Opportunity Zones vs. 1031 Exchanges for Capital Gains Tax Deferral
Since Opportunity Zones offer an incredible opportunity for eligible investors to defer their capital gains until 2027, as well as to avoid any capital gains on any appreciation in their Opportunity Fund investment (given that it’s held at least 10 years), it’s often compared to another capital gains tax deferral mechanism, the 1031 exchange. While 1031 exchanges have many similarities to Opportunity Fund investments, they also have quite a few major differences.
Opportunity Zones and 1031 Exchanges Compared
Opportunity Zones offer an incredible opportunity for eligible investors to defer their capital gains until 2027. They also permit investors to avoid any capital gains on any appreciation in their Opportunity Fund investment, given that it’s held at least 10 years. For these reasons, investing in Opportunity Funds is often compared to another capital gains tax deferral mechanism, the 1031 exchange. While 1031 exchanges have many similarities to Opportunity Fund investments, they also have quite a few major differences.
1031 Exchanges Are Limited to Real Estate, While Opportunity Funds Are Not
1031 exchanges are expressly for “real property”, and exclude residential homes, which, in practice, means they can only be used to defer taxes on commercial real estate. In addition, 1031 exchanges are “like-kind” exchanges, which means, according to the IRS, that the property must be of “the same nature, character or class.” The IRS mentions also mentions that “quality or grade does not matter.”
While this may sound extremely strict, it’s not quite as limiting in practice as IRS rules could make it seem. In fact, it’s not unheard of for retail commercial property to be exchanged for an office building or even an industrial warehouse. However, investors attempting a 1031 exchange should always make sure to consult with experts, as, if they unknowingly exchange “non-like-kind” property, they could be stuck with a large tax bill.
In contrast, Opportunity Funds can invest in both businesses and property. However, to invest in a property, it must be located in one of the 8,700 census tracts designated as Qualified Opportunity Zones (QOZs). However, in order to achieve the tax benefits, the Opportunity Fund needs to either construct a new building, or invest more in rehabilitating a building than they did to purchase the property in a first place. To invest in a business, it must be located in a QOZ, and must do 50% or more of its business inside the Opportunity Zone. In addition, no “sin” businesses are permitted to be part of Opportunity Fund investments. Prohibited business types include massage parlors, saunas, golf courses, hot tub facilities, tanning salons, racetracks or gambling facilites, or stores which sell beer or liquor ‘to-go’ as their primary business.
Tax Benefits of 1031 Exchanges vs. Opportunity Funds
The 1031 exchange allows the investor to defer taxes until they sell the exchanged property— which they could also later exchange for another property in a second 1031 exchange. In fact, as long as an investor kept exchanging properties, they could theoretically avoid paying capital gains taxes indefinitely. However, when they do eventually sell their property, they will need to pay the full capital gains tax, including any capital gains that new property has made.
In contrast, if you invest in a Qualified Opportunity Fund, you will only be able to defer your initial capital gains taxes until April 2027. However, if you keep your investment for at least 5 years, you will receive a 10% discount on your deferred capital gains taxes, and if you keep your investment in the fund for at least 7 years, you will receive an additional 5% discount, bringing your total discount to 15%. In addition, if you keep your investment in an Opportunity Fund for at least 10 years, you will not have to pay any capital gains taxes on any appreciation your investment has made since you placed your money in the fund. Investors can keep money in Opportunity Funds until 2047, meaning that they can enjoy nearly 30 years of essentially tax-free gains.
Opportunity Zones Are Time Sensitive, 1031 Exchanges Are Not
The 1031 exchange has been used sine 1921, and is unlikely to be going anywhere soon. However, the same cannot be said about the Opportunity Zones program. In fact, individuals are groups who wish to defer their capital gains on an investment must act quickly, as capital gains can only be deferred until April 2027. In order to take advantage of the full tax 15% capital gains tax exclusion, an investment will need to have been in the Opportunity Fund for 7 years by December 31, 2026, while to achieve the 10% capital gains tax exclusion, the investment will need to have been in the fund for 5 years by that same date.
However, even if they do not make use of these initial capital gains tax benefits by investing after the deadline, investors can still profit from Opportunity Funds, since, as we just mentioned, they will not have to pay any capital gains taxes on the new appreciation of their investment once it has entered the fund.
1031 Exchanges Are Still Superior For Certain Investors
While the Opportunity Zones program offers a much greater potential for tax benefits than the 1031 exchange, it isn’t right for everyone. If you’re an investor who already owns significant commercial property, and wants to exchange one property for a similar property (especially for a property located in a top MSAs or another high or medium income areas) the Opportunity Zones program will not fit your needs.
