Register Today For Alts Expo - Dec 8th
On June 30th, AltsDb co-founders Jimmy Atkinson and Andy Hagans hosted a live one-hour webinar for financial advisors, comparing Opportunity Zones, 1031 exchanges, and Delaware statutory trusts.
This podcast includes an audio version of the webinar, including a short introduction by Andy Hagans.
Watch On YouTube
- What is an OZ Fund?
- What is a 1031 Exchange?
- What is a DST?
- Traditional 1031 Exchange vs. DST Investment.
- Opportunity Zones vs. 1031/DST.
- Key considerations when a client has a capital gain.
Featured On This Episode
- Official Webinar Replay Page – includes downloadable deck (AltsDb)
- Alts Resources For Advisors – includes upcoming CE credit webinar schedule (AltsDb)
Today’s Guests: Andy Hagans & Jimmy Atkinson, AltsDb
About The Alternative Investment Podcast
The Alternative Investment Podcast covers new trends in the alternate investment landscape. Hosts Jimmy Atkinson and Andy Hagans discuss tax-advantaged investment strategies to help you grow your wealth.
Andy: Hi, everyone. This is Andy Hagans, founder of AltsDb, and host of the “Alternative Investment” podcast. Today’s podcast episode is the audio version of a live webinar that Jimmy Atkinson and I co-hosted. So, it was a live one-hour webinar for financial advisors for CE credit titled “Opportunity Zones versus 1031 Exchanges and DSTs,” and the live webinar was accepted by the CFP board for one hour of CE credit. And I also wanted to mention, because I know we have a lot of financial advisors, family offices, IRAs who listen to the show, that we’re planning to do more of these webinars for CE credit for the CFP board, and so, you can view a calendar of those upcoming webinars on altsdb.com/advisors. And we will also list all of our past webinars there on that page so that you can view them on-demand. Enjoy.
Jimmy: Welcome to today’s webinar, “Opportunity Zones versus Section 1031 Exchanges and DSTs.” I’m Jimmy Atkinson, co-founder of AltsDb, and I’m joined by the other co-founder of AltsDb, Andy Hagans. “Opportunity Zones versus 1031 Exchanges and DSTs,” really quick announcement before we get going, just a quick legal disclaimer. This is not meant to be tax advice or investment advice or legal advice. Please consult with an advisor before you make any investment decisions.
The agenda for today’s presentation, we’re gonna be going over three different types of tax mitigation programs, opportunity zones, section 1031 exchanges, and Delaware Statutory Trusts. This is not gonna be a really deep dive into any one of these three. We don’t have enough time to do deep dives in any of them. We’re gonna be touching at a very high level. Some tax considerations and some strategic concerns, both advantages and limitations of each of these three programs. And then, toward the end of today’s presentation, we’ll be comparing 1031s to DSTs and opportunity zones to these more traditional type of 1031s to DST investment programs.
Finally, at the very end of today’s presentation, we will have a link to where you can take the quiz if you need CFP CE credit. And we’ll also make this slide deck available for download. We’ll have instructions on how to download the slide deck at the conclusion of today’s presentation.
So, let’s start with an opportunity zone investment. What is an opportunity zone fund? What is an opportunity zone investment? Some quick general background on opportunity zones, they are the result of a tax policy that is trying to tackle income inequality or wealth inequality. Certain communities of our country got left behind after the recovery from the last great recession, if you will, of ’08 and ’09, and this is a tax policy that’s designed to spur economic revitalization by way of private capital investments into these economically-distressed communities that have been designated as qualified opportunity zones.
It’s a very new program codified into law via section 1400z per the Tax Cuts and Jobs Act that President Trump signed into law at the very end of 2017. So, it’s only been around for about four and a half years right now. In July of 2018 is when all of the zones were finalized. We have over 8,700 such census tracts around the country that had been designated as qualified opportunity zones for the purposes of opportunity zone investing. The investment needs to actually be physically located in one or more of those zones spread all over the country. And unlike a section 1031 exchange or Delaware Statutory Trust, which we’ll touch upon a little bit later in the presentation today, opportunity zones are eligible to be invested in either real estate or operating businesses. So, there’s a little bit more flexibility there with regards to eligibility.
So, what are the tax benefits of opportunity zones? First of all, with this program as with the other two programs, at the end of the day, it’s a capital gain tax benefit. So, with opportunity zones specifically, now, you need to start by triggering a capital gain. And the capital gain does not have to come from the sale of real estate investment property as it does with 1031s and DSTs, but it can come from any type of gain. It can certainly come from real estate, but it can also come from sale of private business or stock or bonds or Bitcoin, art, other collectibles, it really doesn’t matter. Any type of tax event that triggers a capital gain, any type of sale that triggers a gain can be eligible for deferral by rolling over that gain amount into an opportunity zone fund so long as the investor does so within a 180-day period.
And the two main benefits that that investor then gets is, one, deferral of recognition of that initial gain until the end of 2026 is, essentially, roughly five year now, interest-free loan from Uncle Sam. You don’t have to pay taxes on that initial gain until April of 2027. But the big benefit is the second one, zero capital gains tax liability within that opportunity zone investment so long as you reach a 10-year holding period. So, you roll over your initial gain into an opportunity zone fund, you hold that investment for 10 plus years, it grows tax-free kind of like a super Roth IRA tax-free appreciation and no taxation after selling as long as you hold it for 10 years and comply with the various compliance regulations.
There are a lot of different types of opportunity zone investments. All opportunity zone investments, in order to be eligible for the tax benefits, need to flow through a new vehicle that is referred to as the qualified opportunity fund, and a qualified opportunity fund can be either a single-asset fund or a multi-asset fund. And the fund can acquire multiple real estate properties or multiple operating businesses, or maybe just one real estate property, one specific multi-family building, for instance, or work to fund one particular business startup or a business relocation or a business recapitalization so long as these investments are within the geographic boundaries of an opportunity zone.
