The tax timelines for 1031 exchanges and Qualified Opportunity Zones (QOZ) require investments to be made within 180 days of realizing a gain. The rules are clear regarding what needs to happen within each strategy that a taxpayer is pursuing, but there is little guidance on whether both timelines run concurrently or consecutively. Although the Internal Revenue Code (IRC) remains silent on this issue, investors can take cues from specific existing procedures. These breadcrumbs give investors great latitude in deferring gains through a QOZ after a 1031 exchange fails. The critical issue at stake, and the thesis of this article, is “When does a taxpayer recognize the gain from a failed 1031 exchange?”

The Background of IRC Sec. 1031

A 1031 exchange allows a real estate investor to defer the capital gains taxes on the sale of investment property when he or she “replaces” the sold or “relinquished” property with new property or properties of equal or greater value. Exchange procedures are well documented and are outlined in the IRC with additional guidance provided in Revenue Procedures and Revenue Rulings. The taxpayer must engage a Qualified Intermediary (QI)—sometimes called an “accommodator”— to hold the sale proceeds immediately upon the property’s sale or relinquishment. Furthermore, the taxpayer must identify (in writing) replacement property(ties) within 45 days and complete the purchase(s) of identified property(ties)—the “replacement”— within 180 days of the relinquished property sale. The exchange fails if the taxpayer is unsuccessful in identifying replacement property(ties) or in closing on the transactions within the given timelines.

When conducting a 1031 exchange, every exchange agreement between a QI and the taxpayer must contain prohibitive language restricting the taxpayer's access to funds. Often referred to as the G6 restrictions, the vocabulary is taken from 1031k-1(g)6 of the code and cites explicitly when and if the exchanger may access the exchange funds. The tax deferral safe harbor provided under Sec. 1031 is only permitted when the taxpayer is prevented from receiving, pledging, borrowing, or obtaining benefits from the sale proceeds; in other words, the client cannot have access to the funds.

Sellers entering an exchange after July 5 of any year might have an exchange cross into the following year. When an exchange straddles a calendar year and then fails, the taxpayer has the option to report the gain received in the latter calendar year. Specifically, if the funds held by the QI are not returned to the taxpayer until after December 31, the attempted exchange carries into the following year. This situation would create an installment sale under IRC Section 453 (and the 1031 regulations) offered by 1031(k)-1(j)(2). The taxpayer could report gains from the real estate sale in the following calendar year.[1]

The taxpayer wishing to conduct a 1031 exchange must have the exchange in place before selling the relinquished property. Failing to make a timely QOZ investment cannot be reversed through a 1031 exchange.

QOZ Basics

In the Tax Cuts and Jobs Act of 2017, QOZ legislation created an economic development tool that permits investors to invest, in a tax preferential manner, in distressed communities nationwide. The bipartisan efforts of Senator Corey Booker (D-NJ) and Senator Tim Scott (R-SC) incentivized investors with tax benefits to create economic growth in communities identified as economically challenged. Governors from all 50 states nominated neighborhoods and counties to qualify, with the U.S. Department of Treasury certifying those areas. An investment into a QOZ can be made into more than 8,500 census tracts throughout the country. As a result, commercial growth and real estate development stimulate the economy for each federally designated area as intended.

Unlike a 1031 exchange, taxpayers can receive the sale proceeds directly after selling property. Generally, taxpayers have 180 days to invest gain proceeds into a QOZ investment to defer the immediate tax liability. Taxpayers report their QOZ investments with their annual tax filings; if the QOZ investors’ 180-day period extends beyond his or her tax filing deadline, taxpayers should file an extension until after making the QOZ investment.

The QOZ investment defers capital gains through 2026 – payable in 2027. After a 10-year holding period, the QOZ investment's basis adjusts to equal the sale price. Together with eliminating capital gains taxes, taxpayers investing through QOZs are also not subject to depreciation recapture.

QOZs are part of the federal tax code. An overwhelming majority of states aligns with QOZ rules; only eight states are nonconforming.[2] Taxpayers should consider conformity with the federal provisions. Residing in nonconforming states may reduce a taxpayer's state tax deferral on the initial gains invested in opportunity zones. Additionally, taxpayers investing in nonconforming states may also be required to recognize capital gains for state tax purposes on their ultimate sale of the QOZ investment.

