22 OPPORTUNITY ZONE MAGAZINE | ISSUE 2 • VOLUME 2
partners , the idea of contributing further capital as development equity is more realistic , opening up yet another avenue for an OZ entity to comply with both statutes at once .
USING SECTION 1031 FOR INITIAL ACQUISITIONS
Upon the OZ program ' s release , many practitioners correctly concluded that the same dollars could not be used for Section 1031 and an Opportunity Zone investment because some of the requirements of each program diametrically opposed each other . For instance , Section 1031 requires direct investment in real estate , but the OZ rules require investment only through a QOF . This may lead taxpayers to think that a Section 1031 exchange and a QOF investment present an " either / or " choice , but this is not necessarily the case .
A taxpayer could complete a Section 1031 exchange into real estate located in an OZ and use QOF money to construct improvements from scratch or perform enough renovation to meet the substantial improvement requirement . Legally , the taxpayer could elect QOF treatment for the exchanging entity ( which might require adding a member to an LLC treated as a disregarded entity ) and use one of the three methods described in the previous section to secure OZ capital .
Alternatively , the taxpayer could enact a ground lease between the exchanging entity and a QOZB , then begin construction through the QOZB . will end by the time the taxpayer receives the boot from the QI . The IRS has never directly answered this question , but the Section 1031 regulations are instructive for some situations . If the exchange straddles tax years -- meaning the relinquished property is sold in Taxable Year 1 and the exchange period ends in Taxable Year 2 -- then the regulations dictate that the installment sale rules apply to the receipt of boot in Year 2 . When this rule is synthesized with the OZ regulations ' commentary on installment sales , the guidance clearly provides the receipt of boot in Year 2 starts a new 180-day deferral period . But we still do not have an answer if the entire 180-day exchange period elapses during the same taxable year , so in these situations , proceed with caution .
Although most taxpayers and advisors view Section 1031 exchanges and Opportunity Zone investing as rivals rather than companions , a deeper analysis of each compliance regime shows that the two techniques are actually compatible with each other in many ways . QOFs and QOZBs can themselves perform Section 1031 exchanges , or taxpayers can combine QOF investing with Section 1031 to achieve better tax results . For real estate projects taking place in Opportunity Zones , synthesizing Section 1031 exchanges with OZ structuring could make a significant difference in tax outcomes , so both taxpayers and professionals should be aware of the ways the two programs can fruitfully interact with each other .
A taxpayer could also combine a Section 1031 exchange with a QOF investment by taking boot from the exchange and using it as Opportunity Zone capital . This may pose some technical ambiguities , however . For instance , if the exchanger is an individual , the exchanger can only receive boot at two points during the process : the exchanger can take boot directly from the buyer of relinquished property at closing , or the exchanger must wait until the end of the 180-day exchange period . Since the exchanger will be identifying replacement property , the exchanger cannot accept boot from the QI after the 45-day identification period has elapsed .
This raises an important question : if a taxpayer accepts boot after the 180-day exchange period has elapsed , does the taxpayer have any chance to defer capital gain into a QOF ? In other words , does the 180-day deferral period for QOF investing begin the day the taxpayer receives boot , or does the period begin the day the taxpayer sold the relinquished property ? If the answer is the latter , the QOF ' s deferral period
Section 1031 requires direct investment in real estate , but the OZ rules require investment only through a QOF .
Matthew E . Rappaport is vice managing partner at the Falcon Rappaport & Berkman PLLC , where he chairs the taxation and private
client groups . He concentrates his practice in taxation as it relates to real estate , closely held businesses , private equity funds , and trusts & estates . He advises clients regarding tax planning , structuring , and compliance for commercial real estate projects , all stages of the business lifecycle , generational wealth transfer , family business succession , and executive compensation . In the Opportunity Zone space , Rappaport advises regarding structuring and compliance for the setup and ongoing operation of Qualified Opportunity Funds and Qualified Opportunity Zone Businesses .
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