And then, in terms of real estate type operating…excuse me, real estate type opportunity zone funds, I’ve seen a variety of funds, sector-specific funds that target just multi-family all over the country or just multi-family in the Southeast, sometimes they’re sector-agnostic though. So, there are opportunity zone funds that have a broad opportunity zone strategy. Maybe the fund operator just like secondary and tertiary markets in the Sunbelt but is relatively property type agnostic might invest in office and hotel and mixed-use and multifamily. And then again, yeah, you’ve got geographically-concentrated, maybe city-concentrated, region-concentrated, or sometimes you’ve got these big national funds that are location-agnostic. So, lots of different ways you can work with an opportunity zone fund.
So, I wanna turn now to my co-host on today’s presentation, Mr. Andy Hagans. He’s the other co-founder at AltsDb. Andy, when we’re talking about opportunity zone funds, how should an advisor think about opportunity zone funds in terms of portfolio construction for an ultra-high net worth or a high net worth client? And what are some of the advantages and limitations of this program?
Andy: Yeah. Good question, Jimmy. And you know, when we’re talking about portfolio construction, it’s important to keep in mind that the opportunity zone fund, the QOF is a wrapper, right? It doesn’t really describe a particular type of asset because that wrapper usually can hold real estate. Sometimes, it’s holding operating businesses or even operating as a sort of venture capital type fund, but usually, it’s holding real estate. And so, from a top-down perspective, as an advisor, if you’re advising an ultra-high net worth client, typically we’re seeing higher allocations to alternatives and especially real estate in the past 5 or 10 years. That traditional 60, 40 might be a 50, 30, 20 or something like that in today’s day and age. And so, really, we’re usually talking about a wrapper that can be used within that slice of the portfolio that’s devoted to alternatives.
Now, as far as when to take advantage of it, if I could have a client’s allocation be entirely in opportunity zone funds, whatever the allocation to alts is, that would be great from a tax planning perspective, but it’s going to be limited by the timing of the client’s capital gains, right? So, with all of these tax programs really you can think about using them opportunistically, right? So, for instance, if you have a client with that traditional portfolio who wants to cash in some gains, take some chips off the table, you could rotate into some QOFs slowly and regularly, maybe a little bit here and there every year. Or the other extreme, you might have a client who’s, let’s say, exiting a business for a $100 million capital gain. That client will be in a position to allocate much more aggressively into an opportunity zone fund.
And now, let’s talk about some of the advantages and limitations of the opportunity zones tax program. And Jimmy, you’ve mentioned some of these already. I wanna go over all of these, but really I wanna stress the most important ones. So, of course, we have the capital gain deferral of that initial capital gain, but we also have the future capital gain tax liability elimination, right, and that’s the big one. So, once I invest my capital gain into the QOF, any subsequent capital gain that occurs within the QOF will come out tax-free after 10 years, at least at the federal level, without owning any capital gains tax liability. And if you think about the types of assets, the types of investments that tend to be inside a QOF, they tend to be weighted very heavily towards capital appreciation anyway, right? Because going back to the original perspective of the program of place-based investment, so that tax advantage is huge. We don’t wanna let the tail wag the dog. It’s still important to invest in good funds and in good projects. But the advantages of that specific tax aspect of the QOF cannot be overstated.
We also have the elimination of depreciation recapture as well. Reinvested gain does not have to derive from a real estate investment. And this is another big one because we’re gonna be talking about traditional section 1031 exchanges, as well as Delaware Statutory Trusts, and those are gonna be very limited in terms of what types of clients with…what types of gains can even utilize those programs. Whereas with a qualified opportunity fund, any type of capital gain is eligible. On the practical side, you’re going to need to be an accredited investor to invest in these qualified opportunity funds, so that’s a limitation.
And another limitation, we’re limited mostly to real estate, but we’re also limited to opportunity zones within real estate, and those cover about I believe less than 10% of the country, right? So, there’s a lot of places you might like to invest that you cannot in an opportunity zone because there are no opportunity zones located in those places. Another limitation and this is a big one is the 10-year hold period. So this is really a program for patient capital. When we talk about family offices, ultra-high net worth clients that can afford to lock up some of their portfolio for that full 10 years. Another limitation, it’s a perishable incentive. We already have some of the more minor advantages of the program have already sunsetted. Jimmy, I think we should almost add an asterisk to that bulleted item here on this slide because this is going to be debated and possibly legislated for the program to be reformed or extended, but the point is, is it’s a little bit uncertain right now.
Another limitation is the type of real estate or even type of business that can be contained in a QOF, you’re not gonna see triple net leases. You’re not gonna see core assets that are already stabilized contained within that QOF, at least not initially. They’re going to focus mainly on ground-up development. And lastly, the limitation, we have state conformity issues in a few states. So, some investors live in California or New York, two big ones, may still owe state capital gains taxes after that 10-year hold period, but they still get that federal benefit, right, Jimmy?
Jimmy: Yeah, that’s correct. Yeah. I wanted to make sure we pointed that out. If you do have nexus in any of these five states that are listed here in California, Massachusetts, Maine, North Carolina, and New York. And again, I think California and New York are looked at as the two 800-pound gorillas in the room. You’re not gonna receive any benefit of opportunities zone investing on your state returns, but certainly, you do get all of the benefits at the federal level. So, but just something to consider, particularly for California, if you’re in that highest tax bracket, you’re gonna be facing a, I think it’s over 13% headwind now for investing in opportunity zones.
