Can Investor’s Time a 1031 Exchange Into an Opportunity Zone Fund?

There is a lot of excitement about opportunity zones, but one potential game changer could be the possibility of timing a 1031 exchange transaction with an opportunity zone deal. If an investor could time the transaction correctly—a deal that would promise to be highly complex—it could create an option, albeit a long-term option, to transition out of real estate and avoid hefty capital gains taxes. However, the possibility is more fantasy than reality at the moment.

“It is still a new investment opportunity, and some of the legislation isn’t fully finalized,” Davin Carey, managing financial advisor at Carey & Hanna, tells GlobeSt.com. “We are still wrapping our heads around what some of the opportunities might be. I think that opportunity zones could be a significant boon for real estate investment, and if there is a way to successfully marry a 1031 exchange into an opportunity zone or an opportunity zone fund, there is an opportunity for that to be a significant boon to real estate transactions.”

The opportunity zone map targets markets across the US in need of revitalization, however, the map includes many markets that are already seeing organic investor interest. This includes markets like Phoenix and Portland. “The interesting thing is that if you look at the opportunity zone maps, there are a lot of places that people already want to invest,” adds Carey. “I think that savvy sponsors are going to look at this as an advantageous place for clients and investors put their proceeds. If someone can successfully marry it with an exchange eligible product, it is huge. That gives you the ability to take a deferral and turn it into tax free for at least a portion of it. If you have a 10-year exit to be out of real estate entirely, that may be attractive to most people.”

However, timing an exchange into an opportunity zone fund would be challenging, especially considering the renovation component of opportunity zone funds. “One of the challenges of an exchange into an opportunity zone fund—and this is very perfunctory—is the capital improvement component of the opportunity zone fund to reap the fully benefit,” says Carey. “What is challenging is that if you are raising funds to make future improvements in one of these areas, being able to escrow enough to meet all of those specific requirements could be a challenge.”

Timing the two transactions would be highly complicated. So complicated, in fact, that Carey says most investors will probably forgo the attempt. “I think that there will be a lot of complexity there. It is going to require a sponsor that is willing to deal with that extra level of complexity,” he explains. “My gut says that there are not going to be a lot of people that want to deal with that complexity, unless they find a way to be appropriately compensated for it. I would not be surprised to see most of the opportunity zone funds specifically looking for cash investment. The few that have popped up so far appear to be heading in that direction.”

Real estate attorneys, however, are attempting to marry the 1031 exchange rules with the initial opportunity zone regulations to create some sort of framework of how such a transaction would work. In Carey’s opinion, we won’t really know until it happens. “Since things aren’t finalized yet, they are using 90% good work, but we don’t have 100% yet,” he says. “Until we go through the full cycle of the purchase, sale, deferral and everything else, we don’t exactly know how it will work.”