For years, the 1031 exchange has been a preferred, efficient strategy for real estate investors to defer taxes on capital gains associated with their direct real estate investments. However, with the creation of the opportunity zone program outlined in the 2017 Tax Cuts and Jobs Act, there is now another potentially compelling tax strategy to consider. There are some key considerations real estate investors should evaluate when contemplating which program works best for their portfolio.
Key Benefits Of A 1031 Exchange
1. Potential to defer taxes indefinitely: One of the biggest benefits of a 1031 exchange (or like-kind exchange) is the potential to defer tax indefinitely, assuming the 1031 exchange rules are followed with each subsequent exchange. An investment made into a qualified opportunity fund (QOF) also has the benefit of deferring taxes; however, that deferral lasts until 2026 at which point taxes on the invested gain (subject to reductions based on time of investment) are due at the prevailing capital gains tax rate for the 2026 tax year.
2. Estate planning: There are significant estate planning benefits of 1031 exchanges compared to investments made in a QOF. Should a 1031 exchange investor die, heirs immediately receive a stepped-up basis to the market value of the asset(s). This potentially positions the estate to sell the asset and eliminate tax liabilities up to the estate tax exception. Investments made into a QOF, on the other hand, do not receive a stepped-up basis at death. The recipient of the QOF interest has the obligation to pay the deferred taxes in 2026 (or earlier if the recipient disposes of the QOF interest prior to 2026). However, it is not all bad for the recipient since the recipient receives the 10-year benefit of the investment. In other words, if the recipient holds the interest in the QOF for at least 10 years from the original investment, the original investment made into the QOF grows tax-free.
3. Location flexibility: Unlike a qualified opportunity zone investment, the 1031 exchange can occur anywhere within the United States border. This gives the 1031 exchange investor flexibility to invest in any location within any market. A QOF does not have that flexibility. A QOF must invest in property that is substantially located within one of the designated opportunity zones as determined by each state and U.S. territory.
Key Benefits Of A Qualified Opportunity Fund
1. Ability to diversify into other asset classes: The opportunity zone program provides real estate investors the ability to diversify a portion of their existing real estate investment into another asset class. Only realized capital gains invested into a QOF are eligible for the tax benefits associated with the opportunity zone program. Therefore, investors can take the gain associated with a sale of a property(s) and invest it into a QOF and take the original basis and reallocate into another asset class. Investors utilizing a 1031 exchange do not have the same flexibility without incurring a taxable event. Like-kind exchanges require investors to invest into a property that is of equal or greater value. If a 1031 exchange investor purchases a property of lesser value, taxes will be due on the difference.
2. More flexible investment process: I find that making an investment into a QOF is a much less cumbersome process than executing a 1031 exchange. To invest in a QOF, there is no required intermediary, investors can use cash on hand and the timeline to make the investment provides a sufficient window for investors to make an informed investment. Unlike a 1031 exchange, which requires that all funds from the sale of the relinquished property(s) and the purchase of the replacement property(s) run through a qualified intermediary, the investment into a QOF can be wired directly from the investor’s account. Further, there is no tracing of funds in the opportunity zone program, so the investment into the QOF can come from any source the investor sees fit. Finally, to qualify an investment into a QOF, the investor must make the investment within 180 days of realizing a capital gain. If the capital gain was realized within a partnership, the investor will have 180 days from the last day of the tax year for that partnership. This timeline gives investors plenty of time to research investment options to match their risk profile and return objectives. In a 1031 exchange, an investor has 45 days from the sale of the relinquished property to identify replacement property(s) and 180 days from the sale date to close on one of the identified replacement property(s). This can cause issues if the purchase of a replacement property falls through.
3. Ability to diversify real estate portfolios: The recent set of proposed regulations released on April 17 provided some favorable provisions related to multi-asset QOFs. The proposed regulations provide QOFs the ability to recycle investments within the fund without triggering a taxable event at the QOF entity as well as some exit flexibility at the end of the 10-year investment period that potentially allows for single asset dispositions. Therefore, we can anticipate some QOFs to be multi-asset funds. These vehicles will give investors the ability to trade out of a single real estate property and invest into the QOF with a portfolio of assets. Theoretically, this should potentially reduce concentration risk and provide multiple revenue streams to the QOF investors. Although it is possible for a 1031 exchange investor to diversify into multiple assets or even consider an investment into a Delaware statutory trust (DST) portfolio, it is cumbersome for the investor to identify direct investments and execute the 1031 exchange within the strict timelines, and the DST structure has its own limitations that tend to constrain investments to lower-growth options.
In my opinion, if an investor wants to continue to invest in real estate, the 1031 exchange execution is more favorable given the ability to defer taxes via subsequent exchanges and the superior estate planning benefits. However, for those investors looking to diversify a portion of their portfolio out of real estate (i.e., non-gain dollars), an investment with gain dollars into a QOF could make sense. Either way, the real estate investor now has two attractive, tax-efficient options to consider.
The information provided is the author’s opinion of current market conditions for informational and educational purposes only and is not investment, legal or tax advice, nor a security, strategy or investment product recommendation.
Thank you for helping me to understand that a 1031 exchange is a strategy that real estate investors use to defer taxes. It seems like an investor would want to defer the taxes that they pay each year so that they can maximize their gains. It seems like you wouldn’t want to defer taxes for too long so that you don’t have to pay a large amount at once.