What are the differences between Opportunity Zones and 1031 Exchanges? And why might one be a good choice for your own investments?

Which method to use depends largely on investor’s unique set of goals, objectives, and priorities. Jay Frank, the President of Cantor Fitzgerald Capital and Chief Operating Officer of Cantor Fitzgerald Investment Management, shares his perspective on the benefits and advantages of 1031 exchanges. Cantor Fitzgerald is a global financial services and real estate investment management firm. Jay is involved in overseeing the day-to-day operations of the business, providing direction and implementing strategic initiatives. 

Click the play button above to listen to our conversation with Jay.

Episode Highlights

• The differences between Opportunity Zones and 1031 Exchanges.
• Origins of 1031 exchanges – how they came to be and what they look like today.
• An introduction to the 721 Exchange and how it can be a useful tool for both investors and operators of commercial real estate.
• Comparing and contrasting 1031s and other options investors have with Opportunity Zones when selling a real estate property.
• A fund manager’s perspective on what may happen with OZ legislation.
• Market trends and investor perception specific to opportunity zones in 2022 and beyond.

Featured On This Episode

• Jay Frank on LinkedIn
• Cantor Fitzgerald
• Silverstein Properties

Industry Spotlight: Cantor Fitzgerald

Cantor Fitzgerald is a leading global financial services firm, serving clients from over 30 offices around the world. Founded in 1945 as a securities brokerage and investment bank, the firm pioneered computer-based bond trading, built one of the broadest distribution networks in the industry and became the market’s premier dealer of government securities.

Learn more about Cantor Fitzgerald

• Visit Cantor Fitzgerald
• Visit Cantor Fitzgerald on LinkedIn

About The Opportunity Zones Podcast

Hosted by OpportunityDb.com founder Jimmy Atkinson, The Opportunity Zones Podcast features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in opportunity zones.

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Show Transcript

Jimmy: Welcome to The Opportunity Zones Podcast. I’m your host, Jimmy Atkinson. And today, we’re going to undergo discussion on 1031 exchanges versus Opportunity Zones, and we’ll be discussing a few other topics as well. Joining me today to discuss this topic is Jay Frank, president of Cantor Fitzgerald Capital, and co-head of their real estate investment management business. He’s coming to us today from Santa Monica, California. Jay, welcome to the show.

Jay: Thanks a lot, Jimmy. It’s great to be here. I feel like I kind of know you after three or four years of all the great work you’ve been doing, and kind of feel like a celebrity for the first time in my life. So, thank you.

Jimmy: Appreciate that, Jay. Thanks for the kind words. I’m excited to dive in with you today on today’s episode, Jay. We’re going to be discussing OZ’s and where we’re heading in 2022 and beyond, but also a discussion of comparing and contrasting 1031s and some other options that investors have with Opportunity Zones when they go to sell a real estate property. So, to open us up today, Cantor Fitzgerald is a global financial services firm. You guys have been around since 1945, a very large real estate investment platform. Then you guys have been very active in Opportunity Zones since very early on, almost since the inception of the Opportunity Zones program. So, Jay, on your platform, with all the experience that you and your firm have, where are you seeing Opportunity Zone flows, and have those flows changed from where they’re coming from over the last few months and years?

Jay: Good place to start, Jimmy. Thank you. And, you know, while the firm has been around since 1945, I personally have not been, but I have been living deeply in the OZ legislation, you know, going back to December of ’17, when the TCJA Act was put in place under the Trump administration. Also, it’s a good place to start, not the most exciting place to start, but to remind everyone that we do not make investment recommendations or provide investment, legal, or tax advice. So, anytime we’re dealing with complex topics like 1031s and Opportunity Zones, it’s very important that you consult professionals that are licensed to provide specific advice. But in terms of flows, Jimmy, you know, we’ve been at it for three years now, four years since we started looking at the program, and we launched an Opportunity Zone business here at Cantor at the end of ’18, early ’19, with a 50/50 joint venture with a firm called Silverstein Properties.

They’re kind of a newbie. They’ve only been around since 1957. So they’re a newbie from, compared to Cantor. Cantor and Silverstein share a very unique history. Cantor was the firm that occupied the top five floors of the North Tower prior to the 9/11 terrorist attacks. And Silverstein Property is Larry Silverstein, who started the company, and is still the chairman today. He’s in his early 90s. He owned the two buildings. Silverstein Properties owned the two towers, and over the last 20 years now, 20 and a half years, they’ve led the rebuilding efforts of the Freedom Tower and the other properties that make up the overall, the bigger World Trade Center redevelopment. So, in kind of an iconic real estate construction development investment firm, who we partner with, and we’ve now raised over about $600 million of capital in the Opportunity Zone program, and put a lot of money to work, and got a lot of cranes in the air in major cities across the country. So we’re really excited, and very active.

