Today, I’ll talk about 1031 exchanges briefly, then move into the “hottest” new thing that generated from the tax changes at the end of 2017. This is the Qualified Opportunity Zone. The investments in these zones, which exist in every state in the US, must happen before the end of 2019. I’ve done a deeper dive, to make sure I fully understand this as an investor and as an advisor for other investors. This is one of those posts that I could write a lot more. And if your eyes gloss over, then I would just suggest that we speak about it or email about it directly. If you’re not a real estate investor already, this may not be for you. But we can connect anytime: firstname.lastname@example.org
My thoughts, of course, follow:
If you follow real estate investing, there has been a terrific way to defer capital gains into the future called a 1031 exchange, based on the IRS Code numbered 1031. Here is a simple explanation. The idea is that yes, at some point capital gains taxes could be due. But between now and then, you can take 100% of your proceeds and roll into a larger property, and earn significantly larger returns. You are essentially lending yourself money interest-free for a period of time. Let’s take an example.
You purchase a home for $200,000, and use it as a rental property for ten years. After all expenses (including your mortgage), you net $5,000 each year, which isn’t terrible, since you’ve only invested $50,000 in the property. But, it’s only $5000. You choose to sell it, and at that point, the property is now worth $400,000. Great! Not only have you more-than-doubled your investment, since you financed the property, and you have taken depreciation, so you’ve reaped plenty of tax benefits. The downside would be that you have well more than $200,000 of capital gains, taxed at the long-term rate (not including state or local taxes) of 23.8%. So, you’ll owe at least $50,000 in taxes when you sell, likely, more like $65,000.
If you do a 1031 Exchange, you instead use a Qualified Intermediary (QI). You sell the property, and the QI holds the proceeds until the next closing. You identify a new property to purchase within 45 days, and close within 180 days. Hopefully this isn’t a challenge, and you feel the investment is sound. Let’s assume all of this is in place. You roll the entire proceeds from the sale into the new purchase, AND buy a property worth $750,000. You’ve paid your $150,000 mortgage off on the first property, taken $250,000 and put it into the new property (I know, I’m simplifying). So you have a 33% Loan-to-Value mortgage on the new property. This already has a few tenants, and the net annual income after your mortgage will be about $25,000/year.
At some point you’ll deal with capital gains, which keeps people from doing 1031 exchanges in the first place. But in the interim, you’re making 5x your initial income, from the first property. And then you get the added tax benefits of depreciation on a larger property. So, a lot of upside in the deferment.
Qualified Opportunity Zones
What makes the QOZ so tantalizing is this idea that you could completely eliminate the capital gains owed. Instead of a traditional 1031 exchange as outlined above, you purchase a property in a zone, a low-income census tract, designated by the governor of a state as a QOZ. And a QOZ is, by definition, an area that is technically in need of a lot of investment, with an underserved population, or poor housing, or something that makes it a worthy of the designation. Now, you could laugh when you see the areas of New York City that are considered QOZ’s. This means they are considered low-income tracts. Here’s the map:
I’m surprised at the number of areas that are considered opportunity zones in Manhattan alone! Needless to say, if you’re thinking of investing in New York City real estate, you may want to think through the investment here, and decide if it might make sense for you, in the abstract.
In short, here are the mechanics. But I still have way too many unanswered questions, which I’ll outline.
Take the same situation as above, except that the new purchase of $750,000 is in a QOZ or Qualified Opportunity Fund (QOF). The entire investment process here is over a 10 year period. You can invest in a property directly, or in a fund that is doing the investing for you.
At year one, your cost basis is zero. All that means is that you technically will owe 100% of whatever capital gains you would owe on the sale of that original $200,000 property, if you sell the property before year 5. As if you never did an exchange into a QOZ property.
At end of year 5, you only get to add 10% to your cost basis. So you get to reduced your capital gains by that amount, in effect. $65,000 of gains owed goes down by 10%. Not much help.
At the end of year 7, you get to add another 5% to your cost basis. Here’s the kicker. You actually owe capital gains on the original sale, discounted by 15%. So if you owed $65,000, now you owe $55,250. That’s actually due when you pay your taxes on 2026 tax year.
At the end of year 10, you get to then step up your cost basis of the property to its market value. So if you sold it in year 11, and instead of $750,000, it’s now worth $1,500,000. You get to sell it and you owe almost no capital gains taxes, only the difference of whatever it was worth at the end of year 10 to when you sell.
There are a few important things to note:
You cannot invest NEW money into a QOZ. That is, you can’t take cash from your bank account and invest in a property or a Qualified Opportunity Fund (QOF). If you do, you don’t get the benefits of the step up in year 10.
