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 Zones Program outlined in the 2017 Tax Cuts and Jobs Act, there is definitely another potentially compelling tax strategy to consider for all investors. The key consideration should be the length of time an investor is looking to invest, as that is the ultimate benefit of investing into a QOF, for investors looking to maximize long term investments of ten years or longer. There are some key considerations real estate investors should evaluate when contemplating which program works best for their portfolio.
BENEFITS OF A QUALIFIED OPPORTUNITY FUND “QOF”
1. MUCH MORE FLEXIBLE TYPE OF INVESTMENT: 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.
2. ABILITY TO INVEST INTO A NEW ASSET CLASS: The opportunity zone program provides real estate investors the ability to diversify a portion of their existing real estate investment into another asset class and different markets set to appreciate in the next decade. 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.
3. ABILITY TO DIVERSIFY YOUR PORTFOLIO: 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.
KEY BENEFITS OF A 1031 EXCHANGE
1. 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.
2. 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.
3. ESTATE PLANNING BENEFIT: 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.
Ultimately, the decision as to which investment strategy works better rest in the hands of each investor in relation to their current portfolios, they short or long term goals, and the incentive they wish to capitalize on. Either way, the real estate investor now has two attractive, tax-efficient options to consider and will do so until the end of 2026 if they are interested in QOF investments.