In terms of flows, you know, it’s interesting. And I deal with CPAs. I deal with attorneys, real estate agents, developers, and Ultra High Net worth and High Net Worth families. And I would say the majority of flows, the largest flows, come from people selling businesses or business interests. I’d say the second largest place of flows are people that are decreasing their equity exposure by taking risk out of the stock market, at especially times like now, when equities are priced close to where they were priced before the dot-com bubble, so you’re seeing a lot of people with a lot of gains from a very long bull market taking some of that risk off the table, and using the Opportunity Zone for the gain portion that’s generated. And then, to a lesser extent, I mean, you see it from our incollectibles. And then also, a lot less than I would think, Jimmy, you see it coming from people selling both investment real estate, as well as personal real estate, whether it’s a primary residents or a, you know, second home, a vacation home type thing.

Jimmy: Gotcha. That’s a good breakdown there, Jay. I wanna talk about 1031s primarily today, and how they compare and contrast with Opportunity Zones. For anyone who has a real estate investment property, and they go to sell it, they oftentimes have at their disposal what’s referred to as a Section 1031 exchange, which offers some great tax benefits. Before we dive into our discussion on how they compare and contrast with OZs, can you give us a brief explainer on what is a 1031 exchange exactly, for those listeners out there who may not be aware?

Jay: Yeah, absolutely. IRC, Internal Revenue Code, Section 1031, so it’s a part of the tax code. And it’s been around for over 100 years. So, it goes back to the early 20th century. It just celebrated its hundredth birthday. So, it’s been great legislation that’s created a lot of economic activity, tax revenue, jobs, and has helped create the real estate market that, you know, we have today, and the liquid capital market that supports it, which is very, very integral. But on its surface, a 1031 exchange is very simple. It’s only eligible for people selling real estate held for investment purposes. So, think rental properties. It’s not eligible for your home or a vacation home or a lake home or something like that.

So, if you’re selling your investment property…think a, you know, multifamily complex or something. If you sell that property, and you take the proceeds from the sale, both the equity and any debt, and you invest the same amount of money in a replacement property or properties, and you do so following the rules of the code and within the timeframe of the code, you defer the recognition of any taxes, both capital gain taxes on any appreciation of your property that you sold, as well as any depreciation recapture tax that you’ve been aggregating over all of the years that you’ve held the property.

So it’s a way to indefinitely defer taxes, potentially for your life. One of the jokes, Jimmy, is “swap till you drop.” If you exchange, exchange, exchange, and you pass away, your basis steps up, your estate, your kids, whatever, your beneficiaries inherit your property and the estate, the tax basis on that property steps up, and taxes are thus never paid. So 100-year-old legislation, it has been attacked by multiple administrations now, most recently by the Biden Administration. It was originally gonna be limited under the American Families Plan, which has ultimately turned into the Build Back Better plan, or the BBB, which is still, you know, fighting in Washington. And the portion of the BBB that was gonna limit 1031s was actually removed from the Build Back Better plan. So, as of now, 1031 lives on, and for good reason. It’s great legislation. It’s great for the United States.

Jimmy: It’s been on its deathbed a handful of times, as you mentioned, but it keeps on ticking, it seems. And I guess it’s just turned 100 years old, as you mentioned, which is phenomenal. Has a lot more history and a lot more…it’s a lot more familiar to real estate investors than Opportunity Zone investing. But Opportunity Zone investing is one of those options that real estate investors have when they go to sell their property. Jay, you’ve had a lot of conversations with advisors and CPAs and attorneys over the course of your career, I’m certain, in regards to the situation that clients find themselves in when they do sell their investment properties. What are a client’s options typically when they go to sell, or when they’re looking to sell a property?

Jay: Yeah. Number one, they could choose not to sell the property. What’s the rule of medicine? “First, do no harm.” So, the first one is not sell the property, and keep owning it. And actually, that’s not always a bad way to go. Number two, also very obvious, is they could decide to just simply pay taxes and go that route.

Jimmy: Those are probably the two most popular options, I would guess.

Jay: Probably the two most popular options. And by the way, option two is not always planned. Meaning, a lot of people plan to do a 1031 exchange, and life gets in the way, you know, following the rules, identifying replacement property, the short timeframe that you have to complete it. There is some complexity to completing a 1031 exchange, and sometimes, your deal falls through and you end up just paying the taxes. So, not always by choice, Jimmy, but you’re correct. It is a popular outcome.