When is the Gain Recognized?

If the 180-day timelines for 1031 exchanges and QOZ investment overlap, taxpayers cannot access exchange funds for QOZ purposes. This interpretation of gain recognition has caused some investors to struggle or be creative in completing the QOZ investment when funds were delivered to a QI upon the property sale. Some taxpayers have funded QOZ investment(s) with cash on hand or accessed a credit line because exchange funds were tied up. Other taxpayers have aggressively fought their QIs to release funds before the 180-day exchange deadline to fund a QOZ investment, placing undue risks on the QI's business. As with most new legislation and the rules attendant thereto, no challenges have been made as to the issue of whether the two periods run concurrently or consecutively. The most crucial element is understanding when 1031 exchange taxpayers realizes their gains. Accepting the “simultaneous timeline theory” since the advent of QOZs, taxpayers have made QOZ investments before their exchanges have failed. 

The IRC clearly outlines when a taxpayer realizes a gain on a failed exchange where the exchange straddles calendar years. However, missing from the Code is language on when taxpayers recognize a gain during an unsuccessful exchange occurring within one calendar year. The elusive answer defines a taxpayer’s options for deferring taxes with IRC Sec. 1400Z. For example, does the 180-day clock reset for QOZ investments on all failed exchanges?

The straddled exchange has become an installment sale. According to IRC Sec. 453, taxpayers do not recognize the gain until they receive funds from the installment. For the failed exchange straddling calendar years, the installment causes the capital gain to be recognized in the following year—on Day 180 of the exchange. The taxpayer has another 180 days to make the QOZ investment.

The question remains open for discussion without any comment from the IRC or IRS as to the issue of a failed exchange occurring in a single calendar year. Attorneys and accountants could build an argument using the rules discussed above. Consistent application of the known tax law would suggest that taxpayers do not recognize the gain in a properly structured exchange until after the exchange fails. Utilizing the same thought process for an area where the Code is silent generates a unique opportunity for taxpayers to defer capital gains while contributing to the economic growth intended when Senators Booker and Scott first wrote QOZ legislation. 

Does day 180 of all failed exchanges equal day zero for QOZ purposes? Unfortunately, no definitive answer exists today. However, there is substantial evidence that supports the proposition that decisions will favor the taxpayer and that the 1031 exchange timeline and the QOZ timeline run consecutively. Under this theory, taxpayers involved in a failed 1031 exchange should have an additional 180 days to complete their QOZ investment.

Of course, all investors should seek guidance and review their specific situation with their tax and/or legal advisor(s).

Michael Burwick Esq, JD, LLM, is a tax, corporate, and securities attorney and he heads the firm’s efforts with respect to tax deferral, tax mitigation, and tax minimization. Mr. Burwick has developed and successfully implemented numerous tax strategies taken directly from heretofore sparsely used sections of the Internal Revenue Code (IRC). In employing these strategies,  Mr. Burwick has helped businesses of sizes ranging from several million dollars to several hundred million dollars, high-net-worth individuals, families, and other entities navigate the timing and payment of both capital gains and ordinary income taxes in a way that has saved these taxpayers a great deal of money and has resulted in capital that would have otherwise been paid in the form of taxes at the time of sale or during the year earned be put to work for the taxpayer whereby tax obligations have been deferred and are paid over time.

Kyle Kadish believes tax policy should encourage behavior or stimulate the economy.  Putting words into action, Mr Kadish focuses his time on tax strategies for real estate investors, ultra-high net worth families, and business owners.  As President of Advantage Wealth Solutions, Mr. Kadish works to defer, reduce, or mitigate tax liabilities through well founded, yet often underutilized, areas of the IRC.  His client base most often capitalizes tax efficiency through §453, §664, §721, §1031, and §1400z, among other sections of the Internal Revenue Code. Mr. Kadish is also the Due Diligence Officer for TAG Group, Ltd.  In this role, he sources and directs investment opportunities and securities structures for the firm’s SEC Registered Investment Advisor and FINRA broker-dealer.