Originally posted September 2020
Edited April 2024
Discover if this investment is right for you
Real estate investors could defer paying capital gains tax by conducting a tax deferred exchange. While that is still the case, today Opportunity Zone investments could serve as a viable alternative for 1031 investors.
This article discusses how investors considering a 1031 exchange may benefit from investing in replacement property in an Opportunity Zone, and the key differences to be aware of.
Main Benefits of a 1031 Exchange
There are three main benefits real estate investors receive when conducting a 1031 exchange:1
- Indefinite deferral of capital gains tax, provided that the proper rules are followed for every subsequent 1031 exchange.
- Estate planning can be easier with a 1031 exchange, due to the stepped-up basis to the market value of the asset which potentially eliminates tax liabilities.
- Property purchased in a 1031 exchange can be located anywhere in the U.S., providing investors with a wide variety of replacement options for the upleg of a Section 1031 exchange.
Main Benefits of an Opportunity Zone Investment
Opportunity Zone (OZ) investments also have their distinct advantages that a replacement property in a 1031 may not offer:
- Ability to diversify into other asset classes such as infrastructure development, local businesses, along with real estate.
- Process for investing in an Opportunity Zone is less cumbersome, with no qualified intermediary involved and a full 180 days to make an informed investment decision that may better match an investor’s risk profile and return objectives.
- Ability to better diversify the entire investment portfolio by investing in a multi-asset Qualified Opportunity Fund (QOF) that can provide multiple revenue streams to an investor.
Key Differences: 1031 Exchange vs. Opportunity Zone Investments
Both a 1031 exchange and an Opportunity Zone investment allow for the deferral of capital gain, but the costs and benefits are different. Investors should consider factors such as broader portfolio goals, real estate asset class preference, and liquidity needs when choosing between the two options for deferring capital gains tax.
In 2019, the CCIM Institute recently published these key differences between a 1031 Exchange and a Qualified Opportunity Fund investment:2
1031 Exchange
- Relinquished and replacement property must be “like kind” real estate
- Disposition proceeds must be used and tracked through the entire exchange process using a qualified intermediary
- Total amount of sales proceeds received must be reinvested
- Strict property identification rules including the three-property rule and the 200 percent rule
- No reduction in capital gain
- Capital gains can be deferred indefinitely
- 45-day limit to identify one or more replacement properties
- 180-day limit to close on replacement property
- Replacement property must be identified in advance
- Flexibility to refinance, sell, or exchange the replacement property after purchase
- Reverse 1031 exchange allows to close on replacement property first, before selling the relinquished property, while still deferring the capital gain
Qualified Opportunity Fund
- Capital gains from any asset sale (such as stocks and bonds, a business, precious metals or cryptocurrency) can be deferred by investing in a QOF
- Any source of funds may be used
- Only the capital gain must be reinvested, not the entire amount of sales proceeds
- Provide an additional 10% reduction on capital gains taxes owed if the property held for at least 5 years
- Additional gains from Opportunity Zone investments are not subject to capital gains tax, provided the property is held for at least 10 years
- Although capital gains must be reinvested within 180 days, the QOF may take more time to deploy the funds
- No advance identification of properties is required
- Capital gains taxes are deferred only until the end of 2026, not indefinitely as with a 1031 exchange
- Opportunity Zone investments often require substantial improvements or repositioning, which may increase the amount of investment risk
- Opportunity Zones are often cited for unfairly benefiting wealth investors, creating potential uncertainty for investors if the law is changed or repealed
Tax Breaks: 1031 vs. Opportunity Zones
The specific tax breaks offered by 1031 exchanges and Opportunity Zone investments also differ in significant ways. The NAIOP Commercial Real Estate Development Association compares and contrasts how capital gains taxes are treated in a 1031 vs. Opportunity Zones:3
Deferral of capital gains tax
Capital gains can theoretically be deferred indefinitely by using a 1031 exchange, when funds are rolled over from one replacement property to another, time after time. When an investor passes away, the property basis is stepped-up to fair market value, which means the heirs may pay no capital gains tax whatsoever.
However, Opportunity Zones have a hard deadline of December 31, 2026 after which the tax on capital gains tax must be paid. Unlike a 1031, rollovers are not an option when investing in Opportunity Zones.
Reduction of capital gains tax
Although a 1031 exchange can indefinitely defer capital gains tax, the process can’t reduce the capital gains tax. On the other hand, Opportunity Zones can.
If an OZ investment is held for at least five years, the capital gains tax liability is reduced by 10%. Any additional gains from the investment are also free from capital gains tax, provided the investment is held for at least 10 years.
Capital gains tax at disposition
If an investor is still alive when the final 1031 property is sold, all capital gains associated with the 1031 exchange are taxed. But, if the investor dies before the property is liquidated, the basis is stepped-up to fair market value, essentially eliminating capital gains tax liability for the heirs.
Opportunity Zone investments offer a similar potential benefit, provided the OZ investment is held for at least 10 years.
If the property is sold after 10 years, the basis is stepped-up to full market value, which entirely eliminates any capital gain on appreciation. However, the initial capital gains taxes that were deferred by investing in an Opportunity Zone are still due after 2026, either from the investor or heirs.
Conclusion
Both a 1031 exchange and an Opportunity Zone investment can be used to reinvest gains from the sale of a property to defer taxation and gain tax benefits. Which method to use depends on an individual investor’s objectives, such as liquidity needs, portfolio diversification strategy, and long-term investment objectives.
LEARN MORE ABOUT 1031 EXCHANGE
DISCLAIMER
1031 EXCHANGE RISK: Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts, and certain tax consequences may vary depending on the individual circumstances of each investor. Section 1031 rules that must be carefully followed to qualify for a 1031 exchange. We strongly encourage you to seek guidance from both a qualified intermediary (QI) and a tax professional to navigate his process and ensure compliance with relevant regulations. Please note that RealtyMogul does not provide tax advice.
References
2. https://www.ccim.com/cire-magazine/articles/2019/03/opportunity-zones-vs-1031-exchanges/