So, third option is 1031 exchange, right? You could either go find a replacement property on your own, you could hire a real estate broker. And that’s obviously the biggest portion of the 1031 exchange market. But a smaller, less-known part of the 1031 market is what I will informally refer to as securitized 1031s. There’s different types of products that real estate companies put out, where a client can get access to replacement property via a fractional interest, through securitized 1031, utilizing different structures. Some of those structures are a what’s called a DST, or a Delaware Statutory Trust, a Tenant-In-Common, or a “TIC” is sometimes a popular structure. And there’s also structures that’s similar to a 1031 that are called 721 tax-deferred real estate exchange.

So that third option, of doing a 1031, there are multiple paths, right? Your traditional, through a broker, buy another piece of property on your own, but there’s also securitized 1031s. I’ll give you an example. A firm goes out and buys a $100 million Microsoft building, you know, an office building leased to Microsoft, for $100 million. Individual investors could then buy a fractional interest of the $100 million, to qualify under IRC Section 1031 for replacement property. So, if you have a $500,000 exchange, a $200,000 exchange, a $5 million exchange, you can buy that amount of the $100 million Microsoft, a fractional interest, and that can qualify.

Jimmy: I think that’s a great option, oftentimes, because it gives you access to institutional quality properties that you might not otherwise get directly. And in some ways, it’s a little bit easier to do that, too. You don’t have to hire a broker to work with a qualified intermediary to actually accomplish a 1031 exchange. Is that right?

Jay: That’s right. And when they say there’s no free lunch, or the grass is always greener, there’s also negatives to those types of products, depending on who you… Yeah. I mean, there can be, you know, fee structures are very important, because you’re gonna be paying, whoever’s putting that together is gonna charge fees, as they should, right? They need to make money or else why would they do it? But you need, you know, not all fee structures are created equally, so you need to make sure that you’re working with a great operator, right? That knows how to buy, diligence, underwrite, finance, manage, dispose of the real estate, and needs to have a transparent fee structure that’s not gonna dilute your overall return. But, you know, the positives are also obvious, which is companies will have these available right now. So, if you’re in that 45-day window, where you have to identify what your replacement property’s gonna be, which can be really hard to do when you’re trying to find a property on your own, there’s these DSTs sitting out there that are available for you to identify. And they’re already owned, they’re already financed, they’re already under management, and you can just buy a fractional interest. So, the ease of completing one is a big, big benefit, due to the complexities of completing a 1031.

The other thing is, you nailed it. Institutional quality access, you know, someone with $1 million, $2 million, even as little as $100,000, they’re not gonna get access to $100 million building with a long-term lease to Microsoft in whatever, Seattle. And what goes with that, too, is institutional management, right? Institutional financing. A big institutional real estate player is gonna be able to secure more attractive financing, with better terms, that’s typically non-recourse to the investors than someone’s gonna be able to do on their own, without someone putting on a personal guarantee sign their life away. So there’s a lot of potential benefits, but you know, the investor will tend to lose control of the asset. You know, they’re not gonna decide to release Microsoft and negotiate a lease with Microsoft. They’re not gonna make the decision to refinance a $50 million mortgage on the property. They’re not gonna make the decision in five years that it’s time to sell that asset. So there’s a lot of positives. There’s also negatives, so they’re not for everybody.

Jimmy: Yep. So, to recap, I think we’ve gotten through a few of the options so far, six options. One, not sell, two, sell and pay taxes, three, hire a broker, do a 1031 exchange, four is this securitized 1031 exchange, in the form of a Delaware Statutory Trust, or a DST. And I think that brings us to number five, which is the section 721 UPREIT. Tell us about that one.

Jay: Yeah. That’s unfortunately probably the most complex, so I’m trying to keep it brief, but…

Jimmy: Keep it simple.

Jay: …essentially… Yeah. And the Section 721, like 1031, is part of the Internal Revenue Code. And most people know about 1031s. Most people do not know about 721. But a 721 is very similar to a 1031, in that you’re selling investment property. And if you take the proceeds and invest it in the operating partnership unit of a real estate investment trust, or a REIT, you can defer the recognition of taxes. So it’s very similar to 1031, but a 1031 is sell real property, exchange into real property. A 721 is sell real property and exchange into a much larger REIT. And again, there are pluses and minuses of that option. Obviously, most REITs, publicly-traded REITs, non-traded REITs, what have you, they’re not buying $500,000 condos or $2 million multifamily complexes, as part of their portfolio. They wanna buy $50, $100, $150, $200 million type institutional properties.

