New tax reform laws drafted in 2017, have formed a unique investment category: Opportunity Zones. Qualified Opportunity Funds have made its way to the list of favorite ways to avoid or defer capital gains taxes on the trade of specific investment properties like 1031 Exchanges. However, 1031 Exchanges and Opportunity Zones are distinct in many ways. Let’s get a better understanding so that you can make an informed decision to choose the best option available for you.
What is 1031 Exchange?
A 1031 tax-deferred exchange allows investors to reinvest the profits from the trade of investment property in one or more replacement properties without inviting immediate federal (and most state) capital gains taxes on the appreciated value. When the sale and purchase fulfill the 1031 exchange standards, taxes are delayed until the newly procured property is sold. This deferral strategy can be duplicated through any number of exchanges until the tax liability crosses into the individual’s estate upon death.
What is Opportunity Zone Investing?
The Opportunity Zone program was designed to revitalize economically distressed neighborhoods using private investments rather than taxpayer dollars. To incite private participation in the Opportunity Zone program, taxpayers who buy in Qualified Opportunity Zones are qualified to benefit from capital gains tax incentives available exclusively through the program.
Common factors between 1031 Exchanges and Qualified Opportunity Funds
Both 1031 Exchanges and Opportunity Zones:
- Enable investors to delay recognizing the gain on the trade of an investment or property.
- Support investors to reinvest their earnings from previous investments, which helps retain capital in the real estate market, boosting growth.
Differences between 1031 Exchanges and Qualified Opportunity Funds
Despite the fundamental similarities between 1031 Exchanges and Opportunity zones, there are also notable differences in the benefits extended.
A significant difference between 1031 Exchange and investment into an Opportunity Zone is the period for which the taxes can be deferred. When the sale and purchase fulfill the 1031 exchange standards, taxes are delayed until the newly procured property is sold. This deferral strategy can be duplicated through any number of exchanges until the tax liability crosses into the individual’s estate upon death.
However, with a Qualified Opportunity Fund, the investor can delay the taxes on the capital gain from the sale of the prior property until the property is further sold or December 31, 2026, whichever comes earliest. As a result, 1031 exchange investors can defer recognition of their gain for a prolonged period than investors of a Qualified Opportunity Fund.
The eligible property types for investment into 1031 Exchanges and Opportunity Zones also differ. For a suitable 1031 Exchange, the IRS demands the replacement property to be of a “like-kind” to the property sold. The IRS establishes “like-kind” as “property of the same nature, class or character. Quality or grade are not considered important. Most real estate will be like-kind to other real estates.” Additionally, the property needs to be held for business, trade or investment. This implies that any commercial real estate is suitable for a 1031 Exchange.
However Qualified Opportunity Funds must buy in Opportunity Zones, which comprises of nominated distressed communities around the country. Hence only the properties in these zones are considered suitable for investment in a Qualified Opportunity Fund, unlike any profitable real estate for a 1031 Exchange. This is a massive hindrance for any active investor.
Opportunity zone investments have complexities that a 1031 exchange does not. Upon recognition of a capital gain, the Opportunity zone program expects investors to transfer their money to a Qualified Opportunity Fund (QOZ), within 180 days. The QOF is permitted six months to advance 90% of its assets into a project level entity, that will purchase and build the real estate. Once the funds are transferred to the project level entity, the project level entity should have a comprehensive development plan, including the correct address of the property to be acquired. The project level entity then gets 31 months to substantially enhance the purchased property in compliance with the business plan. After 31 months 70% of the assets of the project level entity must be suitable assets, i.e., substantially improved real estate. With a 1031 exchange, there are lesser complexities. Sellers have an identification period of 45 days to identify a suitable like-kind property and 180 days from the date of sale to acquire the exchange property.
1031 Exchanges remain the most popular way to defer taxes indefinitely and not to forget hassle free too. Opportunity Zone investing is a good option, but it is too complex in nature and doesn’t guarantee a fixed income stream. Connect with us if you would like to carry a 1031 Exchange or need Opportunity Zones solutions.