So that was opportunity zones. I think we wrapped that up pretty nicely there, Andy, thanks for coming in and putting that into some more perspective in terms of how it can fit into a client’s portfolio, some of the advantages and limitations. We’ll be doing that for these other two programs we’re about to discuss now, section 1031s and Delaware Statutory Trusts.
So let’s start now with section 1031 exchanges, a huge difference between 1031s and opportunity zones. The 1031s have been around for a very long time. Over a hundred years we’ve been doing section 1031 exchanges in this country. I don’t know that they were called section 1031 exchanges back in 1921, but these days, 1031 refers to the section of the Internal Revenue Code that this tax program is based on and defines the rules and the limitations governing that tax break. And I’m sure the vast majority of folks who are on this call today, especially our financial advisors are probably very familiar with this program. Probably several people on this call have actually done a lot of 1031 exchanges throughout the course of their lifetimes or real estate investment careers. Essentially, it’s a swap till you drop tactic, right?
There’s a lot of similarities between this program and opportunity zones. At the end of the day, it’s a capital gains tax mitigation program just like opportunity zones. But the final benefit is, well, the ongoing benefit is you get to defer capital gains recognition as you exchange out of one real estate investment property into another, and then into another, and then into another, over the course of your lifetime. And then, upon your death, the big benefit that passes through to your heirs is that step-up in basis to fair market value, which essentially means that your heirs escape capital gains taxation. Similar to opportunity zones, where you get to escape capital gains taxation, but you don’t have to die with opportunity zones in order to take advantage of that. It’s just after a 10-year hold we’re here, the main benefit passes on to your errors, but it’s still a good component for tax planning and estate planning purposes for investors who have heavy exposure to real estate investment property.
And then, kind of zooming out and looking at the real estate economy as it were, the real estate transaction marketplace, this code in the Internal Revenue Code, section 1031 really helps grease the wheels of that entire real estate economy, really helps facilitate a lot of the transactions that happen within real estate. And I think if we did away with section 1031 tomorrow, the real estate economy would certainly suffer quite a bit a lot less transaction volume. I think it disrupt a lot of things. I like to point that out.
So, Andy, turning to you now, and again, this is probably very familiar territory, unlike OZs for most of the folks on this call today, but where do section 1031 exchanges fit into the portfolio of an ultra-high net worth or a high net worth investor? And what are some of the advantages and some of the limitations of this particular program?
Andy: Sure. Well, I’ll start with the advantages. The major advantage, you can swap till you drop, right? So, clients who own investment real estate and they can indefinitely chain together 1031 exchanges and avoid paying that capital gains indefinitely. So, I think a lot of clients who are very heavily into that actively owning, actively managing real estate game, they’re going to be already using section 1031 exchanges. Although Jimmy, I wanna point out, we were recently talking with a family office who works with a lot of other family offices and ultra-high net worth clients, and he indicated that even among ultra-high net worth, a lot of wealth managers, a lot of family offices are not using 1031 exchanges.
So, even though I know a lot of people listening, certainly to this webinar, are already familiar with this program, I still think it’s greatly underused, right? Because that ability to swap from property A to property B, and then property B to property C indefinitely all the way until death, and then you get that basis step up to fair market value. So, that’s very, very strong for estate planning purposes, very advantageous.
Another advantage with a section 1031 is the investor control. So, as the investor, the replacement property, you will own that outright. And if you need to sell that asset maybe unexpectedly, maybe you plan to hold that asset for 5 or 10 years, but based on market conditions or cash flow needs, you decide to sell it in year two or year three. Well, if you have executed a traditional section 1031 exchange and you own that individual asset, you can sell it any time you want. And as we’ll see when we discuss DSTs and as well with QOFs, the investor does not have any control over the exit of their investment. They’re pretty much locked in.
So, the limitations of the section 1031, I mean, the biggest limitation with the traditional 1031 exchange is the investor goes from actively owning a property, and then, now they’re actively owning another property. And so, if an investor doesn’t want to be an active owner anymore, a traditional 10 31 exchange with the replacement property being an individual property, it’s going to have that limitation. There are also just some practical legal considerations, the 45-day rule, the 180-day rule, the need to use a qualified intermediary. These are just practical considerations.
So, any investor, any client who wants to perform a 1031 exchange definitely should get professional help, professional advice, make sure to cross the Ts and dot all those Is, because it’s actually pretty easy to screw these up if you don’t have the right help. And I think more and more advisors, especially ones on the cutting edge who work with alternatives more are understanding that helping clients with 1031 exchanges, with DSTs, with QOFs, that’s not necessarily just the job for the real estate agents. More and more advisors are helping their clients out because this fits into that overall portfolio picture to use these tax programs holistically with an eye to the whole portfolio because you really want to use…
Some of these programs may even work really well together. Right? So, for instance, a client may be using 1031 exchanges for some capital gains, maybe reinvesting other capital gains into QOFs. And even as we’ll discuss, if a client misses a deadline with a 1031 exchange, they may even be able to use a QOF as a backup option. So, I think a lot of these tax programs can really work together, Jimmy.
Jimmy: Yeah, that’s actually a really good point, Andy. It’s not always an either or proposition with regards to your overall portfolio. You can have a little bit of two or all three of these different types of investment programs within your portfolio or within your client’s portfolio, in the case of an advisor, advising clients on investment products.
Yeah, one other thing I wanted to revisit, Andy, that conversation we had with… It was with DJ Van Keuren at Evergreen Properties. He’s the family office manager that indicated to us that… And it surprised both of us, that really not a lot of family offices or not as many as you would think are utilizing this program properly. That’s actually our most recent podcast episode on the “Alternative Investment” podcast that you and I co-host, Andy. So shameless plug there to listen to that episode if you haven’t yet for anybody out there watching today.
