For all their long-term tax advantages, real estate investments can also be structured to provide immediate tax benefits. For decades, investors have used Section 1031 exchanges, also known as like-kind exchanges, to swap real estate assets without triggering taxable gains. Now the new Qualified Opportunity Zone program provides another way to postpone and eliminate certain taxable gains. So, which is better, a 1031 tax exchange or a QOZ real estate investment?
What Is an Opportunity Zone?
The government established opportunity zones as part of the Jobs Act in 2017, adding them to the tax code to incentivize long-term investments in low-income urban and rural communities. An opportunity zone’s investment rolls over capital gains and helps a real estate investor to both earn more and keep more of their gains. Investors don’t buy properties directly in an opportunity zone; instead, they buy into an opportunity zone fund.
What is A 1031 Exchange?
1031 exchange rules offer similar benefits as opportunity zones; either capital gains tax deferral or elimination. A 1031 has a different framework than opportunity zones but gives you a similar outcome.
In a 1031 exchange, you must buy and sell properties within a short timeframe, but where you can invest isn’t limited geographically. These are called like-kind exchanges, where you’re exchanging one asset for another that is just “like” it.
Similarities Between 1031 Exchange and Qualified Opportunity Zones
- Both programs allow the investor to defer capital gains taxes on the property. While the rules and regulations for each plan are unique, each program gives tax deferral incentives. If deferred indefinitely, properties purchased under a 1031 Exchange will be inherited by your heirs at the time of your death, without any tax burden whatsoever.
- Both the 1031 Exchange and Opportunity Investment Fund encourage investors to reinvest their profits back into the real estate market. Therefore, both programs help keep the market secure. In the case of Opportunity Investment Funds, investors can also help rebuild impoverished and underserved communities, giving new life to previously underdeveloped areas. In both cases, the emphasis is on economic growth, helping not just the investor, but all those involved.
- Each program allows investors to diversify their investment portfolios. By adding commercial real estate investments to a portfolio, investors can protect their funds in the event of a significant stock market crash.
Differences Between 1031 Exchange and Qualified Opportunity Zones
However, this is often where these two investment vehicles diverge.
- Timeframe of Gain Deferral
Perhaps the primary difference between a 1031 exchange and an investment in a QOZ is the deferral timeline. For the 1031 exchange, an investor can defer tax on the gain from the original property sale until the sale of the replacement property. Alternatively, they can continue to roll the investment into a third property, and defer tax until the final property sells.
With QOZs, there is an option. QOZs allow for the deferral of tax on the gain until either the sale of the property or December 31, 2026, whichever comes first. With that in mind, 1031 exchanges may be more affective vehicles for longer-term deferral, since there is at present no deadline.
- QOZ Exclusions
Additionally, when it does come time to pay tax on the capital gain, there is a difference in how much of it will be taxed. With 1031 exchanges, it is straightforward. When the gain is eventually realized—when the property investment is sold for cash—the investor will need to recognize the full capital gain for tax purposes.
For QOZs, if the gain is deferred long enough by holding onto the investment, the investor may be able to receive exclusions on a percentage of the gain. For example, if the investment is held for more than five years, 10% of the gain can be excluded, meaning that only 90% of the final capital gain would be taxed. If held for seven years, the exclusion ticks up to 15%.
- Step Up Basis
If the QOZ investment is held for at least 10 years, the investor can receive the stepped-up basis on the investment. When the investment is eventually sold, the basis (or amount of original investment) is increased to the fair market value at the time of the sale. Since taxpayers are taxed on the capital gain, or difference between their basis and the sale price, this effectively makes the transaction tax-free. This does not exist with 1031 exchanges.
- Property Types
There are some subtle differences in the types of properties into which QOZ and 1031 exchange investments can be made.
With 1031 exchanges, replacement properties must be of a “like-kind” to the previous property sold, meaning it is “of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.” It must also be used for a trade or business or for investment. There are no geographic requirements.
Personal property (not real property) no longer qualifies for like-kind tax-free treatment, effective 1/1/2018. With QOZs, investments must be made by Qualified Opportunity Funds into Qualified Opportunity Zones, which are government-designated distressed communities across the country. Only property in these areas qualify for the tax-deferred/tax-free treatment.
- Original Investment
1031 exchanges follow the “like-kind” rule when it comes to the original capital investment, whereas with QOZs, any capital gain is allowed, whether from a real estate or stock market sale.
Which Investment Strategy is Best?
Both a 1031 Exchange and an Opportunity Investment Fund give investors tax advantages. Depending on your overall financial goals and your current real estate portfolio, only you can determine which investment option works best for you.
While 1031 Exchanges and Opportunity Investment Funds are two separate tracks that generally cannot be combined, there are ways to roll an existing 1031 into an Opportunity Zone purchase. For example, if you’re interested in purchasing a property using an Opportunity Investment Fund, you can sell the property on which you have a 1031 tax deferment. Upon that sale, you will use those funds to purchase an Opportunity Zone property. Now, you’re under an entirely different tax structure, but you can reduce your overall tax burden by owning the property for at least seven years.
How Sera Capital Can Help With 1031 Exchanges and Opportunity Investment Funds
First, we always recommend that any investor talk with a CPA or tax attorney who is knowledgeable about 1031 Exchanges and Opportunity Investment Funds. Our experts can give you the most up-to-date details regarding each investment strategy and help you find the option that works best for you and your family. If you have questions on which investment route makes the most sense for you, contact us at Sera Capital for professional guidance.