Real estate investors have used the Section 1031 exchange for decades to exchange assets while deferring taxable gains. On the other hand, the Qualified Opportunity Zones program offers real estate investors the ability to defer taxes and, in some cases, even eliminate taxable profits altogether, leading real estate investors to demand: Which is better, a 1031 tax exchange or a qualified opportunity area real estate investment?
The IRS has established strict regulations for both alternatives, and some real estate investments may qualify for both tax breaks. Before choosing between the two approaches, real estate investors should understand how the differences affect their taxable gains.
What is a Qualified Opportunity Zone?
Economically distressed communities in need of investment and revitalization are known as “Opportunity Zones,” but many properties within these districts have undergone significant change and are ripe for development. Following the Tax Cuts and Jobs Act 2017, Opportunity Zones provide tax incentives to invest in community development in these zones to encourage economic growth and job creation .
Areas of opportunity range from rural areas without services to degraded neighborhoods, including areas that have experienced economic redevelopment. Each state’s governors designate a small number of parcels that meet the criteria for official designation as Qualified Opportunity Zones (QOZs). Opportunity Zones are designated and certified by the Secretary of the US Treasury Department, with the approval of the IRS.
Over 8,000 Qualified Opportunity Zones exist in the United States, representing 12% of all census tracts. The Department of Housing and Urban Development website provides an interactive map showing where the Opportunity Zones are. Rural areas account for nearly 23%.
The federal government has created qualified opportunity zones to encourage investment and economic development. This landmark legislation has come with several tax benefits for individuals who have invested through a qualified opportunity fund. Qualified Opportunity Funds (QOF) are investment entities, such as corporations or partnerships, created to invest in real estate in areas of opportunity.
Investments made by eligible opportunity funds must meet specific criteria. For example, real estate assets must be new or significantly renovated. It is forbidden to buy an existing property without making significant improvements. Substantially improving an Opportunity Zone property means Opportunity Fund investments must equal or exceed the value of the asset and must be completed within 30 months.
Benefits of a Qualified Opportunity Zone
Capital gains deferrals from prior investments are the primary tax benefit of Opportunity Zone programs. In particular, an investor who transfers capital gains from a previous investment in a QOF within 180 days of the date of sale can defer taxation on the gain until December 31, 2026.
Opportunity Zones can be a great solution for any capital gain, long or short term. Gains can come from the sale of real estate, the sale of a closely held business, or the sale of any type of valued asset, including stocks, works of art, collections or other valuable assets.
Additionally, if qualified opportunity fund investors hold their investments for a minimum of five years, they may further reduce their deferred capital gain as their cost base will increase by 10% at that time (Note: under the current tax legislation, an investment made after December 31, 2021, will not be eligible for the basic increase of 10% since the deferred taxation on December 31, 2026 will occur before the retention period of five years is respected). And those who can hold their QOF investments for 10 years or more can enjoy 100% tax-free gains. This gives investors a competitive advantage in building wealth.
What are 1031 exchanges?
By participating in a 1031 exchange, investors can exchange one investment property for another while deferring capital gains taxes that would otherwise be owed at the time of the sale. In this strategy, investors can significantly improve their properties without paying income taxes.
If you want to dive deeper into 1031 Exchanges, check out my masterclass, Master The 1031 Exchange.
Benefits of a 1031 Exchange
Similar to qualified opportunity zones, the primary benefit of a 1031 exchange is tax deferral. Once an owner exchanges an investment property for another property of a “similar type”, they can defer taxes on their gains until the replacement property is sold. This tax deferral gives investors more funds available to increase their purchasing power through higher down payments and more expensive replacement property purchases. This way, investors can leverage their cash and grow their wealth.
Additionally, 1031 exchanges are also very flexible when it comes to ownership type. Investors can, for example, exchange one property for another, combine several properties into one or exchange the existing property for several smaller ones.
Which investment should I choose: QOZ or 1031 Exchange?
Although QOZ and 1031 exchanges serve to defer capital gains taxes, there are significant differences between them. Therefore, determining which program is preferable depends on the goals and objectives of the investor.
For tax deferral, 1031 exchanges have the advantage
If the primary goal of the investor is to stay in the real estate investment business for the rest of their life, the 1031 exchange is superior to QOZs. These investors don’t want to cash out, or maybe they just want to cash out at a much later date (and they’re willing to pay capital gains taxes at that time if they do).
To make profits, QOZ funds have the advantage
If an investor intends to make a profit at some point in their life, a QOZ might be a better option because QOZs separate the basis and the capital gain. On the other hand, if an investor wishes to preserve his base for other investments or opportunities, he can choose to invest only the capital gains. An investor using a 1031 exchange is at a distinct disadvantage because, to receive full tax deferral, they must transfer all proceeds from the sale into the new investment.
As an estate planning tool, 1031 exchanges have the advantage
Because an investor can defer the tax deferral of a 1031 exchange indefinitely, 1031 exchanges can be useful estate planning tools. Deferred gains are eliminated upon passing. Suppose the investor keeps the property for the rest of his life. In this case, their heirs receive a progressive basis based on the fair market value of the property at the time of death, canceling out any previous appreciation in value. Additionally, capital gains taxes are not imposed on such heirs upon the sale of the asset.
However, any beneficiary of a QOZ fund who inherits its interest before December 31, 2026 will inherit the original tax base of the investment, as QOZs do not provide for an increase on death. Thus, they will be liable for taxes; however, if the successor continues to hold the QOZ fund interest for at least 10 years after the initial investment, its tax base will be increased to the fair market value of the investment upon disposition under the QOZ program.
Key points to remember
- A Qualified Opportunity Zone and 1031 exchange provide tax benefits to real estate investors.
- A QOZ and a 1031 tax exchange require different strategies that investors should understand before deciding which path to take.
- Investors in Qualified Opportunity Areas primarily benefit from carrying forward capital gains from prior investments.
- The main advantage of a 1031 exchange is that investors can exchange or consolidate investment properties while deferring capital gains taxes at the same time.
- When it comes to deferring taxes, 1031 exchange has the advantage.
- When it comes to making a profit, the edge goes to qualified opportunity areas.
- If you compare QOZ and 1031 exchange in estate planning, the 1031 exchange has the advantage.
Investing in 1031 exchanges offers many benefits to investors, including significant tax benefits and the ability to grow and leverage their wealth with minimal financial obligations. However, to fully benefit from it, you must respect specific deadlines and rules.
It is important for an investor to always consider their long and short term goals as well as their income and equity goals. Both 1031 exchanges and Qualified Opportunity Zones have their respective pros and cons. A skilled planner and tax team can help an investor determine which strategy or combination of strategies best suits their needs.
Chief Investment Strategist, Provident Wealth Advisors
Daniel Goodwin is Chief Investment Strategist and Founder of Provident Wealth Advisors, Goodwin Financial Group and Provident1031.com, a division of Provident Wealth. Daniel holds a Series 65 Securities license as well as a Texas Insurance license. Daniel is a representative investment advisor and trustee for corporate clients. Daniel has been serving families and small business owners in his community for over 25 years.
Securities offered by AAG Capital Inc., member SIPC and FINRA.