But let’s move along now. So, that was section 1031 exchanges. We’ve covered opportunity zones. Let’s move on to our third and final investment product…program which is the Delaware Statutory Trust, which offers a lot of the benefits of 1031 exchanges but in a passive, fractionalized way.
I’ll get to that in a minute, but the DST hasn’t been around as long as 1031s, but it’s been around a lot longer than OZs. It was enacted in Delaware in 1988. And it was first approved for use as 1031 exchange as eligible replacement property for a 1031 exchange by the IRS in 2004 with Revenue Ruling 2004-86. So about… What is that? About 18 years now that this program’s been around for real estate investors to exchange into a DST. Some of you on the call may have familiarity with TIC or tenants in common, or tenancy in common structure. DSTs have some similarities with that older type of program, which I think dates back to 2002, if I’m not mistaken. It’s a couple of years older than DSTs, but DSTs, in almost every way, are more favorable, more advantageous than the TIC program. DSTs basically overtook TICs, especially coming out of the great recession.
And essentially, what it is, and we’ll get to the advantages and limitations. Andy will cover that in a minute here. It’s an investment vehicle or a wrapper that allows investors to essentially exchange out of a current investment property into a replacement property in which they are passive investors. I’ll note that there are a lot of restrictions around what 1031…excuse me, what DST properties can be and can do. We’ll get to those in a minute.
And the other benefit here is that it’s fractionalized ownership of replacement properties. So, you get access to more expensive, higher-quality, institutional-type deals. Let’s say you have a net proceeds of $1 million from the sale of an investment property. You’d normally have to 1031 that into a replacement property worth about that amount. Instead, if you want to invest passively into a DST, you can come into a larger DST that might be $25 million or $50 million or a $100 million or more, and get a million dollars worth of that larger portfolio, fractionalized ownership.
And then, just a logistical consideration here, the trust, the Delaware Statutory Trust is run by a trustee or a sponsor, which then actually operates that property. So, you’re not operating it directly. Andy, I hope I didn’t steal too much of your thunder there. I’ll ask you the same question I asked you about OZs and section 1031 exchanges, when can a DST be incorporated into an investor’s portfolio? And what are some of the advantages and limitations of this program?
Andy: Sure. That’s a great question. And it’s important to remember that a DST is just a specific type of replacement property within a section 1031 exchange. So, all of those usual limitations of a 1031 exchange, for instance, the 45-day rule, 180-day rule, a lot of those other regulations, an investor still needs to follow those when investing into a DST. The biggest difference is active versus passive, right?
And that’s both an advantage as well as a limitation of the DST. And I think a lot of advisors when they’re looking into DSTs for clients, a lot of clients who are maybe getting closer to retirement or maybe are in retirement, and maybe they have actively owned and managed real estate assets for decades, but they’re getting to that phase in life where they want to enjoy life a little, relax, and like I said, enjoy life. So, maybe they’re getting tired of the three Ts, and they’re not interested in actively managing their real estate portfolio anymore. So that’s a time where they can do 1031 exchanges out of those properties that they own and into DSTs where they will be passive investors.
And as you mentioned, with the DST, an investor can access institutional-grade real estate. And even if you take like an ultra-high net worth client, maybe they do have a capital gain of, let’s say, $30 million on a transaction or $20 million on a transaction. So, maybe they could access some of that higher value real estate if they wanted to, but with DSTs, they could even take that 20 million capital gain and invest it into multiple DSTs and so be diversified as well as passive. So, a lot of advantages there.
Another advantage of the DST, and this is a limitation as well, is the relative predictability. So, all of these are kind of double-edged swords. The DSTs, they tend to hold core or core-plus type assets, very stable, geared towards income generation, not geared towards capital appreciation. So, that’s not to say that an investment in a DST will not generate any future capital gain, but because of the limitations surrounding DSTs, some of which are known colloquially as the seven deadly sins, and we’re gonna cover these as well.
But because of those limitations, those legal limitations, DSTs are very limited in terms of what kind of real estate assets they can hold. And then, also the type of value add that they can do on those assets. And for that reason, again, they’re very geared towards stable, income generation type assets. So, back to who these are appropriate for, a lot of investors who are near retirement, entering retirement, in retirement, an income-generating asset sounds great, a passive income-generating asset. So, it’s just different horses for different courses, Jimmy.
And I think the DSTs are growing in popularity. They were popular a while back, and then, they sort of lost favor for a while. And now they’ve kind of come back into fashion. And I think the new iteration of DSTs, I think they’re a little bit of a better deal for investors. So, I think they’re increasingly popular with very high net worth, ultra-high net worth, and advisors, and for a good reason.
Jimmy: Yeah. Great way to defer capital gains and eventually escape that capital gains tax liability all while being a passive investor, which, as you mentioned, Andy, can be a double-edged sword. Pros and cons to whether or not you wanna be passive or active really depends on where you are in your stage of life, where you are in the course of your career. I did wanna cover some of the restrictions around DSTs governed by that IRS Revenue Ruling 2004-86. They’re known colloquially as the seven deadly sins. And they really just restrict what things that a trustee can do. And they’re really designed to just prevent the misuse of power by trustees and really regulate what DSTs can do, because DSTs oftentimes do have multiple investors coming into them. Sometimes dozens, if not hundreds, and these rules are designed to protect those investors. I’m not gonna read each one of these.
Again, we are gonna have this slide deck made available for download. We’re gonna give you those instructions in a minute here, but just to go over a couple, this first one here limits how a DST can open and close. You open once and then you close the fund, and you can’t make another capital call. You’re not allowed to renegotiate the terms of existing loans. You can’t renegotiate existing leases. The cash reserves you can’t…there’s only so much you can do with the cash reserves. Essentially, the cash has to flow through to the investors. And then, this last one here, which we pointed a couple of times, you can’t make significant improvements to the property. That’s in direct opposition to opportunity zone investing where you have to make substantial improvements to existing property, or it has to be ground-up construction.
