Until recently the 1031 Exchange has been one of the most tax efficient investment vehicles commonly used by real estate investors. That is, until the start of the Opportunity Fund under the Qualified Opportunity Zones program established by the Tax Cuts and Jobs act of 2017 (“TCJA”). The Opportunity Fund shows the prospect of being the real estate investment tool of the future. One reason is that Opportunity Funds provide investors the ability to defer and reduce their initial capital gains tax bill. As well, the Fund offers ways to eliminate any capital gains taxes earned from certain investments. While the 1031 Exchange allows investors to defer paying capital gains tax on the sale of real property by reinvesting or “swapping” the proceeds into new property.
The purpose of this post is to untangle the similarities and differences of the 1031 Exchange and Opportunity Funds and guide real estate investors as to which investment choice is the best.
1031 Exchanges or Like-Kind Exchanges offer investors to defer paying a capital gains tax on the sale of real property by “swapping” the proceeds of the sale into a new property. By leveraging investor purchasing, the 1031 exchange provides investors a way to preserve the gross equity earned from a real property investment.
A Qualified Opportunity Fund is a privately managed investment vehicle, whose sole purpose is to invest at least 90% of its assets directly into QOZs. Investing in a QOZ through a Qualified Opportunity Fund (“QOF”) allow investors to potentially defer paying capital gains tax on certain appreciated asset sales until 2027. Better yet, an investor has the possibility of avoiding to pay any tax on gains from the QOF investment if held for the time prescribed. For a detailed explanation of QOZ and QOF go here.
Differences between 1031 Exchange and QOF
Opportunity Funds, unlike the 1031 Exchange, offer investors the ability to invest only the capital gains instead of the entirety of their investment. QOFs provide broader choices of investments that qualify for a tax deferral as well as the opportunity to abate all taxes on capital gains after the sale of the asset. Moreover, an investor has the possibility of a basis step-up of 15% (or more) of the initial deferred amount of the investment. However, the main difference is that 1031 is real estate specific, while QOFs allow investors to invest capital gains into other assets than just real property.
Below is a table containing essential differences between a 1031 Exchange and an Opportunity Fund.
So which is better?
There are several consideration investors must take into account when choosing one investment vehicle over the other. As with anything, it’s a case-by-case discussion, in determining whether the QOF is more suitable than the 1031 Exchange, and the investor must be one that is passively looking to diversify their portfolios through professionally managed pooled funds. While as 1031 Exchanges are more appropriate to active, experienced real estate investors who have the resources required for continuing oversight and management.
Investors with gains coming from an appreciate asset sale beyond real estate (including stocks, bonds, or other business assets) will find QOF a more favorable choice. However, 1031 Exchanges limit investors with only gains coming from a real property sale.
If you have questions about how to better take advantages of this new opportunity contact us:
Adam J. Yormack, Esq
This Yormack Law Practice Update is for informational purposes and intended to update our clients and friends on legal developments. Nothing in this Practice Update should be construed as legal advice or a legal opinion, and readers should not act upon the information contained herein.
The Tax Cuts and Jobs Act (TCJA) provides that, for investors who have rolled capital gains into an opportunity fund and hold that investment in the opportunity fund for a period of ten years or more, that any additional gain realized by such investor from liquidating such investment will not incur additional federal capital gains taxes. However, please note that, given the uncertainty regarding future Treasury Department guidance, each prospective investor should consult with their personal tax advisor, and qualified legal counsel, and nothing in this article or any of the links attached creates a client attorney relationship.
Thank you to, Carlos E. Alvarez, for his research, edits, and input for this article.