Likewise, if you want to defer paying your capital gains taxes further out than April 2027, investing in an Opportunity Fund may not be a good choice. Finally, it’s also important to realize that Opportunity Funds strictly limit people investing in funds who are financially affiliated with the fund itself (ex. a company selling commercial real estate to an Opportunity Fund in exchange for a a certain number of shares). Generally, such affiliated entities can own no more than 20% of the shares of Opportunity Fund. In comparison, 1031 exchanges have no such rules, and funds can easily be exchanged by related parties.
Related Questions
What are the differences between Opportunity Zones and 1031 Exchanges?
The main difference between Opportunity Zones and 1031 Exchanges is that Opportunity Zones are a tax incentive program that allows investors to defer and reduce capital gains taxes on investments made in designated low-income communities, while 1031 Exchanges are a tax deferral strategy that allows investors to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar property.
Opportunity Zones are a relatively new program, created by the Tax Cuts and Jobs Act of 2017, while 1031 Exchanges have been around since 1921. Opportunity Zones are designed to encourage investment in low-income communities, while 1031 Exchanges are designed to encourage investment in similar properties.
Opportunity Zones offer investors the potential to defer and reduce capital gains taxes on investments made in designated low-income communities, while 1031 Exchanges offer investors the potential to defer capital gains taxes on the sale of an investment property by reinvesting the proceeds into a similar property.
For more information on Opportunity Zones, please visit the IRS website. For more information on 1031 Exchanges, please visit the IRS website.
What are the benefits of investing in Opportunity Zones?
The benefits of investing in Opportunity Zones include deferring capital gains taxes until the investment is sold or by December 31, 2026, whichever occurs first. Additionally, investors who keep their money in an Opportunity Fund for at least 5 years will receive a 10% reduction of their capital gains tax liability, while those who keep their investment in the fund for at least 7 years will receive an additional 5% discount, for a total 15% capital gains tax discount. Lastly, investors who keep their money in an Opportunity Fund for at least 10 years will not have to pay any capital gains taxes on any additional appreciation their investment has experienced since it was placed in the fund.
Source: Commercial Real Estate Loans and Multifamily Loans
What are the risks associated with investing in Opportunity Zones?
The main risk associated with investing in Opportunity Zones is that the investor may not be able to take full advantage of the tax benefits if they need to use their funds within a few years. According to Commercial Real Estate Loans, it's generally recommended that investors have a minimum 10-year investment horizon in order to take full advantage of the tax benefits. Additionally, investors who wish to start their own Opportunity Fund should have at least $1 million in assets to invest, as the operational and administrative costs of opening a fund may negate the potential tax benefits.
What are the requirements for investing in Opportunity Zones?
In general, most experts believe that it’s not worth investing in an Opportunity Fund unless you have a minimum 10-year investment horizon. This way you can take full advantage of all of the tax benefits of Opportunity Fund investing. Therefore, if an investor is elderly, in poor health, or may need to use their funds within a few years, investing in an Opportunity Fund may not be the best choice. For commercial or multifamily real estate investors who wish to start their own Opportunity Fund, it’s generally recommended that they have at least $1 million in assets to invest. Otherwise, the operational and administrative costs of opening a fund may negate the potential tax benefits.
How do Opportunity Zones compare to other tax deferral strategies?
Opportunity Zones offer a unique tax deferral strategy compared to other tax deferral strategies. Investors who invest in an Opportunity Fund within 180 days of their sale may defer capital gains taxes until they sell their investment or by December 31, 2026, whichever occurs first. In addition, investors who keep their money in an Opportunity Fund for at least 5 years will receive a 10% reduction of their capital gains tax liability, while those who keep their investment in the fund for at least 7 years will receive an additional 5% discount, for a total 15% capital gains tax discount. And, in what may be the most appealing element of Opportunity Fund investing, investors who keep their money in an Opportunity Fund for at least 10 years will not have to pay any capital gains taxes on any additional appreciation their investment has experienced since it was placed in the fund.
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What are the tax implications of investing in Opportunity Zones?
Investing in Opportunity Zones can provide investors with three main tax benefits. According to Commercial Real Estate Loans, investors may defer capital gains taxes until they sell their investment or by December 31, 2026, whichever occurs first. Additionally, investors who keep their money in an Opportunity Fund for at least 5 years will receive a 10% reduction of their capital gains tax liability, while those who keep their investment in the fund for at least 7 years will receive an additional 5% discount, for a total 15% capital gains tax discount. Lastly, investors who keep their money in an Opportunity Fund for at least 10 years will not have to pay any capital gains taxes on any additional appreciation their investment has experienced since it was placed in the fund. According to Multifamily Loans, Opportunity Funds can self-certify, meaning that they do not specifically need to be approved by the government.