We’re gonna pull it all together here in a minute, but just wanted to break for a second just to remind everybody, we’re probably gonna go here for another 12 to 15 minutes, and then we’re gonna have a live Q and A session to kind of round out the hour. So, if you have any questions, please use that Q and A tool in your Zoom toolbar. It should be a little Q and A icon at the bottom of your Zoom app. Submit questions, we’ll get to them in about 12 or 15 more minutes here.
So, again, just to pull it all together, comparing 1031 exchanges to DSTs. Andy, did you wanna walk us through some of these major differences between these two types of exchange programs?
Andy: Yeah, sure. And let’s start right away with the qualifying investor. And this is a big one because any investor who owns an investment real estate asset can execute a traditional 1031 exchange. The investor does not need to be accredited, but with a DST from a practical standpoint, you have to be an accredited investor to invest in a DST, so that’s a big difference. Number of investors with a traditional section 1031 exchange, you’re on your own for better or for worse, you have total control. With a DST, theoretically, unlimited number of investors. From a practical standpoint, DSTs are often capped at 499 passive investors. Ownership, with a traditional 1031 exchange, you own that replacement asset. With a DST, you actually own your shares of the trust, right? So, the client will own shares of a trust versus owning that underlying asset.
In terms of risk profile or investment strategy, and this is a big one because a traditional 1031 exchange gives you total freedom for any type of replacement property, right? So, you could opportunistic, value add, triple net, or core, core plus all over the map. Whereas with the DST, because of those seven deadly sins and some of these legal restrictions on the program, you’re pretty much limited to what I would call core, core plus, stable, income-generating assets that are probably somewhat limited in that future capital gain arena. In terms of real estate price range, with a traditional 1031 exchange, whatever you can afford, right, with your principal, with your capital gain. Whereas with the DST, because you’re pooling together your funds with other investors, the investors can access that institutional-grade real estate. So, that’s a pretty big difference. Holding period, again, because your control with the traditional 1031 exchange, the holding period is whatever you want.
You have that ability to get liquidity whatever the market will bear, at least. Whereas with a DST, a typical full cycle for a DST is between 5 and 10 years. So, you’re basically illiquid during that time period. And there may be a limited ability for an investor or one of your clients to get some liquidity through some sort of redemption program or something like that, but there’s usually going to be a discount or a penalty, and so, that’s not really a great option. So, I would say, if you have a client who’s interested in a DST, they should go in knowing and with the ability to be illiquid for that full 5 to 10-year life cycle. And lastly, the restrictions of the seven deadly sins, those are only pertinent to DSTs.Those don’t apply to a traditional section 1031 exchange.
Jimmy: Yeah. Great summary there, Andy. I think just to kind of drive the point home one more time, I’d say like, the two biggest differences here are the active versus passive, right? 1031s just a lot more control. DSTs, you’re giving up that control for better or worse. And then, the other big difference is, the ownership, you want fractionalized ownership in a more institutional-quality deal, or do you wanna control smaller type properties one to one? Those are the big differences there in my mind.
So, now, to pull it all together, how do opportunity zones, going back to the very beginning of our presentation, that newer tax program that was first enacted at the end of 2017, how do they compare to 1031s and DSTs? A lot of this is gonna be review but important to drive home these points here. The full tax benefit timeline varies quite a bit between OZs and 1031s.
OZs, you get the full tax benefit after achieving a 10-year holding period. You’re a taxpayer, you trigger a capital gain, you roll it over into an opportunity zone fund within 180 days. Ten years later, you dispose of your opportunity zone asset, you’ve got a big gain. The gain gets written down to zero for tax purposes and that’s it. With 1031s and DSTs, you can continually exchange from one property into a replacement property, into another placement property, deferring that capital gain all the way down the road until the day that you die, and then, the benefits pass onto your heir is only upon death. So that’s a big difference there.
Triple net leasing, very common strategy with both section 1031 direct ownership and with Delaware Statutory Trust investments. The underlying assets within the DST are often structured around 1031…excuse me, triple net leasing. With opportunity zones and this says not allowed here. This should actually say severely restricted, I guess. There are some ways you can do some triple net leasing within an opportunity zone fund, but the way that the IRS regulations are currently written around opportunity zones, triple net leasing is a big red flag, and you’re severely restricted in the amount of triple net leasing that you can do within an opportunity zone fund. It can only be a very small part of the overall underlying assets of such a qualified opportunity fund, essentially, to the point where in practice it’s basically not allowed.
Investment eligibility, huge difference here. If your client is a real estate investor and only really ever has real estate gains, then I would say…that I would say either program is an option for your client. Or I should say, actually, if your investor doesn’t even necessarily have to be limited to real estate, but if your client has real estate gains that you’re considering, either program is an option. If you’re looking at gains from non-real estate, if you’re looking at gains from the stock market or sale of a privately-held business, or maybe low basis, highly appreciated Bitcoin was a very popular type of gain that many advisors and investors had deal with or got to deal with, I should say, in 2019, and 2020, and 2021. Those types of gains aren’t eligible for 1031s or DSTs, and really opportunity zones are the only way to go here in terms of these three basic programs. That’s a huge difference.
And then, in terms of what you can hold, what types of assets you can hold within each type of program, if you wanna continue to do real estate, you can do either one. You can do opportunity zones or 1031s, or DSTs. 1031s or DSTs have to be like kind exchanges, real estate into real estate, but opportunity zones, a little more flexibility. The gain can come from anywhere as I just mentioned, but also the gain doesn’t necessarily have to go into a real estate asset. It could be used to invest in operating businesses as well. Now, in practice, most opportunity zone investments that I’ve seen in my time as founder of OpportunityDb, the vast majority of investments, the vast majority of assets that are being invested in by qualified opportunity funds are real estate, but I have come across a handful of operating business ventures as well that can receive opportunity zone equity.