And so, one new type of option that has really come out in the last five, six years, it’s very interesting, we call it the two-step transaction. A client could sell their million-dollar duplex. They could do a 1031 exchange, step one, a 1031 exchange into that $100 million Microsoft DST. They’re gonna buy a $1 million fractional, 1% fractional interest, of a $100 million property. And then, two or more years later, that Microsoft property could be sold, through a 721 exchange, to a much larger REIT, that wants to own $100 million Microsoft buildings. And the client’s second step would be to go up into that REIT, again, maintain that tax-deferred status. Positives are you’re going to a much larger, theoretically, larger, more diversified portfolio, with more risk mitigant measures and protections in place, some liquidity might be built into it, especially if it’s a publicly-traded REIT, daily liquid. If you were to pass away, your basis would step up, and your beneficiaries, your estate, would be able to get access to the investment, with no tax liability, right?

And then, some of the negatives. Again, you’re losing control. There’s gonna be cost involved for the firms that put these together, and you’re never able to do another 1031 exchange, right? It’s your last stop. So, again, they’re not for everybody, but it’s another option. It’s a fifth option. So…

Jimmy: And then the sixth option, I think is… Well, I think it’s my favorite one, right? It’s Opportunity Zone investing. So, I think our listeners are very familiar with Opportunity Zones at this point. So, in your conversations, Jay, with different advisors, CPAs, attorneys, financial advisors, what are their levels of fluency with these six different options?

Jay: Human beings do not talk about things they’re not comfortable talking about, right? And especially professionals, they do not…professionally being lawyers, attorneys, etc., CPAs, they don’t wanna talk about something that they’re…have the chance of looking stupid. And I think one of the problems of the Opportunity Zone… I think the government got a lot of things right with the program. And I think the final regs cleaned up a lot of the original issues of the legislation, but I’m very supportive of the program. I’m an ambassador, as you are. But one of the negatives, and I’m not sure there was a better way to do it, is the complexities. And even though OZs have been out for four years, which seems like a long time, that’s 96 years less than 1031s have been around.

Jimmy: And it’ll always be 96 years less than 1031s, right? So that’s the problem, they’re playing catch-up.

Jay: That’s right. And the percentage difference will get smaller, but the absolute… So, the learning curve For Opportunity Zones is steep, and it’s steeper than 1031 exchanges. So, time, plus complexity is, I think, what has kept more capital formation in the space, which comes from these professionals that provide advice to investors from doing so. And so, a big part of what we do every single day are continuing education presentations for CPAs, for financial advisors, for attorneys, to teach them about all six of these tool, and which ones are better for investors in different situations. And sometimes, two or three of the six can be used in the same situation, for the same client selling a property, part of the proceeds go into their own exchange, part of it goes into a DST, part of it they pay taxes on, part of it goes into Opportunity Zone.

There’s a lot of complexity here, but the advisors that are doing the best job, they might not be fluent in all six languages, you know, options one through six, but it’s kinda like, I joke, like, you know, conversational Spanish, like, I could get around Mexico if I needed to, but I’m certainly not fluent. If they just need to be conversational, so that they provide all options to the client, to make sure they’re acting in the client’s best interest, because every single case is different. But that’s what I think is holding it back. And, you know, we have come a long way in the last four years. Credit to individuals and firms like yours.

Jimmy: Well, I agree with you. I think advisors oftentimes are very familiar with many of the options, particularly the first three, don’t sell, pay taxes, hire a broker, do a 1031 exchange. Maybe they have some familiarity with DSTs, but yeah, the 721 UPREIT is a little bit esoteric, I suppose. And OZ funds, in particular, are esoteric, and they’re brand new as well. And I think we still have a long way to go before enough advisors and CPAs and other types of advisors have enough of that conversational fluency, as you mentioned. They should know enough to be dangerous at least, and be able to point their clients in the right direction. I think we’re getting better at that as the years have gone by. But, you know, certainly, in the first few years of the program here, there wasn’t enough awareness of Opportunity Zones, and I hope that’s changing slowly but surely, as each day passes. So, Jay, what are some considerations that an investor selling a real estate property should take when he’s trying to decide which of these six options to take? When is a 1031 the best route? When is a DST the best route? When is an OZ fund the best route?

Jay: The first thing they should do is make sure they’re getting advice from their CPA, tax attorney, and/or financial advisor, right, that’s acting in their best interest. Getting professional help, that’s critical.

Jimmy: Right. And you are not giving advice right now during this podcast, just to be clear.

