Opportunity Zones vs. 1031 Exchanges

For years real estate investors have enjoyed and understand the benefits of the Section 1031 Exchange program.  This allows the capital gain from a sale of business or investment real estate to be deferred with the reinvestment of proceeds into another like-kind property.  Like-kind is very broad when it comes to real estate, as this means any other piece of real estate used for production of income. E.g.  an apartment sale can 1031 into a track of vacant land or an office can 1031 into an apartment. 

In the Tax Cuts and Jobs Act of 2017, code 1400Z-1 and 1400Z-2 created qualified opportunity zones to encourage investors to move money into economically distressed areas of the U.S.  This investment may allow taxpayers to defer or even possible exclude any capital gains from taxation.  The opportunity zone refers to investments in a Qualified Opportunity Fund (QOF), which has been established under the code and regulations. 

There are several differences with the 1031 and QOF in terms of the investment characteristics.  The QOF can defer capital gains from any assets, can use any funds, and only are required to invest the gain amount.  The 1031 requires the exchange must be like kind in nature, funds must be tracked to purchase the new property, and the new property must be equal, or more than the value of the property being sold.  The QOF allows you to invest only the gain you have on stock into an approved fund without any capital gains.  The 1031 would require you to reinvest the $1MM of value you sold the office building for to another piece of real estate of $1MM or higher in value. 

The QOF Investment (QOFI) can be into any qualified QOF.  The 1031 has strict rules such as the 200% rule, three property rule, and 95% rule.  The QOFI allows for capital gain reduction of up to 15% after a 5-7-year hold and 100% after a 10-year hold.  This effectively makes the capital gains on the investment tax free.  The 1031 has no capital gains reduction, only a deferment of taxes due to a later date. 

The 1031 has 180 days to identify and close on replacement property.  Advance notification must be made for replacement property prior to closing.  The QOFI does not have the same limits.  The 180-day period may be just the beginning for the QOF to invest funds and even longer for electing partners in a partnership that did not make such an election.  The QOF also requires no advance notice prior to investing.

The 1031 allows you to defer the gain on the sold property indefinitely.  The QOF deferral is only until 2026.  In that year, investors will have tax on corresponding income.  The 1031 is broad in allowing you to invest in any other real estate used for income, while the QOF must be in an approved QOFI.  The 1031 investment may not require additional investments while the QOF may need more improvements on the property. 

The 1031 provides great flexibility to finance, sell, or exchange the replacement property after purchase, whereas the QOF may have some lost benefits if not held for 10 years.  The QOF starts the 180-day clock when capital gains would otherwise be recognized and there is no indication that an investment be entered into before that time would benefit from this election.  The 1031 allows more flexibility here with the possibility of a reverse 1031 exchange, which allows the investor to purchase the replacement property first and then sell the disposition property, while still enjoying the deferral. 

These outline just a few differences between the 1031 and the QOFI.  The real estate investor should consult with tax advisors and other professionals to see which one would sever him best in the current situation when considering some deferral of capital gains taxes.  The analyst should have a knowledge of both programs when completing analysis on these types of properties.