The investment amount, we touched upon this a little bit, but I think it bears repeating. The opportunity zone program, in some ways, you could say is a little bit more flexible in that it allows you to take your principal off of the table. The tax benefit only applies to the gain amount.
So, let’s say you have a million dollars of basis in some stock and you sell it for $3 million, so you’ve got a million dollar in basis and a $2 million gain. Only the $2 million gain gets rolled over into a qualified opportunity fund, that leaves you with a million dollars in principal that you have flexibility with. You can reinvest it elsewhere. You can stuff in your mattress if you want, or buy a new car, buy a house, whatever. There’s a lot more optionality there. Although there are no tax benefits that get associated with that million dollar benefit, so that’s kind of the drawback there. Whereas with 1031s and DSTs, you need to reinvest the entire net proceeds of the sale of the real estate investment property into the replacement property in order to get the full benefit of either one of those programs.
In terms of how you think of where each of these programs fits into your client’s portfolio or your portfolio, if you are an ultra-high net worth or high net worth investor yourself, opportunity zones bob because of the way that the statute is written, because of the way that the regulations are drafted, basically stemming all the way back to the policy intent of the program. We’re looking for either new ground-up construction or substantial improvement of existing distressed properties.
So, your focus here, your investment objective, when you do an opportunity zone deal or an opportunity zone investment is going to be on capital appreciation, excuse me. Whereas with section 1031 exchanges, it’s really more of a choose your own adventure. It can vary widely. You can go into a core or a core plus, stable replacement property deal, or you can go into something that might be a little bit dilapidated. It needs some substantial improvement. And then, when we’re talking about a DST investment specifically in this right column, you’re really only limited to that other end of the spectrum compared to opportunity zones. You’re limited to core and core-plus stabilized assets.
Timeline for investment, they both have a 180-day rule. At the end of the day, you have 180 days from the date of sale typically. There are some exceptions there that we don’t have time to get into. From the date of sale in order to then roll over into either one of these types of programs. The difference though is that DSTs and 1031s have a 45-day identification period where you have 45 days to identify up to 3 replacement properties. Oftentimes, you blow through that 45-day window, and you’re kind of out of luck with regards to doing a section 1031 exchange. Opportunity zones can be a good fallback there. You’d still have a gain that you triggered in theory, right. and then you would have 135 days left in order to possibly do a qualified opportunity fund investment.
Ease of investment, opportunity zone funds self-certify with the IRS. So, if you wanna run your own fund, you can certainly do so. It’s a little bit of legwork in terms of some regulatory compliance hurdles you have to clear every year, but there’s no red tape really to cut, no bureaucracy you have to go through in order to get approval. You just do it and self-certify with the IRS every year. That’s if you wanna run your own fund. If you wanna just come into another fund as a limited partner, all you do is just write someone a check and move along. You have to file one more tax form every year with your tax return while you hold the qualified opportunity fund as a limited partner investor, but that’s about it. Whereas with 1031s and DSTs, you have to work through a qualified intermediary in order to run your existing property into a replacement property to properly do the exchange.
And then, investor or advisor knowledge of the program is somewhat limited with opportunity zones. Hopefully, today’s presentation helps shed a little bit more light on opportunity zones for everyone. But 1031s and DSTs, I think there’s a rather healthy knowledge of the program. So, there’s just gonna be a lot more investors, particularly if they have expertise with real estate, they’re just going to have a lot more familiarity or muscle memory, I like to say sometimes, with regards to section 1031.
Opportunity zones are still the new kid on the block. Everyone’s kind of still trying to figure out what they are and how they can fit in. So, that’s another consideration you need to really understand. I would say this though, I would say, if you’re an IRA or another type of financial advisor who can understand these three types of tax mitigation programs, you really have a lot to offer prospective clients or existing clients, existing investors in your Rolodex in your system in terms of a story you can tell them about how you can help place them into these different types of investment products. You’re gonna have a huge leg up on the crowd, especially if you can get your arms around opportunities on investing for sure.
So, some other considerations here really quickly before we move into our Q and A period just got a couple of minutes left. I already mentioned bullet point number one, OZs can sometimes be used as a fallback for a failed 1031 if you blow through that 45-day rule. And then, these last two considerations, I guess, keep in mind that with these tax policy programs and not just these but really any type of tax policy program, you’re relying on the whims of the federal government. What’s the balance of power in Congress? What are their objectives? Who’s in the White House also? So, one thing that was kind of in jeopardy for a while when President Biden first took office a year and a half ago was this section 1014, potentially in jeopardy. That is the part of the Internal Revenue Code that regulates stepped-up basis upon inheritance. That would’ve really screwed up a lot of people’s 1031 exchange strategies.
Now, the administration and Congress has since backed off of that, but could a future presidential administration or a future session of Congress 5, 10, 20, 40 years from now potentially do some damage to that part of the code and potentially unwind a lot of these section 1031 exchanges, just something to consider. And then, the second thing, and Andy touched upon this a few minutes ago, are OZs here to stay? Currently, OZs are a perishable incentive. Certainly, you can invest in qualified opportunity funds now and defer taxation and escape capital gains liability 10 years later. That program’s still around through the end of 2026. People are still gonna be making investments in them through most of 2027.
But are they gonna get extended? Are they here to stay? Just another consideration. There is some legislation out there that would extend the program by an additional two years, maybe that gets passed. Maybe it is the first step in regularly renewing OZs every year. Just something to keep an eye on, something to consider.