Jay: Thank you very much. That’s right. I am not giving advice. I’m not a CPA, I’m not an attorney, but I do enjoy talking about it. As do you. And I know a lot about it, obviously. That’s the first step. The second thing, and I’ll try and keep this very general. If you have…the smaller gain you have, the more likely just paying the taxes on that small gain is gonna make sense. You got a $1 million property, and if you sell it and pay taxes, you’re gonna owe $30 grand in taxes because you have such a small gain, or you’re gonna take all million dollars and do a 1031 exchange? There’s definitely a time and a place to do a 1031 in that example. But at some point in time, it’s kinda like let’s just pay the taxes and have more flexibility on where you go from here, right?

Jimmy: Yep.

Jay: That’s probably the biggest takeaway is there’s no right or wrong answer. There’s no rule. A lot of this has to do with investor preference. What’s your age? What’s your risk tolerance? What’s your sophistication? What’s your liquidity needs? What’s your estate planning situation? What’s your capital gain? How long have you owned it? Is it short-term or long-term? How much depreciation do you have? What are your kids or your kids’ kids? What are their interest in continuing the real estate business when you don’t want to do it anymore? What’s the rest of your portfolio look like?

So there’s a lot of complexity that transcends just the real estate being sold. It’s about your overall financial picture. And that’s why getting good advice is so paramount. But here’s where we’ll generally go when we’re talking about 1031s versus Opportunity Zones. 1031s tend to be superior the lower the basis the client has on the property they’re selling, and the more debt they have on the property. So, the lower your basis and the more debt. To use a real example, you bought a property for a million dollars. You sell it for a million and a half, and you’ve depreciated that million-dollar property to zero, because you’ve owned it for 30-something years, and you have a half-million dollars of debt on the property. So, here you are, your basis is zero. So everything above zero, you’re gonna owe some sort of taxes on it, whether it’s cap gains tax or depreciation recapture, and you have a loan on it. And so, if you decide to just pay taxes, you gotta pay the loan off, and then you owe taxes on all million and a half of the sale. If you do an Opportunity Zone investment, you gotta pay off the half a million dollar loan, and you need to put a million and a half dollars into the Opportunity Zone, but you only have a million bucks, right?

Because when you sold the property for a million and a half, the first 500 went to the bank to pay off the loan. So, you either need to come out of pocket with an additional half-million, to fund the full one and a half million in the OZ to defer all your taxes, or you’re gonna have a partial taxable event. Generally speaking, that is textbook 1031 exchange. Whether that’s 1031 on your own, DST, 721, etc., that’s a whole different planning discussion with your financial team. But that’s a textbook 1031. A textbook Opportunity Zone, so, the other end of the bookend, the less debt you have, and the more basis you have, the more attractive the OZ is. So, the example is, you buy a property for a million. Let’s say the property was land. So you don’t depreciate it, Jimmy. So, your basis is still a million, and you sell it for a million and a half, and you never had debt. You just owned it all outright, right? Which is not uncommon.

So, no debt, and a high basis, right? And a high basis relative to the sale price. So, let’s walk through what that looks like. If you just wanna pay taxes, you’re gonna owe taxes on the half a million dollars of gain. Okay? You got a million and a half proceeds, you gonna owe taxes on a half million, there you go. Number two, do a 1031 exchange, okay? That, a lot of people will do a 1031 in this example. You take the full million and a half, and you exchange it in a replacement property, using any of the 1031 options, option three, four, or five, that are available to you. Not a bad outcome, and you’ve deferred the recognition of taxes on that half-million dollar gain. But you still got all of your money tied up in a new 1031.

The Opportunity Zone, in my opinion, this is textbook Opportunity Zone, because this is how it works with the Opportunity Zone. You sell the million and a half dollar property, that million-dollar basis, you get to put in your pocket tax-free. You get to take those chips off the table. Only the half-million dollars of gain is even eligible for investment in OZ for, to get the tax benefits, by the way, as you know, Jimmy, and as your listeners have been taught by you. So, the half million is the only thing that needs to go into the Opportunity Zone. You get all the tax benefits of the Opportunity Zone program, and you took a million dollars of liquidity off the table, outta the game, no longer subject to any sort of IRS tax regime. So in that situation, the Opportunity Zone seems very attractive. Every other case falls somewhere in the middle of those two examples, and it depends on who you are and what you’re looking for.

Jimmy: Yeah. I was visualizing a four-quadrant chart, or some sort of matrix while you were talking, where you’ve got four different boxes. You’ve got basis on one axis and you’ve got debt on the other axis, and depending on which quadrant you’re in, if you’re firmly in one corner or the other, 1031 or OZ, but otherwise, a little more gray area. Might depend on your personal situation. So, in your experience, Jay, looking at some examples coming in through your platform, or some clients come across you, or just based on conversations that you’ve had with advisors and CPAs, how often would you estimate is an OZ fund better for a particular investor who’s selling a real estate investment property than a 1031 exchange?

