1031 Exchange vs. QOZ Real Estate: Which Tax Break Is Better?
For all their long-term tax advantages, real estate investments can also be structured to provide immediate tax benefits. For decades, investors have used Section 1031 exchanges, also known as like-kind exchanges, to swap real estate assets without triggering taxable gains. Now the new Qualified Opportunity Zone program provides another way to postpone and eliminate certain taxable gains. So which is better, a 1031 tax exchange or a QOZ real estate investment?
Both options have strict rules determined by the IRS, and some investments may qualify for both tax breaks. But private real estate investors need to understand the differences between these two tools and how they impact their taxable gains before deciding which one to use.
The QOZ program was created by the 2017 Tax Cuts and Jobs Act to encourage investment in economically distressed areas nationwide. Qualified Opportunity Zones are neighborhoods that states have targeted for investment incentives, based largely on median income in those communities. The Opportunity Zone law establishes certain tax benefits for investors who re-invest capital gains into a new type of investment vehicle known as Qualified Opportunity Funds, which in turn, invest in the opportunity zones. The Treasury Department has certified 8,700 qualified opportunity zones in which QOZ deals can be located, which creates high competition in the areas with the best fundamentals.
The 1031 tax exchange (named after its section in the Internal Revenue Service code) has evolved from an almost century-old incentive known as a like-kind exchange—selling and buying the same type of properties of equal value. Its primary purpose has always been to permit taxpayers to maintain property investments without being taxed on unrealized paper gains and losses during the course of continuous investment. Thus, a like-kind exchange would not produce a capital gain.
It’s important to note that prior to TCJA, Section 1031 applied to like-kind exchanges on any investment property type—both personal and real. For instance, it was possible to do a like-kind exchange with cryptocurrency to avoid taxation. Now personal property has been disallowed from this type of tax treatment. So investors can no longer swap personal property, and businesses can no longer replace machinery as a non-taxable event, Now the like-kind exchange rules only apply to business real estate properties. A taxpayer’s home does not qualify, because it is not held primarily as an investment.
Taxes Deferred Indefinitely: 1031 Exchanges
A like-kind exchange can defer capital gains anywhere in a real estate portfolio. If a couple buys property for $70,000, sells it for $100,000, and then invests the entire sum in a new property—or in shares of a private equity real estate fund–the transaction is a wash; there’s no taxable gain. The timeline for a 1031 exchange requires the investor to identify the new asset within 45 days of the original asset’s liquidation, and to invest the proceeds within 180 days. However, a caveat exists when property is held in a partnership or an LLC created as a partnership; its individual shareholders cannot use their shares in an exchange because they don’t own the real estate, just shares in the partnership.
Other tax benefits to real estate investors, such as depreciation, work in tandem with a like-kind exchange. For example, the couple above may have claimed $2,000 in depreciation on the original property. Their cost basis on the new investment then would be not $100,000, but $68,000—the cost of the original $70,000 purchase less $2,000 in depreciation. In the coming years, they can write down depreciation expenses on the new property, which will make more of the final proceeds subject to low capital gains tax rates. And the day of tax reckoning can be delayed indefinitely if the couple holds the property or exchanges it for a like-kind option again.
Taxes Deferred Through 2026 and Gain Elimination: QOZ Funds
Similar to a like-kind exchange, an investor can defer capital gains from the sale of an appreciated asset by investing those gains in a Qualified Opportunity Zone Fund within 180 days of sale. Notably different from a 1031 exchange, only the gain needs to be invested in order to take advantage of the deferral, and the opportunity is available from the gain on any appreciate asset. There’s no requirement to invest in “like kind” property.
The deferred gains invested in a QOZ Fund are taxable on December 31, 2026, or when the investment is sold, whichever is earlier. While the deferral period is limited, investors who hold a QOZ Fund investment for a minimum of five years will have 10% of the deferred gain permanently forgiven.
The most significant difference between deferring a gain through a 1031 exchange and investing a gain in a QOZ Fund is that, if an investor holds a QOZ Fund investment for a least 10 years, that investor will pay no tax at all on any appreciation in the QOZ Fund investment. This bears repeating: all the gains ultimately realized on a sale of the QOZ Fund investment, or assets within the Fund, after a 10-year hold are tax free.
The Ultimate Analysis: Which is Better?
The significant difference between the two options is that the 1031 exchange is a deferral program with unlimited duration, while the QOZ program has a limited deferral period, but affords tax-free profits after a minimum 10-year hold. The determination of which program is better will vary based on each individual investor’s objective. If an investor’s primary goal is to defer taxes indefinitely and never access the investment capital, the 1031 exchange would be the preferable solution; however, if an investor wishes to realize the profits on an investment at some point in their lifetime, a QOZ Fund is the better option.
Because the taxes deferred in a 1031 exchange can roll on indefinitely, the 1031 exchange option can be a valuable estate planning tool. If an investor is willing to hold onto investment property for life, the taxable gains disappear; the investor’s heirs receive a step-up in basis to the property’s fair market value on the date of death, erasing any previous appreciation in the value. Those heirs can sell then the asset immediately without a capital gain. Under the QOZ program, there’s no escaping the taxman on December 31, 2026, and any person who inherits an interest in a QOZ Fund prior to that date will assume the original tax basis in the investment (no step-up upon death) and be obligated to pay the tax; however, if the heir holds the QOZ Fund interest until a date that is at least 10 years from the original investment, their tax basis will receive a step-up to the investment’s fair market value upon disposition.
This chart breaks down the requirements and timelines for both types of investment structure:
|1031 Exchange and QOZ Investments Compared|
|Opportunity Fund Investment|
|Fund Opportunity||Property held for investment|
purposes (not homes)
|Investments in Qualified Opportunity Zone assets (business or real estate)|
|Investment Vehicle||Third-party custodian||Qualified Opportunity Fund|
|Source of Capital Gain||Must be from a business real estate sale||Can be from sale of any asset|
|Timeline||Identify replacement property|
within 45 days of sale; all proceeds from prior sale must be reinvested within 180 days
|Reinvest eligible capital gains within 180 days of realization|
|Eligible Property||Property held for investment|
purposes anywhere in the U.S.
|Property in designated Opportunity Zones|
|Deferral of Invested Capital Gain||Until final sale; multiple rollovers possible||No later than 12/31/2016; 10% lower basis if investment held 5 years|
|Tax on Appreciation||No tax until final sale;|
from original basis
|Tax-free after 10 years|
|Hold Period||Indefinite||Minimum of 10 years for full tax benefits|
|Estate Planning Considerations||Heirs owe no capital gains tax||Heirs responsible for deferred capital gains tax, but not on appreciation|
There are significant pros and cons to both 1031 like-kind exchanges and QOZ real estate investments. Which one is better depends on each investor’s goals and tax planning strategies. Ultimately, just as with any investment or estate planning decision, the decision isn’t based on tax considerations alone.