For a long time, 1031 exchanges have continued to allow real estate investors to defer capital gains tax. With 1031, the investors roll their investment deals forward to another ‘like kind’ exchange for an indefinite period while deferring taxes on the way. However, the advent of opportunity zones has proven to be a viable alternative for 1031 investors with their numerous tax advantages. In this article, we will discuss the various qualified opportunity zones tax benefits versus 1031 exchange and how investors can transition from 1031 to Opportunity Zones to enjoy additional tax incentives and write-offs.
1031 Exchange explained
Section 1031 of the United States Internal Revenue Service’s tax code states the 1031 exchange. 1031 exchange rules or ‘like-kind exchange’ allows investors to defer capital gains in their real estate portfolio.
When a commercial or personal property is sold, the investor can invest all the proceeds from the sale into another similar, ‘like-kind’ property. As a result, 1031 investors can delay paying taxes. Therefore, in a 1031 exchange, capital gains become tax-free for an unlimited time.
Main Benefits of a 1031 Exchange
1031 Exchange investment vehicle provides these major benefits:
1. Investors can enjoy the unending delayed exchange of capital gains by following the rules in every subsequent deferred exchange.
2. When the investors receive tax deductions, they save more which increases their overall purchasing power. Therefore, they can invest in an expensive ‘like-kind replacement rental property that generates more returns. As a result, they can leverage this rental income to build their wealth in the long term.
3. Real estate investors can select from a wide variety of options across the US for a 1031 exchange.
What is an Opportunity Zone Investment?
The Tax Cuts and Jobs Act Program legislated the Opportunity Zone Investment program in 2017. Qualified Opportunity Zones Funds provide investment incentives in the form of tax benefits.
Therefore, this encourages real estate investors to invest in poverty-stricken areas in the US. Hence, Opportunity Zone investments strive to benefit low-income communities with job creation and infrastructure development.
Furthermore, investing in Opportunity Zones Funds prevents the investors from paying huge capital gains taxes.
This program enables investors to sell their assets and reinvest their capital gains as well as the profits into QOZ Funds. As a result, this investment vehicle aims to uplift the 8700 Qualified Opportunity Zones in the country.
Main Benefits of an Opportunity Zone Investment
Opportunity Zone investment provides several well-defined advantages, including:
1. Investing in an Opportunity Zone requires no qualified intermediary. Furthermore, the investors get 180 days to make a well-informed investment decision that is apt for an investor’s portfolio and return objectives.
2. The Qualified Opportunity Zone Funds involve multiple asset classes. Therefore, an Opportunity Zone Investor Can not only diversify their entire investment portfolio but also generate numerous revenue streams.
3. Opportunity Zone investments are a direct effort to accelerate the economic recovery of impoverished areas in the US.
Read Lilypads’ detailed blog on how Opportunity Zones work here.
How does 1031 Exchange differ from Opportunity Zone Investments?
Although both 1031 exchange and opportunity zone investments offer tax deferral benefits, they differ in certain ways. However real estate investors must analyze their long-term portfolio goals and risk preferences while choosing one vehicle over the other.
The key differences between 1031 Exchange and Qualified Opportunity Fund are:-
1031 Exchange
- The replacement or relinquished property should be a ‘like kind’ real estate asset.
- When the initial asset is sold off, a qualified intermediary must oversee how the investor is reinvesting the disposition proceeds.
- It requires the Reinvestment of the entire amount of sales proceeds.
- 1031 exchange follows strict property identification rules. This also includes the Three property rule and the 200 percent rule.
- There is no reduction in capital gain.
- The investors can defer their Capital gains indefinitely
- In the 1031 exchange, the investors have a 45-day limit to find one or more replacement properties.
- There is a 180-day limit for closing the deal on a replacement property. However, the replacement property must have been identified in advance.
- Investors have the flexibility to refinance, sell or exchange the replacement property after purchase.
- In the case of reverse 1031 exchange investors can purchase replacement property even before selling their original asset while enjoying tax deferral.
Qualified Opportunity Funds (QOZ)
- These allow the capital gains investment from any assets such as stocks and bonds, a business, precious metals, or cryptocurrency.
- Re- investable amount includes only the capital gains.
- If the property is held for at least 5 years then the investors can enjoy an additional 10% reduction in capital gains
- When the property is held for at least 10 years then the additional gains from Opportunity Zone investments will not incur capital gains tax.