So wanted to take a moment to thank everyone for attending today’s presentation. We’re gonna get to the Q and A in just a moment here. But just wanted to point out some free resources that we have available to all of our viewers here today whether you’re watching us live right now or if you’re watching us on the recording at a later date, you can download this presentation deck. And we also have a bonus guide, our free investor’s guide to alternative investments available at the URL on your screen, altsdb.com/advisors. Again, that’s altsdb.com/advisors.
We also have a QR code on the screen right now, if you scan that with your phone. Unless you’re watching on your phone, that might be tough, but if you’re watching it on a computer screen, you can scan that and it’ll take you to that same URL. And also the quiz for CFP CE credit is also available on that website URL as well. Andy, any last thoughts from you, or are we ready to move into our Q and A session here?
Andy: Well, just one more plug because I know we have about eight minutes to go and I saw we got several questions, and we probably won’t be able to answer them all in-depth. But I did wanna plug our podcast because we have scheduled several guests over the next six weeks discussing both DSTs as well as qualified opportunity funds in a lot of depth. So, there’s gonna be a lot of good media information on our podcast in the next six weeks.
So, any advisors listening who would like to subscribe, you can just open up your podcast listening app, it’s called the “Alternative Investment” podcast, and we are also available on YouTube. If you just go to youtube.com and type in “altsdb,” we’ll pop up there. So, had to get that plugged in, Jimmy, but I saw we have a few questions, so maybe we could at least briefly hit on some of those before we call it a wrap.
Jimmy: Yeah, sure, Andy. So, first, question here and it looks like you already tagged this one as one you want to answer. How did fees compare between opportunity zones and DSTs?
Andy: Yeah. And I need to give this answer a bit of an asterisk because it really depends on the fund, right? It depends on the individual QOF. It depends on that individual DST because the different fees for each fund, there are a lot of similarities, but they can actually be pretty different. Certain fees that exist with one fund or one trust may not even exist with another. So, sometimes it can be hard to do an apples-to-apples comparison.
That being set out, I wanted to point just a few things out. Number one, DSTs are often sold through broker-dealers, right? And so, whether you’re an advisor or an accredited investor looking into purchasing a DST, that’s just a cost to be aware of. Whereas with QOFs, some QOFs are sold through broker-dealers, but a lot of them are registered as 506Cs, and so, they’re sold directly to retail investors, can invest in them sort of outside that broker-dealer network.
One other consideration that I think is pretty important. So, for QOFs, QOFs are mainly investing in ground-up development and in their fee structure, both of these are gonna have upfront costs. They’re gonna have ongoing management fees, and then, they’re gonna have disposition or closing costs at the back end. But the fee structure of QOF will often have that waterfall, and QOF investments are often weighted heavily towards future capital gains. So, I would encourage IRAs and wealth managers to really look into the waterfall as well as that preferred return and kind of decide risk-reward with the particular QOF if it’s worth it.
But honestly, outside of some of that generalized advice, there’s really no…there’s no quick answer to this. For each product, you have to look at the PPM, and you have to look at those individual fee structures because they do vary from product to product.
Jimmy: Oh, yeah. Great thought there, Andy. One other thing I might note is that because opportunity zones typically will invest in ground-up construction, oftentimes you’ll have some construction management fee for the first couple of years of an OZ investment. So, look into that. Sometimes it’s wrapped up into the asset management fee, but I would just ask the fund operator, the syndicator of whichever OZ deal you’re looking at, that question. What about construction, who pays for those types of management fees there? Where you won’t get that at all in a DST because you can’t do a ground-up in a DST.
Andy, it looked like another one here was tagged for you, also. This question comes in from Ben. He asks, “Can you 1031 out of a DST?” It’s a great question.
Andy: Short answer, yes. Yeah. A DST is it’s just a replacement property in terms of a 1031. So, you can maintain that swap till you drop strategy 1031 in and out of DSTs.
Jimmy: Right on, Andy. And then, let’s see, Sean asks, “For 1031 number of investors is one, please explain.” “Thanks,” he says. And I think I’m just gonna kind of roll back through to this slide here, Andy, we’re talking about this line right here, “Number of investors on a 1031 exchange.” It’s really just one investor. You, the investor, are the one performing the section 1031 exchange out of a property that you control an investment property that you control and own by yourself. And you exchange into another one that you directly control and own and operate yourself. So, just one investor is considered there.
Whereas with a DST investment, you’re investing the proceeds of the sale of one property that you have sold and owned and controlled on your own into what’s essentially a fund, a pooled trust of dozens, if not several hundred different investors. So, I think that was the distinction there. Andy, I don’t know if you had anything else to add, but hopefully answers that question we got from Sean there.
Andy: No, I think that’s good, Jimmy. And another question regarding 1031s, “Are 1031s at risk of being axed or severely reduced?” This questionnaire mentions that they remember that being discussed as part of the Build Back Better program. And I do think it’s worth addressing this especially, Jimmy, because we mentioned that qualified opportunity zones are subject to some political risk. And I think that is also true of section 1031 exchanges, and therefore, also Delaware Statutory Trusts.
I mean, I would say this about 1031 exchanges, I very much doubt that that tax program will get axed. It has been around for a very, very long time, and if it went away, that would be a severe blow to the entire real estate industry, which is a huge industry. I mean, think about like where we are right now in last day of June in 2022, where we’ve seen volume real estate sales activity has basically fallen off a cliff. Now, imagine if 1031 exchanges were suddenly taken away and how much worse that would make the transaction activity, especially in a rising interest rate environment. I do not see it going away. I mean, it could be a political punching bag. I do think that there’s a risk that, at some point, legislators might nibble around the edges, might do some sort of minor reform, but speaking personally, just personal opinion with all of my disclaimers that this is just a personal opinion, I don’t see it being severely curtailed.