Jay: Yeah, I haven’t got this one in a while. A couple years ago, we started asking ourselves the same question. And our hypothesis, which proved to be wrong, was that Opportunity Zones are probably more attractive than a 1031 20%, 25% of the time. Which, by the way, when you look at the 1031 exchange market, Jimmy, it’s well over a hundred billion dollars a year. So 20%, 25% is not a small number, right? You’re talking about tens of billions of dollars. It’s a huge market opportunity of money that probably should be going into OZs. That was our hypothesis. And we ended up internally building out a pretty complex calculator, that compared paying taxes, doing a 1031, doing an opportunity zone, and running it through a 10-year simulation of expected return, amplified by the various tax benefits of the different of legislation.

And when we started doing this and we started plugging real-life examples, we have an advisor, “Hey, I got, you know, John’s selling this over here.” “Okay. What’s his basis? How much debt? How long’s he owned it? What state you live in? What’s his tax bracket?: Right? There’s, I don’t know, 20-something different variables? Maybe 15 different variables? Plug it into the calculator and say, okay, after 10 years, if they both deliver an 8 IRR, or 10 IRR, whatever number you want to choose, this is how much money they’d have. This is how much money they’d get liquid today. This is what their situation would look like in 10-plus year. And, you know, here’s how much total taxes they would’ve paid, and here’s how much total taxes they did pay.

And what we started finding is about 50% of the time, maybe even slightly more than 50% of the time, the Opportunity Zone was a superior route to go, and we were shocked. And I would also add, I think I’m unbiased here, because we have a major 1031 exchange platform at Cantor Fitzgerald. It’s a slightly bigger business for us than our Opportunity Zone business, so I’m definitely biased to both of these together, but between one or the other, I’m not biased. It was simply, like, what’s best for the client? And we found that at least half, if not slightly more than a half of the time, the Opportunity Zone. Now, if you’re talking to myself, you know, I’m in my working years, I’m making money, I don’t need income, I’m thinking about growth, and, you know, long-term value creation, I’m gonna skew more towards Opportunity Zone in these situations. And someone who’s retired, 75 years old, they’re trying to generate safety and income off their portfolio, and they have other different considerations than I have with where I am in my life, that person might skew more towards the 1031 route for a bunch of different situations. So the personal element is one of the most important elements when making these decisions and considering your alternatives.

Jimmy: Sure. But at least half of the time, it seems that an OZ fund would actually be better for a client than a 1031 exchange. But given that, how often do you see investors make that choice of deferring their capital gain into an OZ fund, versus a 1031 exchange? What’s the actual split on what investors do?

Jay: I think it’s a low single-digit percentage. And that right there is the fallacy, because investors… It’s not even…you said it, you worded it as what percent are making the decision, right? I would take it a step back. Most of these investors don’t even know that the Opportunity Zone is an option, because their professionals aren’t telling them about it. And it might be not that their professionals are trying to harm them. They just don’t know themself, right? The Opportunity Zone is new, four years, and relatively complex, and not everybody’s fluent. And people don’t talk about things they’re not comfortable talking about, especially when they’re in a position to give advice. So, that’s the unfortunate part, and I think if people are aware of all their options, and can do their analysis, I think they’ll find that an opportunity zone is actually a superior route for them, often. A lot more than 1% or 2% of the time, and probably closer to 50-plus percent of the time.

Jimmy: Yeah. That’s amazing.

Jay: I think we’re seeing more, and we’re seeing, you know, this conversation, I feel like I’ve had a lot of time, during presentations over the last couple of years, all over the country, we’re teaching people about these tools so that they can lay out all the options and understand them for the client, and help them provide better advice to individuals.

Jimmy: Why aren’t we seeing more real estate gains from investment properties going into OZs? Why is it only 1% to 2% of the time, when it should be closer to 50%, in the examples we were given before?

Jay: Most 1031 exchanges are done through a real estate broker. A real estate broker is real estate licensed, not securities licensed. Opportunity Zones funds, while they do not have to be, tend to be securities transaction. So, real estate brokers can’t get compensated on an Opportunity Zone fund, most of the time. So it’s not in their best interest to understand Opportunity Zones. It’s not in their best interest to become expert. It’s not in their best interest to tell their client, who called them about finding a replacement property, “Oh, maybe you should look at Opportunity Zones.” Right? So, the advice is gonna come… And when you’re selling a property, your first spot is not like, “Oh, let me see what my CPA thinks,” or, “Lemme see what my financial advisor or my estate planning attorney thinks.” Your first call, “Hey, call my broker. Hey, I got 45 days to identify, what do you got? You know, I’m looking for a new rental income property, and I got a gun to my head, and I gotta move quick. What’s out there?”