- The reinvestment of capital gains in Qualified Opportunity Zones must occur within 180 days.
- In case of reinvestment, investors do not need to identify the properties in advance.
- Capital gains taxes are delayed until the end of 2026.
- Opportunity Zone investments often require additional improvements or replacement. As a result, investors may face higher risks of losses.
How are 1031 investors migrating to Opportunity Zones?
If a 1031 investor wants to migrate to opportunity zones investment they need to follow a simple procedure.
Here, when the investors sell their investment property they can realize their gains instead of rolling the amount forward into a 1031 ‘like kind’ asset.
Furthermore, they can take the next 180 days to invest some or all of their capital gains into a Qualified Opportunity Fund. Therefore this transition from 1031 to Opportunity Zone investments allows the investors to defer taxes on the capital gains until 2026.
Moreover, if they invest in opportunity zones before the end of 2021 they can reduce their 2026 tax liability by 10%. In addition to this, if the investors hold their investments within an opportunity zone for 10 + years, they can eliminate taxes on the capital gains they earn within the opportunity zones.
Opportunity Zones offer better tax benefits:
1. Rollover
Usually, in a 1031 exchange, the investor must invest both the principal and the capital gains in a ‘like-kind property’. Moreover, investors must carry both their principal and capital gains forward with the debt within 180 days from the sale of the property.
However, it becomes challenging for investors to identify a like-kind property within such a short span. Moreover, they also need to hire a qualified intermediary to conduct starker exchanges that ease property swapping.
But, Opportunity Zone Funds allow the investors to only reinvest the capital gains from the sale proceeds within the next 180 days. So, the principal and profits of the initial investment remain intact.
Therefore, by keeping their original investment untouched, the investors receive tax benefits on the gain portions they invest. Consequently, they receive instant liquidity plus tax benefits.
In addition to this, Opportunity Zone investments do not require any middleman. Hence, the absence of intermediary charges streamlines the investment process making it more cost-effective than the 1031 exchange.
2. Diverse Qualified Assets
In 1031 exchanges tax benefits are applicable to only real estate investments. As a result, the investor cannot obtain avail of tax benefits for profits from the sale of other appreciable assets.
These include commercial assets, stocks, and bonds, cryptocurrency, any kind of business, artwork, etc. Thus, the 1031 exchange does not allow the investors to unify capital gains from different assets into one investment for tax benefits.
But, Opportunity Zone Funds allow the investors to reduce and defer the capital gains tax for up to 7 years when they sell any kind of asset. Therefore, Opportunity Zone investments grant a greater degree of flexibility and diversification.
3. Actual reduction of capital gains tax
Although the 1031 exchange delays the decided capital gains tax indefinitely, it doesn’t reduce the amount of taxes owed. If an investor opts to receive tax benefits, they continue swapping the properties, until eventually selling them off.
On the other hand, not only does an Opportunity Zone investment defer the capital gains tax payable on the initial gain till 2026, but also reduces the capital gains tax. It reduces the tax liability of investment by 10% if a property is held for 5 years.
Furthermore, it also reduces the tax liability by 15% when an investment is held for more than 7 years. In addition to this, an investment that is held for more than 10 years, does not incur any capital gains tax.
4. Capital gains tax at the disposition
When the 1031 property is finally sold off, the investor must pay all the due capital gains associated with the 1031 exchange. But, if the investor dies before the liquidation of the property, then the tax basis receives a fair market value treatment. Therefore, it eliminates any outstanding capital gains tax liability for the investor’s heirs.
Likewise, Opportunity Zone investments, when held for 10+ years, also eliminate any capital gains on the appreciation. However, the investor or their heirs must still pay the initial capital gains taxes, which they delayed till the end of 2026 by investing in an Opportunity Zone.
Opportunity Zones are a clear winner
Both a 1031 exchange and an Opportunity Zone investment allow the deferral of capital gains, but the cost and benefits are different in both cases. When compared, Opportunity Zone investments appear more streamlined with their potential for greater diversification, multiple revenue streams, and a longer time span for making an informed decision making.
However, the investors aiming for tax benefits must analyze their risk tolerance, liquidity needs, and investment portfolio goals before selecting either of the two investment vehicles.