If you find yourself choosing between disposing of property in a tax-free like-kind exchange (LKE) or investing gains from a sale in a Qualified Opportunity Fund (QOF), there are some major factors to be considered.
As you are probably aware, in a LKE, a taxpayer doesn’t recognize gain or loss realized on an exchange of like-kind real properties if both the relinquished property and the replacement property are held for productive use in a trade or business, or for investment purposes. In a QOF investment, a taxpayer can defer gain from the sale or exchange of a capital asset with an unrelated party that is invested in a QOF. Although both a LKE and a QOF investment can allow a taxpayer to defer gain realized on a sale or exchange of property (real property in a LKE; capital assets for a QOF investment), there are many differences between these complex transactions.
In a LKE, both the relinquished property and the replacement have to be real property located anywhere in the U.S. On the other hand, an investment in a QOF must be located in a geographic area designated as a Qualified Opportunity Zone (QOZ). A QOF can invest in QOZ stock, QOZ partnership interests, and QOZ trade or business property as long as those investments meet certain detailed requirements. At least 90% of a QOF’s investments have to be in the QOZ.
In a deferred LIKE (the most common form of LKE), the replacement property has to be identified within 45 days and acquired within 180 days. Although an investment in a QOF has to be made within 180 days, there is no separate identification requirement.
Extent of Investment Required in the Replacement Property or in the QOF
In a LKE, the entire proceeds from the exchange of the relinquished property have to be invested in the replacement property in order to defer the entire gain. However, an investor in a QOF doesn’t have to invest any of the proceeds allocable to the recovery of his basis in the disposed property.
Length of the Deferral
In a LKE, a taxpayer recognizes the deferred gain only when he or she disposes of the replacement property in a taxable sale or exchange. Some taxpayers choose to continue the deferral by engaging in another LKE when they dispose of the replacement property. On the other hand, any gain deferred by investing in a QOF is recognized upon the earlier of the sale or exchange of the QOF investment (an inclusion event), or on December 31, 2026. Thus, in a LKE, a taxpayer can defer the gain indefinitely by choosing when to dispose of the replacement property in a taxable transaction, but, the gain deferred by a QOF investment has to be recognized before 2027.
The replacement property acquired in a LKE generally has the same basis (i.e., a substituted basis) as the relinquished property pus boot paid. Although the initial basis of a QOF investment is zero; that basis is increased by: (a) 10% of the deferred gain if the investment is held for five years, and (b) 5% of the deferred gain if the investment is held for seven years. Thus, by holding a QOF investment for seven years, a taxpayer can reduce the amount of his or her deferred gain that has to be recognized by 15%. On the other hand, a taxpayer will eventually be taxed on the entire amount of gain deferred by the LKE if the property is sold.
Any gain on the sale of the QOF investment is permanently deferred if the taxpayer holds the QOF investment for at least ten years. On the other hand, any gain from the disposition of the replacement property in a LKE in a taxable transaction has to be recognized.
Related Party Transactions
Gain from the sale or exchange of a capital asset to a related party does not qualify for deferral under the QOF rules. However, a LKE can occur between related parties. In that case, gain realized on a related party LKE is generally recognized if either the relinquished property of the replacement property is disposed of within two years after the exchange.
Estate Tax Issues
Under current law, an individual taxpayer with deferred gains from LKEs would receive a step-up (or down) on the subject real estate at death. There would be no income tax paid on the deferred gains. The value of the asset would be included in their estate and possibly subject to estate taxation.
A QOF investment held by an individual at death would be included in their estate and possibly subject to estate taxation. However, there would not be a step-up in basis. The deferred gain would be income to the beneficiary and included in their taxable income in 2026 (or earlier if disposed of).
As you can see, the analysis of which investment appropriately meets your investment goals can be quite complex. We would be happy to assist you in analyzing which of these investments would be more suitable for you. Contact us at 615-385-0686, or email firstname.lastname@example.org if you’d like to discuss the best option for your situation.investments, property