And probably, that first call maybe should be, well, multiple calls should be to the whole team selling the property. “Here’s the situation. Let’s explore my options, and what direction should I go?” And it’s that broader financial team, financial advisor, wealth manager, CPA, attorney, etc., those are the individuals that are probably in the better position to bring this up as a potential option that might be in their best interest. That’s a big part of it, and like what we said earlier, four years, OZs, 100 years, 1031, complexity of OZs, simplicity of 1031, the familiarity bias is a big deal, and 1031s are great. They’re a incredibly powerful tool, and a lot of people have been using them to build their wealth for generation. You know, it’s been a longer than almost everyone who’s alive in the world today. So, I think that helps to explain it. And 1031s are great. I’m not saying anything bad about 1031s. They’re a great option, and that’s why so many people use them.

Jimmy: Oh, absolutely. And just other thing I want to add in is, you know, oftentimes, if you blow through your 1031 exchange, particularly if you miss your 45-day identification period, OZs are still a good option for you, because OZs, there’s no 45-day rule. It’s just the 180 rule, after you realize a gain. So, I just wanted to point that out. If you’re sitting on the sidelines with a 1031 exchange and you think you blew it, you might still have some time to do an Opportunity Zone investment.

Jay: Let’s expand that, Jimmy.

Jimmy: Yeah. Go for it.

Jay: Any gain… Forget real estate for a second. Well, real estate included. Any gain that’s generated on a K-1 tax form, which is how most real estate gains are generated, that’s how most business gains, right? S-corps, LLCs, will generate K-1s, not a 1099. So, any type of gain that’s passed through on a K-1, you don’t just have 180 days. You actually have 180 days from the date your tax return is due. And so, if you sold a property in January of 2021, not last month, 2021, a long time ago, right, over a year ago, your tax return’s due March 15th of 2022, right? Fast forward 180 days from March 15th, 2022 lands you on 9/11 of 2022. You actually still, on a gain that you’ve already probably will pay taxes on, and even if you didn’t even know OZs were a thing until this call…

Jimmy: Maybe long forgotten about that sale, even.

Jay: Long forgot about that sale. Six-figure, seven-figure tax liability has already been paid. That is still in play until September for eligibility. So there are a lot of those types of small things, whether it’s you blew your ID period, you know, you weren’t able to execute, or you took constructive receipt, and you didn’t realize you couldn’t do that with a 1031, or it’s a gain from a long time ago, but it was on a K-1, so it’s still eligible. There’s a lot of those out there, and, you know, a lot of people could save a lot of money in taxes if they just knew more about this.

Jimmy: Yep, absolutely, Jay. Well put. I’m glad you brought that up. Wasn’t sure if I wanted to get into that, but you described it nicely. Thank you. Couple of grab bag questions quickly before we go here. We’re coming down to the end of our episode today. Did we talk about that fourth hidden benefit, or now its’s the third hidden benefit of Opportunity Zone investing, unrecaptured gain?

Jay: That’s funny. We did, and I’ll add to that. So, someone called me after the Super Bowl, and remember, I live in Santa Monica, so it was down LA, in SoFi in Inglewood, and Dr. Dre was the halftime show. So, a lot of people would call me, they said, “Now I understand your Dre analogy. I didn’t understand the joke about Dr. Dre.” I’m like, “Really? You didn’t understand?” So defer, reduce and eliminate, right, were the three primary tax benefits. The defer was powerful, the reduction was a very small tax benefit, and the elimination of cap gains, if held for 10 years or longer, was the by far and away the most lucrative benefit, assuming the fund performs well. The fourth tax benefit, now the third, hidden, because the R in “DRE” is gone, right? So, it’s just DE, you know, defer and eliminate?

The third one, it’s part of elimination. And the third tax benefit is you depreciate real estate, right? So, this has, there’s two implications here. One, if you own your own real estate, like we were talking about earlier, and you have depreciation, that depreciation is eligible for investment into an Opportunity Zone fund. The final regs of OZ land allow you to treat unrecaptured straight-line depreciation as gain for OZ tax purposes. So, a lot of people don’t know that, and that is another reason why people don’t always think OZs when they’re selling real estate, and they think 1031. That’s really important to understand that. The second one, more specific to the question you’re asking, is once you’ve invested a gain in an Opportunity Zone fund, assuming the OZ fund’s doing real estate development. Most are, right? Once those buildings are put into use, you know, certificate of occupancy, you start depreciating those properties.

