should you simply walk away from 1031 exchanges and opportunity zone investments? Absolutely not! Both vehicles represent incredible opportunities in terms of saving money, growing wealth, and contributing to not just your own portfolio but also areas of the country in dire need of investment capital. Just do not blindly assume these two valuable tools in your toolbox are your only two options.