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What’s the Difference Between 1031s and QOZs?
Managing real estate investments over the long term can be a testing experience. It is not really set and forget, as there are running costs involved, bills, charges, and multiple taxes that need to be paid. When everything has gone well and you liquidate your property, you’re hit with a significant capital gains tax bill.
Whether you need this money for a new opportunity or simply want to maximize your returns in the long run, the ability to minimize and defer inevitable taxes is a powerful tool to have at your disposal.
1031 Exchanges and Qualified Opportunity Zones (QOZs) are both tools used by intelligent investors to generate superior flexibility and advantaged positions in their tax liabilities over the long term.
Understanding how to leverage each vehicle is critical to getting the most out of them as they each have specific requirements, rules, regulations, and timelines that need to be met.
Here we will take a look at the brief differences between the two, particularly in regards to the key timelines for each.
Why an investor would be interested in each vehicle
Since each investment vehicle has different requirements and features, it pays to understand what each one is before diving into the timelines of key events.
1031 Exchanges are one of the best ways to defer taxes on real estate investments and transactions. They don’t eliminate the tax, but they shift when it is assessable and therefore payable. In a perpetual cycle, this can go on and on, having potentially significant intergenerational benefits too. How? 1031 Exchanges involve selling one property while buying another. Since the investor never pocketed any profits and instead rolled them into the new property transaction, there is no taxable income.
This property can also be sold using a 1031 Exchange or eventually sold without one when the taxes become due. The investor is essentially swapping property following the guidelines set out by IRS code Section 1031.
QOZs are another vehicle designed to incentivize investors to roll over their capital gains to invest in the growth and renewal of underserved communities across the country. Their aim is to encourage economic development by making it tax-effective to invest in real estate, infrastructure, and even small businesses in these zones.
They do this by temporarily deferring due capital gains taxes until the end of 2026 and also reduce total taxes owed the longer the investment vehicle is held. It’s a socially responsible way to invest tax effectively and potentially generate additional returns in real estate over time.
1031 Exchange timelines and identification rules for investors
There are critical dates to remember when identifying a potential 1031 Exchange investment opportunity. When the investor’s initial property is sold, the proceeds are transferred to the qualified 1031 Exchange provider.
They then have up to 45 calendar days from that date to identify up to three replacement properties that may be purchased and the funds redeployed into. Then, the investor must close on one or more of these properties within 180 days of the sale of the original property OR by the due date of their tax return for the year when they made the sale.
It’s also possible to complete a 1031 Exchange in the reverse order. That is, an investor could purchase a property before selling an existing one. The timeline is the same – identify the saleable property within 45 days of purchase and sell it within 180. Keep in mind that there are limitations – the new property must be purchased for as much or more than the previous one was sold. Investors can also only transfer to a similar kind of property. For example, a residential investment may be sold to fund only another residential property investment.
As a further example, say an investment firm sells its industrial property on September 1, 2021, for $10 million. It will need to find three suitable replacement industrial properties worth at least $10 million by October 15. Then the purchase of one or more of those properties must be complete by February 22, 2022.
QOZ timelines and general steps for investors
The process to invest in a QOZ is similar to a 1031 Exchange as the investor is relocating their proceeds into a new asset. There is a range of requirements, but, at a high level, the investor must go through an approved Opportunity Fund which is set up to invest in a valid Opportunity Zone (QOZ) and adhere to the associated timing rules. As with 1031 Exchanges, the investor must reinvest their funds into the Opportunity Fund within 180 days of the sale of their property.
Once the Opportunity Fund has purchased a property, the next relevant date is December 31, 2026. The investor can defer payment of capital gains taxes until no later than this date or the date that they withdraw or pull their funds from the fund. Furthermore, if the investor holds their investment in the QOZ for five years or more, their tax payable is reduced by 10%, and if held for seven or more, 15%. When held for ten years or more, there is no tax payable on any appreciation on reinvested capital that was a result of the QOZ.
December 31, 2028, is the last day QOZ’s are investable, and December 31, 2047, is the final day the QOZ investment can be held (it must be sold).
HUDSONPOINT Capital makes tax-deferred investments simple
1031 Exchanges often suit investors who want to manage their own property, while QOZ’s appeal to investors who believe opportune property developments are the way to go, as well as the positive social impact. Investing in QOZ’s and 1031 Exchanges can sound like a daunting task, and it often is. Discovering where to invest, the legal and compliance implications, as well as the time involved can make both options seem out of reach.
HUDSONPOINT Capital acknowledges this concern. We’ve put together a range of passive investment funds that take the headache out of the process. Often these types of investments require significant capital and are out of reach for the average retail investor. Through our strategic partnerships we have access to options, including QOZ’s and 1031 Exchanges via DSTs (Delaware Statutory Trust).
To learn more about how to invest in 1031s and QOZs, CONTACT US TODAY or visit our Learning Center.
IRC Section 1031 is complex tax language, therefore you should consult your tax or professional for details regarding your situation. There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal.
It is not intended and should not be construed or relied upon as legal or tax advice. No tax benefits are guaranteed as a result of investing in a Qualified Opportunity Fund. Potential investors should consult their tax advisers with respect to the U.S. federal income tax consequences of an investment in a Qualified Opportunity Fund.
This is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation of any products or services. Opinions are subject to change with market conditions. The views and strategies may not be suitable for all investors and are not intended to be relied on for legal or tax advice.
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