That being said, if you’re ever worried about that and you’re sitting on a property with a massive capital gain, I guess, it’s a good time to 1031 out of it possibly. So, you can always factor that into your timing. I mean, I think a lot of people will also factor that timing into qualified opportunity funds if they believe that that program is actually going to be sunsetted when it’s due to be sunsetted. You may see a flurry of activity right before that deadline. But what do you think, Jimmy? What’s your personal take on that question?
Jimmy: Well, what’s scary about what a year, year and a half ago, when there were a lot of rumors floating around about a potential Build Back Better plan severely curtailing that main benefit, that step up to fair market value upon death. I think if I recall correctly, they were gonna potentially limit that to $500,000, which could do…which could result in a huge tax bill for a lot of people upon death for their heirs. Thankfully, that didn’t go through. It doesn’t look like it’s gonna go through, but I don’t know. It’s really hard to predict the future, Andy. I kind of think you’re right though. It seems like it would be politically unfeasible to try to push something through like that that would severely curtail it.
But anyways, let’s move along to a couple more questions here. I think we’ve kind of spoken our piece on that. Jeffrey asks a relatively simple question here. I might get these next two or three here, Andy, if you don’t mind, but feel free to chime in. Jeffrey asks, “Can cash that is not capital gains still be invested in a qualified opportunity zone fund? And will that cash receive the 10-year plus tax benefit if invested properly in a qualifying project?” So a two-part question.
Jeffrey, the answer to your first part of your question is, yes, cash can be invested into a qualified opportunity zone fund. It doesn’t have to be capital gains, but it’s not subject to any of the favorable tax treatment, only capital gains dollars receive that tax benefit. At some point, I’m hoping that some future reform legislation passes that would enable for cash or non-capital gains money to get treated the same way. But at current moment, the whole program was designed to unlock unrealized capital gains, primarily out of the stock market, and to redeploy that capital into these economically-distressed communities. So, that’s the way that the statute and the regulations around this program are written. Unfortunately, yeah, cash cannot receive any of those benefits.
So we are at the top of the hour now. So I wanna thank everybody for coming. If you have to bounce, I won’t hold it against you, but I think, Andy, we got a couple more questions we can still answer if you wanted to go over for a couple more minutes. I’ve got a few more OZ ones here that I wanted to get to, but just like to remind everyone of the time so we don’t keep them for too long. Again, head over to altsdb.com/advisors to take the quiz if you’re looking for CFP CE credit, or if you’d like to download this presentation deck.
But to move along with the questions, Nikita asked, “Did you guys touch on the 10% and 15% discounts on capital gains that OZs used to offer after 5 or 10 years? If not, could you discuss this topic?” So, Nikita, no, we didn’t cover that, but let me back up in the slide deck here to near the very beginning of the presentation. I mentioned these two tax benefits here for capital gains, deferral period until 2026 and then no capital gains tax liability on the subsequent OZ investment.
There did use to be another benefit in here, which was on your initial gain that you get to defer until the end of 2026. if you achieved a 5-year holding period prior to this special date that is written directly into the statute, December 31, 2026, if you achieved a 5-year holding period prior to that, you got to reduce the amount of gain that you recognized on this date by 10%. So, if you had a $1 million gain that roll over into a qualified opportunity fund, for tax purposes, when you go to file your 2026 return, so long as you achieve a 5-year holding period prior to then, you get to recognize that $1 million gain as simply a $900,000 gain.
Now, if you do the math there, you can recognize pretty quickly that you had to have invested into a qualified opportunity fund prior to the end of 2021 in order to achieve that 5-year holding period by 2026. There was also a seven-year benefit, very similar benefit. You had to invest prior to the end of 2019, and that got you a 15% reduction. So, that million-dollar gain became 850,000 for the purposes of paying your 2026 taxes.
So, that’s a little bit of background on that. Nikita, I hope that answers that question. So, those benefits are no longer eligible. I will say this though, if that reform legislation goes through, the reform legislation we were discussing earlier, it would potentially, depending on when it gets passed and whether or not some of the provisions within the legislation get rewritten or not, it could potentially reopen those 5 and 7-year 10% and 15% basis step-up windows once again. So, it’s something to keep an eye on there.
One or two more questions here. Andy, I’m gonna hog the stage for one more question, if you don’t mind. And then, maybe if you see one on here that you like, we can get to it. Otherwise, we can call it a day. But I’ve got a question here about, “I’ve heard that OZs can be used in the event of a failed 1031. Can you elaborate on that? So, that’s simply, I’ll just kind of review this slide right here. So, it goes back to that 45-day rule failure. So, OZs don’t have a 45-day identification period, whereas 1031s do. So, if you fail that 45-day period, if you do not properly identify replacement properties within that first 45 days, your 1031 is blown, but you still have a gain and you still have 180 minus 45 equals 135 days left to do an opportunity zone investment. So I hope that answers that question.
Andy, did we have any other questions on here you’d like to address or we’re a few… I think we’re almost five minutes over now, so maybe we can call it…
Andy: Yeah, I think we’re running out of time, but I wanna mention again that we have some DST experts coming on the “Alternative Investment” podcast in the next few weeks. So, I think we want to note down some of these questions and we have a lot of other in-depth content that we’ll be discussing there. So, I’d welcome anyone listening to subscribe to that. And we also have a free guide to DSTs on our website. If you go to altsdb.com and scroll down to our footer, the bottom of the page, where you can download those guides. And I think a lot of the questions will be answered there.
Jimmy: Awesome. Well, Andy, thank you again for joining me today, and a huge thank you to all of our listeners and viewers out there today. Thank you for participating and thank you for viewing. We’ll get the recording out later tonight or tomorrow to everybody who signed up. So, thanks, again. Take care. Have a great rest of the day, have a great weekend, and happy 4th of July to everybody else out there as well. Thank you.