Why Opportunity Zone Investments Will Not Replace Section 1031 Exchanges
Opportunity zones are the result of the provision of the Tax Cuts and Job Act of December 2017. This investment vehicle was created to foster economic development in economically distressed communities by encouraging investors to direct their funds. These communities, called Qualified Opportunity Zones, are characterized by poverty, poor standards of living, and low education and work qualifications. Investors enjoy immediate and consequent tax benefits if they meet the qualifying criteria.
The question then is whether the opportunity zone real estate program should replace Section 1031 Exchanges or is compatible. To answer this requires a delve into the similarities and differences between the two wheels.
The similarities between 1031 Exchanges and opportunity zones
Section 1031 Exchanges tax benefits have some similarities to investing in Qualified Opportunity Funds.
- Both encourage investors to redirect gains from previous investments, keeping money within the real estate market and encouraging growth.
- Both mostly anchor their investments in real estate
- Both allow investors to defer recognition of the gain on an investment or property sale.
The differences between 1031 Exchanges and opportunity zones
Though these two programs are similar in their focus on real estate, they have significant distinguishing features in tax treatment and rules on gains.
1. Tax treatment
Eligible defer period
When taking advantage of a 1031 Exchange, an investor may defer the tax on gains from the previous property sale until the replacement property’s sale. Moreover, if the investor decides to roll over the investment into another qualifying property, the defer on subsequent gains continues until they sell the property.
On the other hand, investing in a QOF allows deferral of the tax on the gain from the previous property sale under two conditions; the sale of the property or December 31, 2026, whichever comes first.
Therefore, 1031 Exchange investors can defer gain recognition longer than investors in QOF, where the property is still held past December 31, 2026.
Capital gain tax deductions
The 1031 Exchange allows an investor to defer gain recognition from a property sale for a lengthy period. However, they must recognize the whole capital gain whenever they sell the property.
On the contrary, an investor in a QOF gets to defer their gain and receive a percentage exclusion of the gain. If they hold the investment longer than 5 years, they are eligible for a 10% reduction of the tax on gain. If they hold the property for 7 years, they qualify for a 15% reduction. This deduction means that they pay tax on 85% of the gain on the sale.
Full tax exemptions
The QOF offers a 100% capital gains exemption if the investor holds the property for longer than 10 years. This is an enormous advantage over a 1031 Exchange, where the investor pays the whole accruing tax on capital gains.
The QOF uses the stepped-up basis to value property at the time of sale after holding for 10 years. This means that the basis, i.e., the original investment amount, is increased to the fair market value at the time of sale. As a result, tax accruing is based on the difference between the basis and the sale price, which will effectively be zero and tax-free.
On the other hand, the 1031 Exchange uses the original basis even at selling the replacement property. The tax accruing is the difference between the basis of the original property and the replacement property sale value.
2. Eligible property
The IRS requires replacement property in a 1031 Exchange to be like-kind to the sold property. For example, real estate will be like-kind to another real estate as long as the property is used for a trade, business, or investment. Therefore, any commercial real estate property qualifies for a 1031 exchange.
Conversely, QOF can only invest in opportunity zone real estate in designated, needy communities. Therefore, the qualifying property must be in the opportunity zones, unlike any commercial assets in a 1031 Exchange.
Moreover, investments in a 1031 exchange must only originate from sources following the like-kind rule. However, investments in QOFs may originate from multiple sources, whether real estate or the stock market.
Both the 1031 Exchange and Qualified Opportunity Fund are feasible projects for investors. While the 1031 exchange beats a QOF in the eligible defer period, opportunity funds promise higher tax deductions on capital gains the longer an investor holds the property.
