What’s the Difference Between 1031s and QOZs?

What’s the Difference Between 1031s and QOZs?

Before 2017, real estate investors had limited options to defer paying taxes, and a majority used 1031 like-kind exchanges to swap real estate assets without triggering taxable gains. Then Congress passed the Tax Cuts and Jobs Act in December 2017, presenting the real estate market with a new tax-saving opportunity: the creation of Qualified Opportunity Zones (QOZs).

Congress established Opportunity Zones to encourage long-term investments, especially in low-income urban and rural areas. The intention was to boost economic development and job creation in these distressed areas.

In many ways, the tax advantages of both Qualified Opportunity Zones and 1031 exchanges are similar. However, investors need to understand the key differences to minimize taxes best.

 

A Quick Overview of Opportunity Funds and the 1031 Exchange

1031 Exchanges (or like-kind exchanges) enable investors to defer paying capital gains tax on a property sale by reinvesting proceeds into a replacement property. This process is sometimes called “swapping.” A 1031 Exchange allows an investor to preserve the gross equity earned from a real estate investment, which increases their buying power.

Qualified Opportunity Zones (“QOZs”) are economic investment vehicles that provide tax incentives to real estate investors who roll over their capital gains to invest in the growth and revitalization of underserved communities. Investors use qualified Opportunity Funds (“QOFs”) to facilitate investments in opportunity zones that help improve these regions while also providing investors with specific tax advantages.

 

How are Opportunity Zones and 1031 Exchanges Similar?

• Both are instruments instituted into the United States tax code to spur economic growth.
• Both provide opportunities for investors to defer and/or avoid taxes for capital gains and impose a 180-day limitation on the time taxpayers have to complete the investment.
• Both allow investors to extend deferral across multiple sales, given that they keep rolling the net proceeds into other qualified investments. (Although, under current law, QOF tax benefits go away after 2026).

 

How are Opportunity Zones and 1031 Exchanges Different?

While certain similarities may help real estate investors feel as if they can really “go either way” when it comes to choosing which investment vehicle is most tax-efficient, there are some big differences between the two as well that should be considered.

 

The Bottom Line

1031 exchange was once the only tax-deferring instrument available. With the arrival of QOZs under the Tax Cuts and Jobs Act of 2017, investors now have a new option. And while both vehicles are comparable in that 1031 exchanges and investments in Qualified Opportunity Zones provide tax incentives for real estate investors, essential differences separate the two investment vehicles.

 

Common 1031 exchanges may be more suitable for real estate investors who understand what they want to buy, want to control and manage their own property, or want to invest in a simple triple net lease site. Conversely, opportunity zones may work for someone who thinks development provides a greater potential return on investment or wants to defer gain realized on a non-real estate investment. Additionally, QOFs could help investors interested in investing in a portfolio of properties rather than one or two.