Complicated. If a large gain, usually 1031 is better.
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What factors should be taken into consideration when selecting between 1031 Exchanges and the Opportunity Zone tax incentive?
What are the advantages of investing in an Opportunity Fund over investing in a new property using the 1031 Exchange program, and vice versa? How do investors make better decisions when weighing their options?
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This is obviously a fact-driven, case-by-case anaylsis! But in general, the differences are that 1031 exchange requires all money to be rolled over, in contrast to Opportunity Zone only requiring the gain to roll over. Second, 1031 generally requires a one tax year minimum hold ("investment intent”). OZ is optimal at the 10-year investment, as then the gain in the fund is tax-free. Must hold to 2025 to get the optimum deferral. These are the basic major differences.
Each case must be evaluated based on specific facts and taxpayers’ goals. After the 2017 Tax Cut and Jobs Act, 1031 transactions are limited to real estate transactions. Even real estate will trigger 1245 depreciation recapture, so a full analysis of the nature of the gain is necessary. Assuming your state also fully conforms to the federal OZ program, an OZ transaction can offer significant long-term benefits - namely the full tax exemption on post-reinvestment appreciation after a 10-year hold. Negatives are that you will still pay tax on the deferred gain in 2026 or 2027, regardless of whether you still hold the property. A 1031 transaction can defer the gain indefinitely until replacement property is sold. OZ investing will likely have more set-up and annual reporting and legal/ tax maintenance costs. Another advantage of an OZ investment is the taxpayer can only reinvest the capital gain. Therefore, the taxpayer can take any remaining net proceeds and use it for other purposes. A 1031 seldom allows a taxpayer to pull out cash without taxability. If you live in a non-conforming state - CA, HI, MA, MS, NC, PA - a 1031 will likely be the better avenue to save state tax.
Section 1031 defers tax liability until the acquired property is sold, so there is no tax due in 2026. On the other hand, when the acquired property is sold, there is no basis step-up, so the full amount of the appreciation (including the accrued appreciation from the first property) will be subject to tax. Section 1031 only applies to the sale of real estate and the acquisition of real estate. Section 1031 applies to the proceeds of sale, so (in general) more money must be invested in order to avoid current tax. And Section 1031 requires a "qualified intermediary" to hold the funds if the sale and acquisition do not happen simultaneously. The OZ rules allow one capital asset (in particular, stock, but also a broad range of other capital assets and assets used in a trade or business) to be sold, and only the gain (not the proceeds) to be invested in a completely different kind of asset. OZs can require a professional advisor to set up the appropriate opportunity fund and subsidiary entity, or the review of publicly available funds in order to invest in a third party's opportunity fund. Opportunity fund investments must be made in designated low-income communities, while 1031 investments can be made anywhere. So, the key questions are: Do you plan to sell real estate? If no, then 1031 is out. Do you plan to invest in real estate? If no, then 1031 is out. Do you plan to invest in an opportunity zone? If no, then OZ is out. Are you prepared to pay the tax liability in 2026? This one requires more thought. The proposed regs allow you to refinance an OZ property and distribute the proceeds, which might help pay the tax. Regardless, a like-kind exchange simply won't have a tax bill in 2026, unless the acquired property is sold at that time. Do you plan to invest the "proceeds" or just the gain? 1031 for the former; OZ for the latter. Do you expect big appreciation in your investment and are willing to hold for 10-plus years? Then OZ would be the favored investment.
This is a great question. If you have sold real estate and plan on continually reinvesting in real estate, 1031 exchanges are the simpler way to go, but they don't shelter capital gains from non-real estate investments. However, you don't eliminate your gain only defer it. As clients have asked me how they eliminate their gain on a 1031 over the long term, I tell them it's simple; just die. (I've had many clients for 25 years plus, so it's applicable and they get my macabre humor.) With a 1031 you only need to be in a property two years and can then move on. If you have capital gains from highly appreciated assets such as stocks, other asset sales or real estate, you can invest them in an Opportunity Zone project. In fact, it's one of the only methods of moving non real estate gains into real property without paying capital gains at the time of realization. You have to be prepared for a long term hold, and either management involvement or giving up control to a third-party fund. At the end of the 10-year period the capital gain on your initial investment is reduced and the capital gain on the real estate Opportunity Zone investment over the 10 year hold period is forgiven. State tax laws vary as well. Of course, you would need to talk with your CPA or tax attorney to see how the rules apply to you.
The most important thing to remember is you pay 0 percent federal taxes if you hold your opportunity fund investment for 10 years. In the Opportunity Zone investment you are not limited to real property. You can invest in funds that are operating businesses, not just real estate.
One of the major differences is that in the case of OZ, only an amount equal to the gain realized or part of it must be invested. Other is the time required to realized 100% exclusion and that for OZ is a temporary deferral of the gain. Taxpayers’ preferences and priorities are important to consider.
Based on your question, I assume you're selling an asset eligible for a 1031, but it's worth noting for others who may be interested in the question that one of the key distinctions between 1031s and an OZ investment is the wide breadth of capital gains -- short and long term from virtually any source -- eligible for OZ deferral, compared to the much more limited world of eligible 1031 assets. Assuming a capital gain is eligible for both, I advise clients to consider the following primary factors in deciding between a 1031 and OZ investment: type/location of desired reinvestment. Though fewer asset sales qualify for a 1031, there are generally more options for a 1031 purchase than an OZ investment. Second is timing. I've seen too many investors get stuck in a bad deal because of 1031 money "burning a hole" in their pockets. The more generous timeline for reinvestment of gains in a QOF, along with the lack of a tracking/intermediary requirement, is a huge benefit. Third is liquidity needs, the ability to take a return on capital from an asset sale and reinvest just the capital gains in a QOF allows investors more flexibility to re-invest only partial-proceeds of a sale as compared to the treatment of "boot" in a 1031 exchange. Fourth is an individual's age/health. A 1031 may be a better choice for an individual closer to a step-up in basis at death. Fifth is anticipated appreciation. The tax-free sale after 10-plus years is the most important benefit for most of my OZ clients because they're primarily buying/developing property in distressed areas poised for a turnaround. Someone whose priority is asset stability and annual cashflow might not expect to see that same appreciation and so the value of that tax-free sale would be diminished.
This decision requires considering a variety of factors, including the property's income tax basis, the taxpayer's future plans, the taxpayer's inclination to control his/her own investment, the amount of debt on the property being sold, whether the property will be developed, and quite a few more.
The distinction is that with a 1031 exchange, you are limited to: taking title directly to real estate (on your own or as tenants in common in a group investment structure) or a Delaware statutory trust. Both have significant limitations and may limit your investment opportunities. For instance, you cannot invest in a typical syndicate selling LLC or LP interests, as those are personal property interests and are not elegible for 1031 exchange. You can invest in LLC or LP interests under OZ rules, as long as the property is in the OZ and the company you invest in meets the requirements of a Qualified Opportunity Fund.
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