You CAN invest appreciated stock (not only real estate proceeds) into a QOZ or a QOF. That’s really neat. So there aren’t the same restrictions of when you’re looking to do a 1031. It’s interesting for people who are moving out of the stock market perhaps and want to invest in real estate.
You can also invest in businesses in a QOZ (with lots of rules about what those business can and can’t be, no massage parlors, no tanning booths for instance).
A QOF will be charging you a management fee of 1% or more.
My questions and concerns:
In the midst of this, which seems like a way to eliminate a lot of future gains, there are so many unanswered questions, and, of course, risks. First, you have to hold the property for ten years in order to take advantage of the fully stepped-up cost basis. A lot can happen in ten years. Real Estate Investment property is already a relatively illiquid investment, so tying yourself into a QOZ property means you need to be prepared to deal with the volatility of an uncertain market, and in an area that is designated to be in need of repair, hopefully on the way up.
If you aren’t investing directly, akin to a mutual fund, you’re then paying a management fee to someone to look after a property. Now, this may make sense here, given that you’re paying 10% over ten years in the full value to eliminate 100% of your capital gains. But if you think about it, you’d be paying 23.8% to just pay the gains today. So you’d still be paying half of your gains here and also taking the risks of the manager you’ve hired. This QOZ craze will undoubtedly attract its share of charlatans. These seem like added costs and risks that I’d want to avoid. never mind that the interests of the syndicator are to deploy assets to get fees, not always to get the best deal on a property.
Don’t forget- You have to plan ahead for the 85% of the capital gains that are due on in year 7. In this case, where you’re earning $25,000 per year with the new property, you can sock away two years’ worth of income, and put it aside, perhaps in some other liquid investment, to plan for the taxes due in year seven. You must also consult with your accountant to be sure what those gains are. So, if you’re investing in a QOF, you actually end up paying MORE in fees than if you had just paid your taxes on the front end and invested in anything with low management fees.
How will city and state treat the capital gains? Are they cooperating with the Federal scheme? Some of these questions have not yet been fully answered.
If you’re selling stock to invest in a QOZ or a Fund, can you only put the capital gains into the fund? Or can you also put your cost basis portion? I haven’t gotten this answered yet.
I am still confirming that if you’re selling a property, that you can roll over the full proceeds into a QOZ or QOF. Again, you don’t necessarily want to get into an illiquid investment vehicle without all of your questions answered.
Market Value- in Year 10, it seems you’re going to have to get a new appraisal to determine that Market Value. It’s a small expense to factor in, but it seems like appraisers will have their hands full.
Mortgages- the federal government hasn’t weighed in on whether these purchases can be mortgaged. I would have to assume this will be allowed, but you never know. And the big difference between normal low-income area incentives and the QOZ of the moment- this is far less regulated. The upside may or may not be as great, but it’s certain that more leverage will be taken to juice returns, and there could be great money made- but I could also see many more funds going belly-up if overleveraged. I’m saying that this could a great opportunity, just depending on which section of the “stack” you invest in.
How does depreciation play a part during the 10 years? Does the step up in year 10 allow you to ALSO eliminate the depreciation that you’ve taken over the 10 years? This is pretty critical. Think of it this way. Your $750,000 new property you can depreciate over 27.5 years, so each year you can deduct $27,272 as depreciation. This effectively eliminates your income on the property (remember $25,000 per year), but it also lowers your cost basis by that amount each year. In year 10, will your cost basis be increased to that number we discussed, $1,500,000- does that wipe away the depreciation you’ve taken (now $270,000) as well? Or is your real cost basis in year 10 $1,500,000 less $270,000? It’s information we don’t yet know.
In all, it seems like the step-up in year 10 is really the reason why anyone is doing this. It allows you to make more money on your money until the year 7 capital gains taxes are due, then to wipe away most if not all of your 10 years of capital gains on the new property.
The biggest concern then comes down to the cost of all of this tax shuffling. How much are you really saving? It will be about what price you buy the new property- hopefully not at some inflated level due to QOZ competition. The least sexy play is just to buy land in a QOZ and hold it. Little needs to be done to manage it. You will know your fixed costs, and while it won’t make money, it also is a direct way to invest. You can always do a joint venture with someone to develop the land, if it came to that. But it doesn’t solve the year 7 tax hit.
If you were already looking to invest in Manhattan real estate, this is a bonus opportunity, but one that hasn’t been fully explained yet, or ruled on the SEC, IRS, whoever. If you plan to be a long-term holder, you may want to look more deeply into it. But know that there is a lot of risk that you’re taking on, and you should be ready to hold for a minimum of 10 years, and have the equity available to subsidize the investment. My biggest concern is that there are so many unanswered questions as you can see. Until those are answered, I’m going to be wary, and will always be looking for opportunities where there’s value, not just because of the flashiness of the new. I would be wary.