And because of the Tax Cuts and Jobs Act, and because of new construction, there is a tremendous amount of depreciation through bonus depreciation that is passed through to investors over the first 10 years life of that new asset, which happens to perfectly correspond with the holding period of an OZ fund, right. Ten years plus is the critical number to get to maximize the tax benefits. Well, the hidden tax benefit, this is extremely lucrative and important, is after 10 years, your basis steps up to fair market value. That eliminates all new capital gain taxes generated by the fund over the whole period. That’s the tax benefit everyone knows about. It also eliminates all recapture of the new depreciation that’s been taken from owning that asset and depreciating that asset during that whole period. So those appreciation expense is gonna lead to any rental income distributions that are paid to investors over the whole period being highly tax-efficient, if not 100% tax-efficient, none of which is recaptured. Because your basis steps up after 10 years upon exit, up until 2047. So there are several tax benefits. Combining all three is the holy grail, and often misunderstood.

Jimmy: Yeah. Well put there. I love the “DRE” acronym. I used that as well for the first two or three years of the program, defer, reduce and eliminate. Great Super Bowl, by the way. I grew up in LA myself, grew up a Rams fan in the ’80s and ’90s, and I was definitely happy that the Rams won on Sunday. “Go Rams,” I should say. Before we go, Jay, let’s get your take on all things OZs for the rest of the year here in 2022. How do you view the opportunity today and going forward with Opportunity Zones?

Jay: Sure. And I don’t think this is a necessarily a popular belief, but I think that the Opportunity Zone program as a whole, not in a perfect, straight, linear line, but when we get to 2026, at the end of ’26, when this program, as of now is set to sunset and go away, hopefully gets extended or made permanent. But assuming it goes away, I think more money is collectively raised year after year after year after year, more than the last, that some of the tax benefits get a little diluted as time goes by, but the 10-year tax benefit will always be in place, right? But I think, due to the compounding effect of education, the momentum of what you and me and everyone else is doing, leading to more and more money coming in the program, 1% of people selling real estate to consider OZs, three years from now might be 10%.

And that is a significant increase in flows, that should and could be coming into the space. So I’m of the belief that more money continues to go into the QOZ program for the next five years, before this thing goes away, mainly due to education about how lucrative the program can be. And by the way, not just lucrative for people’s wallets, which is important, very important, but also lucrative for these lower-income communities that could use investment. And by the way, you and I didn’t plan this, but Inglewood, and where SoFi Stadium is, in that area, a lot of it’s in an Opportunity Zone. And so, you think about all those dollars, and Super Bowl dollars, and $6 million that was invested in the local community over the Super Bowl weekend, you know, that’s going into small businesses, minority communities, it’s creating jobs, it’s creating tax revenue, it’s attracting investment. And the fact that that was an Opportunity Zone enabled some, a lot of this to happen. So there’s a lot of good things coming from these QOZ programs. Big fan, and I hope it’s made permanent.

Jimmy: Absolutely, Jay. And that reminds me, three years ago, I actually wrote an article on the NFL stadium neighborhoods that were located in Opportunity Zones. There’s quite a few of them. I think they were… I’m looking at the article now. There’s 18 as of when I wrote this. I don’t think that it’s changed. So, I’ll post a link to that in the show notes today. But yeah, right of you to point out that Inglewood, kind of a downtrodden area for many years, and, you know, the area around SoFi is really helping to revitalize that area, Jay. Absolutely correct. Well, Jay, it’s been a pleasure speaking with you today. I think we’ve got all caught up on 1031s and other options versus Opportunity Zones for real estate investors who are selling investment properties. Before we go, Jay, can you tell our listeners where they can go to learn more about you and Cantor Fitzgerald?

Jay: Yeah. Thanks. Obviously, OpportunityDb is a phenomenal resource, and that’s why you’re listening to this podcast. But to learn more about Cantor, cantor.com, C-A-N-T-O-R.com, and click on real estate, and you’ll find some information there. Otherwise, our team’s available at 855-9CANTOR. 855-9CANTOR. Just google “Cantor Opportunity Zones,” and you should be able to find some educational content from us. So, thanks a lot, Jimmy. Keep up all the great work. A lot of respect for what you guys do, and really appreciate it.

Jimmy: Terrific, Jay. And for our listeners out there, as always, I will have show notes, as I mentioned, for today’s episode, on the Opportunity Zones database website. You can find those show notes at opportunitydb.com/podcast, and there you’ll find links to all of the resources that I discussed on today’s show with my guest, Jay Frank, from Cantor Fitzgerald. Jay, it’s been a pleasure. Thank you.

Jay: See you later.